Jane, Peter and Jeff are co-owners of a successful business. Jeff contracted a serious disease and died soon after. He left his share of the business to his wife, Amy.
Many years prior to Jeff being diagnosed with the illness, the business had taken out $200,000 of life cover on each partner for use as business ownership protection. However, no buy/sell agreement was put in place. After Jeff’s diagnosis, he was unable to obtain more life insurance.
Over the years, the business had grown significantly where Jeff’s share was valued at $780,000 on his death. The partners had not reviewed the insurance policies to maintain the cover levels in line with the increasing value of the business. This left Jane & Peter with a $580,000 shortfall to pay out Amy.
Jane & Peter were therefore left with a number of unpalatable options, including:
- Accepting Jeff’s wife as a co-owner. The problem here is that Amy has no skills to help in the business. So Jane & Peter would be doing all the work and giving a third of the profits to Amy.
- Or Jane & Peter could find a third party to buy the business and use that money to pay out Jeff’s wife – but there aren’t any obvious takers that Jane & Peter know already. So they would have to take on a new partner who they don’t know – possibly leaving them vulnerable to someone they won’t get on with.
- Another option is to sell the business and pay out Jeff’s wife from the proceeds. The problem here is that, without Jeff, the value of the business is a lot less. It is not the best time to be selling. In any case, Jane & Peter both love the business and don’t want to sell.
- The final option is to get Amy to agree to receive the initial $200,000 and then receive regular payments under a vendor terms arrangement. The problem here is that Jane & Peter are effectively in business with Amy until she is finally paid out. This also means the business needs to generate Amy’s payment and pay it in addition to the existing costs of running the business.
Jane & Peter had numerous meetings with Amy and, rather than let the business fold, Amy agreed to the following:
- Receive the $200,000 insurance payout
- Receive $9,000 per month, indexed each year for inflation for the next five years
- At the end of the five years, subject to a valuation of the business, the payments would continue or Jane & Peter could pay a final lump sum.
A better solution
It’s too late now, but Jane, Peter & Jeff should have put a buy/sell agreement in place from day one. They could have funded it with an insurance policy that covers death, and serious illness or disablement. Plus they could have obtained a valuation of the business from their accountant annually and adjusted the insurance sums insured accordingly. As a result, on Jeff’s death, Jane & Peter could have paid Jeff’s wife the agreed amount and Jane & Peter would then have owned the business outright.
The insurance cover required for death, TPD & trauma of $780,000 for each partner would cost each year:
This is based on the following parameters:
- Jane age 42, Peter age 40, Jeff age 38.
- Business valuation: $2,340,000.
That’s a total of $10,381* or just 0.44% of the business’ turnover.
What is business estate planning?
Business estate planning is the process of arranging your business affairs now to help ensure there is no unnecessary deterioration or loss of continuity in your business should it lose you or one of the other owners or other key people through illness, injury or death. With appropriate business estate planning, there should be less risk of:
- A departing owner, or their spouse or estate, taking legal action over a valuation or pay‐out figure
- A departing owner’s spouse or child deciding – against the wishes of the continuing owners – to become an active partner of the business (rather than taking a pay‐out)
- The departing owner’s spouse or family taking their legal right to claim a share of the business profits without having to work in the business
- The control of the business or its assets being frozen due to legal difficulties created by the departing owner, or their spouse or estate.