Business assurance is undoubtedly a lucrative area for the financial advisor to specialize in, as it is such a technical and specialist area that the bulk of advisors tend to avoid it out of fear. Those specializing in it can find a nice niche area avoided by the ‘riff raff’. However, the area is fraught with dangers, even for the expert. The following are problems which always seem to crop up in any business assurance structure:
1. Buy and Sell policies are sold without any buy and sell contract
This, alas, is an all too common occurrence. Often this is not the advisor’s fault – once the clients have the policies, they lose all interest in the agreements, and never get to sign them. Clients unfortunately fail to realize that without a signed contract, they have very little to compel the surviving partners/spouse to buy or sell any shares/interest on a death. This would mean that the whole point for which the policies were taken out would not be achieved. The insurance company is regrettably unable to help, as they would be obliged to pay the owner of the policy and would be unable to get involved after that.
2. Premiums are not paid correctly
This again is an all too common occurrence. In almost all cases, the premiums are paid by the company with the intention of debiting the individual’s loan accounts. In practice, either loan accounts are never debited or created, or if they are, they are incorrectly allocated – normally they are simply split equally without taking account of the different shareholding split. In both cases, according to a SARS guidance note, the policies will not be given estate duty exemption on death. Therefore, by this simple error, policies that should have been free of estate duty, are now made dutiable. In addition, if no loan accounts are ever created, this has the effect that the company has paid for private premiums which is a taxable fringe benefit. Therefore, both an estate duty and income tax problem have now been created.
3. The policies are over/under valued
In practice, the problem arises because no true valuation is done to ascertain the real value of the shares in question. A ‘thumb suck’ value is simply used. This obviously creates a problem that the policies are either higher or lower in value then they should be. Two simple examples will illustrate this:
A’s shares are worth 1 million Rand objectively valued. B takes a policy on his life for 2 million Rand. On A’s death, two problems will arise. Firstly, SARS will say that because the shares were only worth 1 million, the 2 million policy was not a genuine buy and sell policy. This means that, once again, the estate duty exemption will not be allowed. In addition, because B will have paid 2 million for a policy only worth 1 million, this could be seen by SARS as a donation, with B therefore having to pay donations tax on the 1 million donated. Therefore once again a double problem has been created. [Note that this problem will not arise when policies were correctly valued in the beginning, and have simply become out of date due to an unforeseen event or crash in the market.]
A’s shares are worth 5 million Rand. B can only afford a policy of 1 million Rand. B therefore insures A for 1 million, even though the shares are worth 5 million. On A’s death, two problems again arise. Firstly, A’s family will only receive 1 million Rand for a share that was really worth 5 million Rand. Secondly, once again, there is a donations tax risk. SARS could argue that the estate has sold shares worth 5 million Rand for only 1 million Rand. This was intended from the very beginning. The estate has therefore made a donation of 4 million Rand. This means that to compound the pain of only receiving 1 million Rand for a share worth 5 million Rand, A’s family will, in addition, have their pay-out reduced by a potential donations tax assessment!
The best way to avoid these problems is to ensure the shares are correctly valued from the very beginning. The policies should then be made to equal the share values, and not the other way round. This will avoid both tax and personal problems.
4. The company pays the premiums
This problem arises when the policies are expensive and the shareholders would prefer the company to pay the premiums and own the policies rather than have expensive loan accounts to repay. The company will therefore own the policies and pay the premiums. On death of one of the shareholders, the policy proceeds will pay to the company, which will use the proceeds to fund a share buyback.
Although this is legally permissible [and complicated], it creates tax and estate duty problems. Firstly, the policies will not be free of estate duty on death, as they are not being owned by a person who is a partner or co-shareholder of the deceased. Secondly, a company buying back its shares is a deemed dividend, with the result that STC will have to be paid by the company at a rate of 10%. While both these taxes can be ”built-in” to the policy and the amount of the policy increased, this is simply a waste, as if the structure was correctly done none of these taxes would have been payable.
The simple reality is advisors entering this market need to understand the detailed tax and legal issues involved, or they will be causing their clients unnecessary hardship.