Key-man insurance policies vs buy and sell agreements: Which is more appropriate for your business?

Key-man insurance policies vs buy and sell agreements: Which is more appropriate for your business?

INTRODUCTION

There is an important distinction between a key-man insurance policy and a buy and sell agreement. While they are both used in the context of ensuring the ongoing profitability and sustainability of a business in the event of the untimely death, severe disability or critical illness of a key business partner, their underlying purpose is different. We briefly unpack these differences below.

KEY-MAN INSURANCE

The value of a business is largely dependent on the input of key employees or partners in the business. The sudden loss of a key individual may put the business at serious risk. As such, a key person can be seen as someone whose absence (through death, disability or critical illness) will have a material adverse effect on the future of the business. What a key-man insurance policy seeks to do, is to protect the business in the event of the premature death of a key individual or if such key individual becomes disabled or critically ill. Such a policy is taken out and paid for by the company and upon the death, disability or critical illness of the key individual (who may or may not be a shareholder), the policy proceeds are paid to the company (rather than to the deceased estate in the case of a death of the individual). This provides the company with cash flow to enable the business to continue operations while a suitable replacement is found.

BUY AND SELL AGREEMENTS

A buy and sell insurance policy is typically used to fund a buy and sell agreement. The buy and sell agreement itself contains several important provisions to facilitate the orderly transition of ownership of the business, should one of the owners die prematurely, become disabled or critically ill, which provisions may include (amongst others):

  • What events may trigger a buy-out by the remaining shareholders – will it only be the death, disability or critical illness of the shareholder concerned, or will it include other events such as retirement or bankruptcy?
  • What shares each of the remaining shareholders are entitled or required to purchase – all shares or only shares of a specific class?
  • In what proportions the remaining shareholders will purchase the shares – pro rata or in a specified proportion?
  • How the buy and sell agreement will be funded – by way of an insurance policy or other method?
  • How the shares of the company will be valued.

Where a company has numerous shareholders, a buy and sell agreement provides the mechanism to provide for the funds that the remaining shareholders will need to acquire the deceased shareholder’s shares. This has an important bearing on the sustainability of the business as it may not always be a good idea for these shares to be passed on to the heirs – they may not necessarily have the skill set nor the desire to work in the business.

TAX IMPLICATIONS OF KEY-MAN POLICIES

The tax implications relating to the treatment of premiums paid and the proceeds received from a key-man policy are often overlooked. We discuss the various tax consequences briefly below.

Income Tax:

In terms of the Income Tax Act, 58 of 1962 (ITA), a company may be able to claim certain insurance premiums paid on the life of the key-person as a deduction. Whether the premiums could be deducted, will depend on whether the conditions and requirements as set out in the ITA have been met and in each case the particular policy wording will need to be reviewed in order to determine whether it is likely that a deduction will be allowed.

Estate Duty:

Section 3(3)(a) of the Estate Duty Act, Act 45 of 1955 (Estate Duty Act), includes the proceeds from a life insurance policy on the life of the deceased as “deemed property” of the deceased estate, if it meets the requirements of this section, irrespective of who the owner of the policy was or who paid the premiums. However, the full proceeds are not always included in terms of these deeming provisions. The section further provides that where the policy proceeds are not recoverable by the estate, but by the company, and the company also paid the premiums, only the amount by which the proceeds exceeds the total premiums paid plus interest thereon, is deemed to be the property of the deceased estate. However, section 3(3)(a)(ii) of the Estate Duty Act contains an estate duty exemption for these policies, resulting in them not being included as the deemed property of the deceased estate, provided all the requirements listed for the exemption to apply, have been met. If this is the case, no estate duty will be payable on the policy proceeds.

Capital Gains Tax (CGT):

In terms of paragraph 55 of the 8th Schedule to the ITA, the proceeds of key-man policies are exempt from CGT in the following instances:

  • where the person is the original beneficial owner of the policy;
  • where the person, whose life is insured, is or was an employee or director and any premiums paid by the person’s employer were deducted in terms of section 11(w) of the ITA;
  • where the policy is a risk policy with no cash or surrender value;
  • where the policy’s proceeds are exempt from income tax under section 10(1) of the ITA.

TAX IMPLICATIONS OF BUY AND SELL AGREEMENTS

Income Tax:

If the policy to fund a buy and sell agreement meets the requirements of section 11(w) of the ITA, the premiums payable may be deductible and the proceeds may be subject to income tax, again depending on the nature of the receipt.

Estate Duty:

The insurance policy to fund a buy and sell agreement must have been taken out for the purpose of buying out the interest of the deceased person, or a part of the interest – otherwise the policy will not be exempt from the “deemed property” and will be included in the deceased estate.

The deceased must not have paid any of the premiums of the policy. If a deceased has paid premiums on a buy and sell policy, it is likely to be regarded as the deemed property of the deceased and in which case it may not qualify for the exemption referred to earlier.

CGT:

If risk policies are used to fund the buy and sell agreement, the proceeds are exempted from CGT in terms of paragraphs 55(1)(a), (c) and (e) of the 8th Schedule to the ITA.

Any life insurance payments to the original beneficial owners and where no premiums were paid by the deceased, have always been exempted from CGT in terms of the 8th Schedule to the ITA.

If a deceased shareholder cedes his or her policy to a new shareholder, the policy ceded is a 2nd hand policy and historically gave rise to CGT consequences when the ceded benefit is eventually paid out, which is now alleviated by paragraph 55(1)(e) of the 8th Schedule to the ITA, subject to the policies being pure risk policies.

CONCLUSION

Replacement of a key individual or ensuring the orderly transition of ownership of a business (as the case may be) can take time. Although the memorandum of incorporation (MOI) or the shareholders’ agreement of the company may contain provisions on what should happen to the shares on the death or disability of a particular shareholder, they often do not take into account, the practical aspects involved. Additional funding and/or a separate buy and sell agreement is therefore required to ensure that all the necessary requirements and relevant processes are carefully set out and planned for. It’s important to note that, in terms of the Companies Act, 71 of 2008, no other agreement may supersede the shareholders’ agreement or MOI, so the company will need to ensure that if it is a buy and sell agreement they want to enter into, such agreement is properly aligned with the MOI and shareholders’ agreement.

SOURCES:

Mergers and amalgamations in terms of sections 113 and 116 of the companies act

Mergers and amalgamations in terms of sections 113 and 116 of the companies act

Corporate mergers and acquisitions play a significant role in many companies’ growth strategies. They are among the most effective tools utilised by forward thinking boards to scale and grow a business.

With the fast-paced society that we live in today and access to information being so readily available, businesses are scurrying to build shareholder value, taking advantage of potential complimentary industries and making the necessary corporate decisions to gain a bigger share of the markets they operate in.

Since the Companies Act, 71 of 2008 (as amended) (“the Companies Act“) came into effect on 1 May 2011, there has been a paradigm shift in the regulation of South African mergers and amalgamations.

The Companies Act introduced a new form of statutory merger which exists in addition to, and not in substitution of, the pre-existing methods used by companies wanting to effect business combinations, i.e. a sale of shares or a sale of business as a going concern.

The statutory merger is governed in terms of section 113 and section 116 of the Companies Act and the merger agreement is a mandatory requirement in terms of section 113(2).

In addition to each amalgamated or merged company passing the solvency and liquidity test in terms of section 113(1), section 113(2) provides further mandatory terms and conditions that must be addressed in the merger agreement, namely:

  1. the proposed Memorandum of Incorporation of any new company to be formed by the amalgamation or merger, must be included in the merger agreement;
  2. the name and identity number of each proposed director of any proposed amalgamated or merged company must be included;
  3. the manner in which the securities of each amalgamating or merging company are to be converted into securities of any proposed amalgamated or merged company, or exchanged for other property, needs to be detailed;
  4. if any securities of any of the amalgamating or merging companies are not to be converted into securities of any proposed amalgamated or merged company, the consideration that the holders of those securities are to receive in addition to or instead of securities of any proposed amalgamated or merged company;
  5. the manner of payment of any consideration instead of the issue of fractional securities of an amalgamated or merged company or of any other juristic person the securities of which are to be received in the amalgamation or merger;
  6. details of the proposed allocation of the assets and liabilities of the amalgamating or merging companies among the companies that will be formed or continue to exist when the merger agreement has been implemented;
  7. details of any arrangement or strategy necessary to complete the amalgamation or merger, and to provide for the subsequent management and operation of the proposed amalgamated or merged company or companies; and
  8. the estimated cost of the proposed amalgamation or merger.

Further to the above, a thorough regulatory investigation is required to ensure compliance with the relevant regulatory bodies and to ensure that the necessary consents and/or approvals are obtained (i.e. Takeover Regulation Panel approval or exemption, Competition Commission approval, etc.).

A compliant merger agreement, addressing all the requirements in terms of the Companies Act, is imperative for a successful merger. Should you need assistance perfecting a merger, don’t hesitate to give one of our lawyers a call.

Disclaimer. The articles on our website are provided for general information purposes only. We have taken care to ensure accuracy, however the content is not intended as legal advice. Always consult an attorney on your specific legal problems.

Service agreements: why they are necessary and what they should cover

Service agreements: why they are necessary and what they should cover

If you are a service provider of any kind, regulating your engagement with your customers is crucial to show potential investors how you have secured your revenue stream and managed your risk. Investors are going to be interested in how you protect your revenue stream. They will typically assess how “water-tight” your agreements are with your clients in order to determine business level risk.

A service agreement is an example of a revenue contract. This is the agreement that describes how your company generates revenue in return for delivering services and describes the fees which you charge.

Some key considerations for a service agreement are as follows:

  1. Description of your services:

It is important to accurately describe your services so there is clarity and certainty regarding what it is your customers are paying for. It can sometimes work well to describe the services by referring to your website which then provides for a full description of the services in greater detail. This has the advantage of allowing you to evolve your services over time, and change the specific terms and pricing on your website (on notice to the client).

  1. Duration of the agreement:

How long do you expect the service agreement to be in place? Depending on the nature of the services rendered, it may be for a specific period or ongoing. Whether the contract can be renewed and on what terms should also be carefully considered together with termination rights. You will want to ideally strike a balance between easily terminating the relationship when it no longer suits you while still attracting and maintaining a constant revenue stream without too much unexpected disruption.

  1. Risk provisions:

You should consider what warranties you are willing to make with respect to the quality or outcome of your services. This will be specific to your service offering but you should also consider the industry in which you operate and what your average client would expect. Your appetite for risk and the level of risk associated with your services should also determine what warranties will be offered. Another related consideration is what your liability to your clients should be, whether you will have any liability at all and how you manage this.

The other considerations which we discuss with our clients for the purposes of drafting their service agreements include service levels, payment terms, exclusivity, IP and license arrangements, data and privacy matters and whether there are any specific regulatory aspects applicable.

We provide a Service Agreement Package to start-ups and through this process we are able to prepare bespoke service agreements applicable and appropriate for each client. We can also assist with reviewing and updating existing service agreements, if you are not sure whether your existing contract is up to scratch.