It is essential in the successful operation of any business that continuity and succession planning be addressed in the event of a member dying or becoming disabled. Very often, the most effective way to achieve this is with Buy and Sell and/or Key person insurance. However, many members, attorneys and advisors alike misunderstand the implications of the different policies and shareholding structures.

Key Person

Generally, Key Person insurance (Key-man cover), can be described as an insurance policy taken out by a business to compensate that business for financial losses that could arise from the death or extended incapacity of an important member of the business. This type of policy foresees that it may take some time to find and adequately train a new person to function in the same capacity as the previous member.

Buy and Sell

A Buy and Sell Agreement, which usually goes hand in hand with Key-man insurance, is also known as a Buyout agreement. The provisions of a Buy and Sell arrangement may be contained in a traditional shareholders’ agreement or a separate contract.

Essentially, it is a legally binding agreement between shareholders of a business that governs the situation if a shareholder dies or is otherwise forced to leave the business due to incapacity caused by accident or disease. In terms of a Buy and Sell agreement, the contract creates an obligation on the deceased/incapacitated shareholder to sell shares, and an obligation on the remaining shareholders to buy the shares, which transaction is funded by a life insurance or disability policy. In this context and for purposes of this article, the example used will be that of a deceased member.

It is important to note that on the death of the shareholder, shares held do not pass into the estate of the deceased, but are deemed to be sold preceding the date of death. Thus the remaining shareholders never relinquish their control of the deceased shareholder’s shares. It is an essential part of a Buy and Sell arrangement to understand that control of the business remains with the remaining shareholders at all times.

Death and Taxes

On death specifically there are a number of tax implications for business owners generally, as the life insurance policy or key-man policy may form part of the deceased’s estate as “deemed property” in terms of section 3 of the Estate Duty Act 45 of 1955.

However, if these policies meet certain requirements they are exempt from Estate Duty:

  • If the policy was acquired by a person who was, at the time of the deceased’s death, a member or shareholder or partner in the business with the deceased;
  • In case of a Buy and Sell policy, a valid and binding Buy and Sell contract, or similar provision in terms of the Shareholders Agreement;
  • If the policy was taken out for the purpose of acquiring the deceased’s share in the business;
  • If no premium was paid or borne by the deceased.

Thus if the policies are structured correctly, taken out on the life or a member, partner or shareholder who holds shares in his/her personal capacity and, essentially, paired with a correctly drafted Buy and Sell Agreement, the proceeds of the policy will be exempt from the claws of the Estate Duty Act.

However, what about the tax implications where a shareholder in a business is a trust?

The situation according to the South African Revenue Services tax directive, 27/5/20078, where shareholders are trusts, is that the exemption regarding estate duty will not apply, because the shareholder is not the trustee on whose life the policy will be taken out, but the trust. Accordingly, the proceeds of the policy paid in terms of a Buy and Sell Agreement where shares are held in trust will not be exempt from Estate Duty, meaning the amount will be included in the deceased’s estate for estate duty calculation.

The result of this is that, should shares be held in trust, the financial advisor will need to include in his/her calculation of requisite policy proceeds, an amount for estate duty.

It is therefore of fundamental importance that where trusts are used for estate planning, clients are advised by attorneys specialising in the field in order to facilitate the most suitable solution and avoid unforeseen consequences.