Buy/Sell Agreements or Put and Call Option agreements (as they are also referred) are agreements used in the context of business succession to allow for an equity holder’s (Equity Participant’s) estate to be paid out in the event of the their death or disablement. They are commonly used in conjunction with an appropriate policy of insurance (Insurance Policy) to provide certainty for a business on the death or disablement of an Equity Participant. It is not usual for Security Holders Agreements to deal with the death of disablement of an Equity Participant as their scope is usually limited to the operation and control of the Enterprise.
Buy/Sell Agreements can be used in a wide variety of entity types where a few Equity Participants hold the majority of the equity in the business (Enterprise). A Buy/Sell Agreement is applicable where the equity held in a variety of business structures including (but by no means limited to) traditional partnerships, a unit trusts, a proprietary company or other hybrid form of entity.
What is a Buy/Sell Agreement?
Buy/Sell Agreements and Put and Call Option Agreements are used to formalise arrangements where a major Equity Participant dies or becomes permanently disabled and the remaining Equity Participants need to buy the equity from the estate of the deceased. The Put and Call Option can work in either of the following ways:
- where the surviving Equity Participant(s) can force the deceased owner’s Executor or Personal Representative to sell its interest in the Enterprise by exercising a Call Option; or
- where the deceased Executor or Personal Representative can compel the purchase of their interest by the continuing Equity Participant(s) owners by exercising a Call Option.
In each case the exercise of the option stems from the occurrence of a “Triggering Event“. Generally Triggering Events are death or total and permanent disablement of an Equity Participant and are capable of being insured against.
Capital gains tax implications
It is important to consider the capital gains tax (CGT) position of Buy/Sell Agreements to ensure that a CGT Event is not crystallised on the execution of the Agreement itself, but at the point in time when a Triggering Event occurs.
This is achieved by drafting a Buy/Sell Agreement as a Put and Call Option Agreement in order to avoid the position that the execution of the contract itself creates a CGT Event.
Insurance Policy Ownership
Before the terms of the Buy/Sell Agreement can be adequately considered and drafted, the question as to who is to own the Insurance Policy must be answered.
Because of the various parties that may own equity in the Entity, there are various options for the ownership of an Insurance Policy. The ownership of the Insurance Policy will raise issues various taxation questions which need to be considered in light of the tax deductibility of the premium payments themselves. These options for ownership can be classified as follows:
Insurance Trust;
Cross ownership;
Individual ownership;
SMSF ownership; or
Group Insurance Policy.
Insurance Trust
Under this approach an Insurance Policy is obtained by a Trustee(s) for the benefit of the Equity Holder(s). Care needs to be taken to ensure that multiple Trustees are appointed and that the Trust Deed contains a separate power of appointment to allow for the death of a Trustee.
On the occurrence of a Triggering Event, the proceeds of the insurance policy go to the Insurance Trust where a Memorandum of Wishes provides guidance to the Trustee(s) to pay the proceeds to the surviving Equity Participants beneficiaries.
It is generally considered that this method of giving effect to the Buy/Sell Agreement has no adverse tax consequences.
Cross ownership
In situations where there are two or more Equity Participants in the Enterprise it is usual for there to be cross ownership of the Insurance Policy where each Equity Participant is the beneficial owner of the Insurance Policy over the others life.
Consider the situation where X and Y are the owners of a stable Enterprise and execute a Buy/Sell Option Agreement and take out a Policy of Insurance in each others name. If a Triggering Event occurs, an Equity Participant will receive the proceeds of the Insurance Policy which can be used to pay out the estate of the other Equity Participant as provided in the Buy/Sell Agreement.
Are there adverse CGT consequences?
Arguably a CGT Event has occurred as the CGT Asset in the form of the Equity Holders interest in the Enterprise has materialised. Section 118-300 ITAA 1997 provides that:
a capital gain or capital loss you make from a CGT event happening in relation to a CGT asset that is your interest in rights under a general insurance policy, a life insurance policy or an annuity instrument is disregarded in the situations set out in this table.
Paragraph 4 of Section 118-300 provides that the proceeds are tax free where the entity acquired the policy of insurance for no consideration. This situation can apply where a Triggering Event occurs and the proceeds of the Insurance Policy are used by the Enterprise to buy the equity of the outgoing owner to the remaining Equity Participants. This approach however is problematic where it’s likely that new Equity Participants are added or removed from the Enterprise because of expansion or retirement.
Individual ownership
Individual ownership of an Insurance Policy is considered the simplest approach however the cost of the premiums are generally not deductible the individual Equity Participant.*
The idea is that each Equity Participant has the Insurance Policy in the name of the person or entity which holds the equity in the Enterprise. If a Triggering Event occurs then the Buy/Sell Option Agreement stipulates that each Equity Participant agrees to sell their interest in the Enterprise to the remaining Equity Participants.
Despite the simplicity, and the “non-deductible nature of the premiums, the following also need to be considered:
- the amount of cover needed to:
- fully discharge the deceased Equity Participant’s liabilities in the Enterprise:
- the value of the equity in the Enterprise;
- This method also provides more readily for changes in ownership of the Enterprise.
SMSF owned
This option involves individual Equity Participants using their self managed superannuation funds (SMSF’s) to own individual Insurance Policies. This of course will depend on the terms of the SMSF’s Trust Deed and various other compliance issues.
Group insurance
This option involves taking out a in Insurance Policy to cover all the Equity Participants on the occurrence of a Triggering Event. If this occurs the remaining Equity Participants are provided with the liquidity to “buy-out” the equity held by the decreased participants estate.
This option may on the surface appear to be simpler, however a number of issues need to be addressed after the occurrence of the Triggering Event including:
- amending to the amendment of the Entity’s governing documents;
- removing the deceased Equity Participant from the contingent liabilities – for example where a personal guarantee may have been provided;
- factoring into the Insurance Policy the likely cost of the CGT (with the end result being that it may or may not be sufficient); and
- reviewing the amount of cover on an annual basis to ensure that it is sufficient to cover the valuation of the Enterprise.
Further Information
NB Commercial advises individuals and organisations on their business succession issues. To ascertain how NB Commercial Law can assist you to prepare a Buy/Sell Agreement or to assist with your business succession issues, contact us for an obligation free and confidential discussion.