Used wisely, ‘Key Person’ and ‘Buy-and-Sell’ policies can ensure a satisfactory outcome for both your heirs and your business partner(s). Read on to find out how…
Contrary to popular belief, there’s more to effective estate planning than simply preparing a will. Effective estate planning is a complex endeavour with many moving parts. Arranging all the moving parts is the only way of ensuring the effective management and implementation of your wishes after your death.
This blog will look at two insurance products that can play a vital role in effective legacy planning for business owners, business partners, employees and heirs.
Clients face various risks in their personal and business endeavours. One important consideration should be managing the risk your partner(s) or business associate(s) may face after your demise. Value is often tied up in human capital, and the death or disability of a partner, shareholder or key employee can have a dramatic impact on the business’s profitability. Finding a replacement employee and/or buying out a partner’s shareholding from their estate can be a costly exercise.
The effects on the deceased’s loved ones can be equally devastating. Not only do they have to adjust to the sudden loss of a loved one, but they may also be expected to assist with a business they know nothing about. It only makes sense to ensure that the risks associated with these possibilities are planned for, and that funds are available to lessen the financial impact of the death of a shareholder or employee.
Consideration #1: Key Person insurance
A Key Person policy is used when a business has an insurable interest in the life of a person whose death, disability or illness may harm their business interests. A Key Person policy is normally a life insurance product taken out and paid for by the business. The business will be the policyholder, with certain added tax benefits attached to the premiums paid and proceeds from the policy.
The value of the cover should reflect, as accurately as possible, the value the employee brings to the business. When the insured dies (or, in certain cases, falls ill or is disabled) the proceeds of the policy can be used to cover the costs of recruiting and/or training a new employee, without impinging on the profitability of the business.
This risk management may take the form of:
- Securing an overdraft account in the name of the company or entity concerned
- Securing a personal guarantee made by a director
- Repaying a shareholder’s loan
- Providing security for a mortgage bond
- Obtaining liquidity as a contingency for future business endeavours
- During the life of the employee: Income Tax: Section 1 of the ITA deals with the calculation of annual “gross income”. The policy agreement and section 11(w)(ii)(dd)(A) will be considered when attending to income tax. The premiums paid and contingency protection will dictate the application of any tax deductions. The cash flow of the company may order the choice of a premium which is tax-deductible or non-deductible.
- The demise of the Key Person: Estate Duty: In terms of Section 3(3)(a) of the Estate Duty Act, life insurance policies should form part of the deemed property when calculating the dutiable amount of the estate unless the provisions set out in Section 3(3)(a)(ii) of the Act are met. The policy proceeds should not be included as a dutiable amount in the deceased’s estate.
- Paragraph 55 in the 8th schedule of the ITA provides relief from capital gains taxes payable on the proceeds of the Key Person policy (provided several requirements are met).
Consideration #2: Buy-and-Sell policies
Buy-and-Sell policies differ from Key Person policies in that they are specifically geared to cover the cost of buying out the share of a business owned by a deceased partner or shareholder. A Buy-and-Sell policy’s primary purpose is to “provide partners with the necessary cash to purchase the interest of the deceased”.
Typically, a contract is drawn up in which all partners undertake to sell their respective share of the business interest to each other on the date of their individual death. The contract must explain how the price payable will be determined. This form of business insurance is used to fund the Buy-and-Sell agreement between the parties involved, and is not reliant on an employment contract or relationship.
For income tax purposes, the policy premiums paid towards a Buy-and-Sell agreement may be deductible from gross income, if the premiums are paid by the company to the individual shareholder as a benefit.
The pay-out from a Buy-and-Sell policy is not subject to estate duty – provided several important requirements are met:
- The pay-out must be used to buy the business interest of the deceased person from their estate.
- The owner of the policy on the insured’s life must pay the insurance premiums from date of inception.
- No amount must be paid to the estate and/or a relative, a dependent or a family holding company.
Finally, no capital gains tax will be payable, provided the risk policies are used to fund the Buy-and-Sell agreement.
The general simplicity of this agreement and terms based on funding by life insurance may change due to the legal entity involved. Complexities often arise when the shareholders are not natural persons. If the shareholders are Trusts, or shares held by an affiliate company, financial planning advice from a Certified Financial Planner® should be obtained.
The bottom line
Although Key Person and Buy-and-Sell policies have different goals, they can both be used as tools to ensure the ongoing profitability and sustainability of a business. Used wisely they can be a fantastic way of managing estate duty consequences and safeguarding a business’s interests through non-indemnity insurance.
Sentinel International does not offer financial planning services or the sale of any insurance products. However, with more than 20 years of experience in the Fiduciary sector in South Africa, we are uniquely positioned to identify complex risks within your estate and business structure. We would love to give you a trusted professional reference to assist you in obtaining peace of mind when considering your financial and insurance planning.
Our Personal Income Tax Compliance Officers can assist in navigating the deductibility of annual premiums payable when attending to individual tax returns where company-owned policies are involved. Our Deceased Estates practitioners can also provide guidance and assistance in the event of death to help you to navigate the Estate Duty implications.
((LLB)NWU, Admitted Attorney)
- Botes E and Kloppers H “Insurable Interest as a Requirement for Insurance Contracts: A Comparative Analysis” 2018 African Journal of International and Comparative Law 130 – 154
- Botha et al – (eds) South African Financial Planning Handbook 17th ed (LexisNexis South Africa 2019)
- Davis BM, Benecke C and Jooste RD Estate Planning (LexisNexis Online March 2021)
- Estate Duty Act, Act 45 of 1955
- “ITA” –Income Tax Act 58 of 1962
- Reinecke MFB, Van Niekerk JP and Nienaber PM Insurance Part 1 -2 2nd Eds (Volume 12(1) & 12(2) ) LAWSA
- SARS Estate Duty Implications on Key Man Policies https://www.sars.gov.za/wp-content/uploads/Ops/Guides/GEN-ED-01-G02-Estate-Duty-Implications-on-Key-Man-Policies-External-Guide.pdf
- Ya-Fan Wong Article-ttps://dommisseattorneys.co.za/blog/key-man-insurance-policies-vs-buy-and-sell-agreements-which-is-more-appropriate-for-your-business/
 Botha et al p1054.
 Botha et al p1053.
 Ya-Fan Wong Article
 Section 11(w) of the ITA.
 Botha et al p1061 – 1062.
 Paragraphs 55(1)(a), (c) and (e) of the eight schedules of the ITA.