Are You Protecting Your Business? Understanding Key Person Insurance and Buy/Sell Insurance
Are you prepared if something was to happen to you, or your business owners, tomorrow?
If you are a business owner, you’ve worked hard to get to where you are today. And you undoubtedly want to protect your business.
When it comes to understanding the various insurance options out there, it can be hard to know what is best for you. So, let’s break down arguably two of the most important insurance options designed to protect both the interests of the owners, and the business itself.
Key Person Insurance
Key person insurance protects the business from financial loss, because of someone integral to the business, or a ‘key person’, passing away, becoming disabled, or suffering a serious illness.
For example, this is often a founder, C-suite executive, or highly skilled employee.
Key person insurance helps to provide the funds to placate the situation. This may look like hiring a replacement, paying off creditors, or covering lost revenue.
The Buy/Sell Agreement
A buy/sell agreement is a business succession arrangement that establishes what will happen to an owner’s interest in a business following specified events. It intends to protect ownership continuity of a business should a shareholder, partner, or unit owner pass away, become disabled, or suffer a serious illness.
Whilst the buy/sell agreement sets the plan for this ownership transfer, the insurance represents the funding backing the plan.
Buy/Sell Insurance
In summary, buy/sell insurance (sometimes referred to as Shareholders Agreement Funding) helps to provide the money facilitating the transfer of business interest. It can:
- Provide funding to buy out ownership.
- Protect remaining co-owners from undisclosed ownership changes and consequent disputes.
Example: Two siblings own the family business
Scenario:
A brother and sister each own 50% of a family manufacturing company. Both work in the business and want it to remain operational if something happens to either of them.
They establish a buy/sell agreement setting out what happens if either owner dies or becomes permanently disabled. They also arrange appropriate insurance to help fund the transfer.
If the brother passes away:
Without an appropriate succession arrangement, a deceased owner’s shares may form part of their estate and could ultimately pass to their beneficiaries. This could leave the surviving owner in business with the deceased owner’s family or other beneficiaries, depending on the circumstances. You could potentially end up with:
- Sister: 50%
- Brother’s estate/ultimately beneficiaries: 50%
The sister is effectively co-owning the company with people who may have never worked in the business.
So, a buy/sell agreement helps to ensure the surviving sibling can potentially retain control of the business while the deceased owner’s estate receives value in exchange for their business interest.
Potential Tax Implications: Capital Gains Tax
The structure of a buy/sell agreement can also have tax implications. For example, transferring shares or another business interest under the agreement may trigger capital gains tax (CGT). The timing and tax treatment can depend on how the agreement and transfer are structured, so appropriate legal and tax advice should be obtained when establishing a buy/sell arrangement.
Key Person vs Buy/Sell Insurance
Whilst the trigger event for buy/sell is related to the owner, key person is related to a key person of the business, not necessarily an owner.
For a more detailed breakdown, refer to the table below.
| Key Person Insurance | Buy/Sell Insurance | |
|---|---|---|
| Purpose | Helps protect the business from the financial impact of losing a key person. | Helps fund the transfer of a business owner’s interest following an agreed event. |
| Who is insured | A key person whose death, disability or serious illness could financially affect the business. This may be an owner, director or important employee. | Generally a business owner whose ownership interest would be transferred under a buy/sell arrangement. |
| Who it protects | Primarily the business. | Supports business succession arrangements and the interests of the parties involved. |
| Types of cover | May include life, TPD and/or trauma insurance depending on the circumstances. | May include life, TPD and/or trauma insurance to help fund specified succession events. |
| How funds may be used | To help manage financial disruption such as lost revenue, replacement costs or other financial obligations. | To help provide funding associated with the transfer of an owner’s business interest. |
| Ownership focus | Protecting the financial position and continuity of the business. | Managing what happens to an owner’s shares or other business interest. |
| Legal requirements | Key person insurance is not generally a legal requirement for Australian businesses. However, it may be required under particular commercial arrangements such as lending or contractual agreements. | Buy/sell insurance is not generally a legal requirement. A buy/sell agreement is a legal arrangement and should be appropriately documented. Insurance may be used to fund the obligations created by that agreement. |
| Example | A business insures a director whose expertise and client relationships are critical to its revenue. | Two shareholders agree that if one dies, their interest can transfer to the surviving owner with insurance helping fund the arrangement. |
Quick FAQs
Exploring Your Insurance Policy Options
The cost and suitability of key person and buy/sell insurance will depend on factors such as the insured person’s age, health and occupation, the level of cover required, the types of cover selected, such as life, TPD or trauma, and how the policy is owned and structured.
You should understand the different types of insurance, and which ones your business needs.
| What may trigger the insurance | How it can support Key Person Insurance | How it can support Buy/Sell Insurance | |
|---|---|---|---|
| Life insurance | Death (and potentially terminal illness, depending on the policy) | Provides a lump sum that can help the business manage the financial impact of losing a key person, such as lost revenue, replacement costs or financial commitments. | Provides funding that can help facilitate the transfer of a deceased owner’s business interest under a buy/sell arrangement. |
| TPD insurance | The insured person meets the policy’s definition of Total and Permanent Disability | Provides a lump sum that can help the business adjust if a key person is permanently unable to work. | Provides funding that can help facilitate the transfer of an owner’s business interest if they become totally and permanently disabled and the relevant conditions are met. |
| Trauma / Critical Illness insurance | The insured person experiences a specified medical event covered by the policy | Provides a lump sum that may help the business manage the financial impact of a key person’s serious illness or absence. | Depending on the arrangement, may provide funding to help facilitate an ownership transition following a specified serious illness or medical event. |
We’re Here to Help
Regular reviews of your insurance policies are crucial to ensure they align with underlying agreements and consider any potential tax implications.
Common issues can arise when a buy/sell agreement does not have appropriate funding, business valuations or cover become outdated, or the legal and tax implications of the arrangement have not been properly considered.
At Aintree Group, regular reviews across our integrated financial, legal and tax teams can help ensure your policies and underlying arrangements continue to reflect the needs of your business and its owners.
Helpful Resources
- Succession plan template: https://business.gov.au/planning/business-plans/develop-your-succession-plan
- Workforce plan template: https://business.gov.au/people/employees/workforce-planning
- Find the right insurance for your business: https://business.vic.gov.au/business-information/protect-your-business/find-the-right-insurance
This is general advice only and has not been prepared with your individual situation or needs in mind. For personalised advice, we highly recommend that you seek professional guidance from a qualified adviser.
