One structure looks after the company and the other looks after the deceased’s family.
Many small businesses that run today are our own and although we are advised not to put all of our eggs into one basket as it is too risky, we have to, to ensure that our business is a success.
So, how do we protect our basket?
Business Protection covers two main types of consideration, and very often confusing as to the difference:-
- Keyman Protection
- Partnership or Shareholder protection
Key employee or keyman is a term used specifically for an important employee or executive who is core to the operation of the business and his death, disability or absence could prove to be disastrous for the company or organization.
Some businesses have excessive dependency on executives who are extremely important for the smooth functioning of the business. The absence of such key employees can cause huge losses. For example, the valuable salesperson who brings in all revenue for the company or the director who guarantees company loans – if the latter passes away, the lender could demand immediate pay-back of the loan from the business.
What is Keyman Insurance?
For this reason, companies opt for a keyman insurance policy which provides safeguard against losses incurred due to sudden demise or disability of the ‘keyman’. This type of policy is alternatively referred to as key person coverage, key employee coverage, etc.
How does Keyman Insurance work?
The company or the business is the beneficiary in the event of loss and the premiums are paid by the same as a business expense. They come with a first to die option which enables the firm to insure a number of employees in the same policy and hence is more economical compared to a standard life insurance policy.
How much should the cover be?
There are standard formulas to work out what is more suitable for the company to insure based on:-
a) 10 x annual compensation of keyman OR
b) 3 x company gross profit (for last 3 years) OR
c) 5 x company net profit (for last 3 years)
Is the premium cost tax deductible?
If you pay the premiums from the company, this is tax deductible but when the sum assured comes to the company, this must be declared as revenue for that tax year.
Hong Kong is a low-tax jurisdiction but would charge profits tax based on the sum assured.
If this would cause a problem, then alternative arrangements, achieving the same result could be achieved.
These are the owners of the business, whether there is one or many people in place.
What is Partnership /Shareholder protection?
Shareholder Protection is an agreement that ensures that a business has enough money and the ability to buy the shares of a deceased Director/Partner off their family in the event of their death. Shareholder Protection is also known as a Cross Option Agreement or Partnership Protection.
If you run the company alone, whether a sole proprietor or in a limited company, this would allow your family to replace the income they have lost by your demise.
How does Partnership /Shareholder protection work?
Tom (married to Ann) and Joe (married to Sarah) incorporate a business together. The business is doing very well and after five years the company is now worth US$5,000,000. Tom suddenly and unexpectedly passes away and his shares now go to his wife and the children. Ann and the children have no idea how to run the business or even the desire to do so.
In an ideal world, Joe would buy the shares back from Ann and the children for £US$2,500,000, half of the company’s value. This will give Joe full control of the business.
If the company is not cash rich this could lead to a problem. Ann might decide to sell the shares to Mark who runs a rival company as Mark has offered more money for the shares and all Ann wants is the best deal to enable her to look after her family.
Ann may decide she will attempt to run the company. Joe and Ann are friends but had never contemplated working together.
A Shareholder Protection plan ensures that there is a lump sum available to Joe to cover buying back the shares in the event of a partner’s death. The Shareholder Protection plan runs alongside a cross option agreement ensuring that the shares go to the right people.
The plan ensures that:-
- The remaining partner/s/shareholder/s keep control of the business and the shares
- The agreement ensures that all transactions are tax efficient
- The family of the deceased member are properly compensated
- The company continues to run with minimal disruption
How much should the cover be?
It is important to have the company valued to have the relevant cover match the shareholder/partner’s value.
Is the premium cost tax deductible?
This is the same principal under the Keyman insurance arrangements.
Again, if this would cause a problem, then alternative arrangements, achieving the same result could be achieved.
For example, if there are only 2 directors then one could insure the other and have an agreement within the company that the sum assured is to pay out to the deceased’s family.
What is a Cross Option Agreement?
A Cross Option Agreement is an agreement that ensures that a business has enough money to buy the shares of a deceased Partner/Shareholder from their family in the event of their death. This is also known as Shareholder Protection.
When a business is set up one of the main aims is often to make a profit for the business owner and their family. If the business is in fact a partnership then in the event of one of partner’s death, the shares are normally passed to the deceased’s surviving family members and not to the remaining business owner/s, after all the deceased wanted to ensure that if anything happened to them, their family would be protected.
This could now mean that the business can be run by unconnected parties, (i.e. the deceased’s family) and this can have a severe impact on the business and the family left behind and could also leave both parties unhappy with their circumstances.
If the company has the money available then they could offer to buy the shares from the family of the deceased, although many companies may not have the cash available to deal with this situation and this can put a significant financial strain on the business.
A Shareholder Protection Plan is a policy that ensures that on the death of a business partner, a lump sum will be paid out to the company to the value of the deceased’s shares and the money will then be used to buy the shares from the deceased’s family.
The shareholder protection option does not force the sale of the shares.
By adding double option onto the shareholder protection this does force the sale of the shares by either side, (the family and the business). This ensures that the family are looked after and properly compensated and in addition to this the business can continue to run with minimal disturbance to the business’ day to day operations.
It is recommended to have the business valued before opting into one of these plans and then to continue with regular reviews to establish that the valuation is still realistic in the current climate and to ensure that both parties are aware of the insurance entitlement, should the worst happen.
This document should be part of the Shareholder’s Agreement to act like the company Will.
If anyone one shareholder/partner passes away, everyone knows what is to happen with their share and that the business can continue. If there is only one owner, he/she would know that they have replaced their income for a number of years, depending upon the sum assured for their loved ones.