Business Succession

A weakness in many business arrangements is the failure to address business succession issues in the event of an involuntary or voluntary departure by a principal of the business. Failure to deal satisfactorily with this fundamental business management issue can lead to expensive litigation, loss or diminution of a valuable asset (ie the equity in the business), or even the failure of the business itself, eg because the continuing principals are unable to finance the buy-out of the exiting principal.

Unfunded business succession arrangements can be addressed in a separate, but related, partnership, unitholders' or shareholders' agreement. Where the departure is involuntary, eg because of the death, total and permanent disablement or traumatisation of a principal, in many cases the solution is to find funding mechanisms such as the various forms of insurance. A typical form of a business succession (or equity insurance) agreement is where the departure arrangements have been fully funded by insurance.

Ideally, such an agreement would not be finalised without the input of the business' key advisers such as accountants and financial planners, whose expertise will be necessary especially in relation to valuation of the business. There are also many critical capital gains and other taxation issues that need to be addressed if unnecessary tax liabilities are to be avoided.

A trustee can own the insurance policies. In view of the capital gains tax implications, the trustee will be acting as a 'bare' trustee in relation to the insurance proceeds: section 106 - 50 ITAA 1997. The use of a neutral trustee, such as a trustee company, can be particularly advantageous where there is tension between the continuing principals and either the exiting invalid principal or the relatives of a deceased principal.

Usually, the funded succession agreement can be structured without a trustee, using 'self' or 'cross' owned insurance arrangements which can be advantageous to the policy beneficiary, but may be a less attractive option for the other party, eg a surviving spouse wanting to enforce the agreement. Special care in relation to capital gains tax should be taken if ownership of the policies is held by a discretionary trust or a superannuation fund.

While cross ownership of life insurance policies does not present a problem in relation to capital gains tax as the proceeds are exempt under s 118 - 300 ITAA 1997, where trauma policies are in place, cross ownership of the policies should be avoided because the capital gains tax exemption only extends to the insured and defined relatives (see ss 118 - 15 and 995 - 1 ITAA 1997). The higher cost of trauma policies may also mean that a departure caused by a trauma may only be able to be partly funded by insurance.

Usually a funded succession agreement creates'buy' and 'sell' (or 'put' and 'call') options for its parties largely because of capital gains tax considerations - a disposal under this type of agreement would usually be a capital gains tax Event A1, s - 104 - 10 ITAA 1997. While an option agreement may avoid the interest in the business being disposed of as at the date of the agreement (rather than when the options are exercised) and give more opportunity for cost bases to be indexed, it does have the drawback of the parties, including the executor of a deceased principal's estate, needing to appreciate the significance of having to exercise an option.

Possible alternatives to buy - sell agreements include mandatory agreements which should be renewed on a regular basis, or condition precedent agreements. The capital gains and other tax implications, together with any ongoing tax developments, must always be carefully considered when preparing or reviewing business succession agreements.

Another crucial issue to be addressed in respect of trauma insurance is the possibility of the principal returning to full duties and having no further insurance cover for any subsequent trauma that might occur. For example an agreement may be out in place so that if a principal who returns to full duties within 12 months of the trauma will not take the proceeds immediately. Rather, the trustee will hold the proceeds on trust. The trust moneys will then form the funding for a subsequent involuntary or voluntary departure.

It is essential that related documentation dealing with voluntary and/or involuntary departure issues should also be reviewed or put in place at the same time as the business succession agreement for an involuntary departure.

Should you wish to discuss the matters raised in this article please call our office on (03) 9 457 5577 or contact us on info@glenister.com.au

DISCLAIMER
Please note that this information should not be relied upon for decision making or providing advice without seeking expert opinion. Glenister & Co exclude all liability relating to relying on this information.