Topic 5 Buy-and-sell Agreements

Question 1

Needs of parties addressed what are involved in a buy-and-sell agreement

Answer 1

1. Needs of remaining business owners in the event of the death or permanent disability of one of the owners
2. Addresses the needs of the deceased owner’s dependants and the needs of the disabled owner and their dependents

Question 2

The remaining owners need

Answer 2

1. Cash, in order to buy the deceased or disabled owner’s share
2. The right to buy the share from the executor of the deceased’s estate or from the disabled owner
3. If they don’t have sufficient cash, the executor mat offer the share to an outsider, like the deceased’s spouse

Question 3

Dependants

Answer 3

The dependants have lost their income, and they therefore need capital that could substitute the deceased or disabled owner’s income-generating capacity

Question 4

Basics of a buy-and-sell agreement

Answer 4

An agreement between business owners or between a business owner and a 3rd party in which the parties commit to the following:

1. That the remaining owner/3rd party will but the interest of the deceased/disabled owner 
2. That the deceased/disabled owner's interest will be sold to the surviving owners or 3rd party

Question 5

Effect of buy-and-sell agreement on sole proprietor

Answer 5

Sole proprietor can enter into agreement with one of their employees, or with another businessperson, so favorable estate duty treatment for co-shareholders is not allowed

It can also be between 2 sole proprietors with similar businesses, but they will not qualify for the favorable estate duty treatment

Question 6

Effect of buy-and-sell agreement on partnership, CC and companies

Answer 6

They can all make use of this agreement with the estate duty concession

Company or CC itself will not enjoy the estate duty concession if it becomes a party to the contract

Question 7

Clauses included in buy-and-sell agreement

Answer 7

1. An undertaking by the parties that the survivors will purchase the interest of the first-dying of the co-owners
2. An undertaking that the first-dying will, on their death, sell their interest in the business to the survivors
3. A formula to determine the market value of the deceased party’s interest and a clause to the effect that the purchase price will be equal to such market value
4. Agreement as to how it will be funded
5. An agreement on the procedure, if all the owners die simultaneously, etc.

Question 8

Elements of the agreement

Answer 8

1. Value of the business
2. Funding of the buy-and-sell agreement

Question 9

Value of the business

Answer 9

Businesses have to regularly redo the valuation to ensure that the cover to fund the buy-and-sell agreement is still adequate

Question 10

Funding of the buy-and-sell agreement

Answer 10

1. Investment fund
2. Life insurance

Question 11

Investment fund

Answer 11

Parties will invest money on a regular basis for a period of time.

However, this method is highly problematic, as one of the parties may die or become disabled long before sufficient funds have been built up to purchase the deceased’s share

Question 12

Life insurance

Answer 12

Best and easiest method, as funds are available immediately on the death of the life assured.

If agreement provides for the sale of the share or interest on permanent disability of owners, then disability should be added as an accelerator to the death benefit, and not as a stand-alone disability benefit

Question 13

How to structure the arrangement with life insurance

Answer 13

Not all owners participate in the agreement, but it may be agreed that they have to sell their event of death/disablement to cover the risk to the business

They then need to sign the official agreement that contains all the provisions

They also need to take out policies on each other’s lives, which covers the life of each partner participating in the scheme

Question 14

Income tax implications

Answer 14

Policies are usually not owned by the company but by the individual business owners on each other’s lives

The premiums are not tax deductible, and the proceeds will pay out tax-free to the policy owner(s)

Question 15

Estate duty implications

Answer 15

All amounts due and recoverable under a policy of insurance upon the life of the deceased will be included in the deceased’s estate as deemed property

Question 16

Estate duty exemption
Section 3(3)(a)(iA)

Answer 16

If the policy was taken out or acquired by a person who on the date of death of the deceased was a partner of the deceased or held any share or like interest in a company in which the deceased on that date held any share or like interest, for the purpose of enabling that person to acquire whole or part of:
(aa) the deceased’s interest in the partnership concerned; or
(bb) the deceased’s share or like interest in that company and any claim by the deceased against you that company, and no premium on the policy was paid or borne by the deceased

Question 17

Calculation of the cover required if a buy-and-sell policy is subject to estate duty

Answer 17

If policy doesn’t meet the requirements of section 3(3)(a)(iA), the proceeds of the policy will be included as deemed property in the deceased’s estate, provided of course that the deceased’s estate is liable for estate duty

The amount of the cover must be adjusted for estate duty

Cover required ÷ (1 - estate duty rate*)

Question 18

Capital gains tax implications

Answer 18

Buy-and-sell policies are some of the most frequently adjusted policies in the market due to the fact that the value of the business fluctuates.

Legacy policies other than pure risk policies are therefore likely to have already been phased out by the continuous updates and switches to other polices

Buy-and-sell policies are not pure risk policies, so they are not exempt from CGT