The article on Mistakes Buy and Sell Agreement and their funding policies
was written originally in 2008.
There has been a lot of demand for it continuously. Therefore, I have found an old copy and republished it (it too, was lost in the loss of information due to technical problems on the site).
I would also like to give thanks once again to Harry Joffe of Discovery for the information (2008).
If you already have a Buy and Sell agreement in place, or you are looking to put one in place, then this page is for you.
We utilise Discovery Life policies to fund for the Buy and Sell agreement, and for other Business Assurance needs.
These are the 10 basic mistakes that can happen in Buy and Sell agreements, and the policies used to fund the agreement.
- No signed Buy and Sell contract…
This means that there is no obligation to buy or sell on death or disability.
There is no value for the partners share of the business if it is eventually sold.
There is no exemption for Estate Duty, as there is no proof that the life assurance policy was intended for buy and sell purposes.
- Policies are company owned…
This will mean that the proceeds are Estate Dutiable.
There will be Secondary Tax on Companies when the company buys back the shares.
If done as a conforming policy, you will lose Income tax of 28%.
Therefore, 20% lost for Estate Duty, 28% for Income tax, 10% for STC. If no provision for this was made upfront, you sit with a real shortage of cash to buy the shares.
- Premiums are claimed as a tax deduction…
If the policies are not company owned , policies are non-conforming, then premiums are NOT tax deductible.
If your policy has been set up in error as a conforming policy, you would need to replace it.
- Company pays premiums , loan accounts are not set up properly…
In this situation, the individual partners own the policies, the company decides to pay the premiums for the policies on their behalf.
This causes individuals to have a debit loan account with the company, that should be settled EVERY month.
If this is left to year end, they have effectively received a taxable fringe benefit.
If the situation continues over a tax year, then the company has paid the premiums and not the individual, this is definitely a tax problem.
- The shares are overvalued in the Buy and Sell agreement…
“the purchase price of the Deceased’s equity in the company shall be the greater of:
An amount equal to the total net proceeds (after allowing for payment of any tax, duty or levy that may be due) of the policies of assurance; or the value placed on the Deceased’s equity by the auditors.”
If the purchaser pays more for the shares than they are worth, he will be making a donation. As the donor, he will have to pay Donations tax of 20%, even though he has paid over the proceeds. The South African Revenue Service could also look to disallow part of the policy for estate duty exemption, as it could be argued that the policy is not a legitimate buy and sell policy.
- The shares are undervalued in the Buy and Sell agreement…
This happens when the parties to the Buy and Sell agreement cannot afford the cost of the life and disability cover.
In this situation, the Deceased’s estate would be making a donation and would have to pay Donations Tax, this is in addition to the heirs receiving less than the business is worth.
A way to structure this situation is that the outstanding amount be paid off over a period of time. This must be specified in the agreement.
- What if you become disabled , and don’t die?
Allow for Disability in the Buy and Sell agreement and the policy.
Make sure that the definition of disability matches between the policy and the agreement.
If partial disability is allowed via the policy, you need to consider…will it trigger a pro-rata buying of shares?
- The share values are not updated, there is no clause in the Buy and Sell obliging parties to do this…
This could lead to the heirs only being paid what the Buy and Sell values the shares at, unless there is a clear clause in the agreement stating otherwise.
It is important that you value the business accurately and that the values are updated at least yearly… if not your heirs payout could be seriously undervalued.
- Shareholders agreement contradicts the Buy and Sell agreement, no provision for Interest on purchase…
Most shareholders agreements contain a short clause on buyout of shares on death and disability.
To avoid contradictions, you should consider removing it when the Buy and Sell is signed.
Every Buy and Sell should have an interest clause provision, for late payment. This should relate to late payment of outstanding purchase price, as well as late payment to purchase shares after receipt of the policy proceeds.
The Buy and Sell agreement should ensure that the partners buy each other out pro-rata to their current interests, in case the ownership percentage is not reflected properly.
- “No need for agreement, will be sorted out in the Will“…
There is a risk here… Wills can be changed at any time , the agreement can’t.
Consider… if the business goes to one family member… how do the others get compensated?
These are some of the pitfalls that one should be wary of when using life policies to fund a Buy and Sell agreement.
(July 2016- this information is still very pertinent).