Ask The Guru A Question

Question: I read your previous articles on business succession planning. As a financial planner, I want to move more into the insurance risk area. I don’t really want to know the tax stuff as I expect Civic Legal will take care of that. Rather, can you tell me the problems that your clients face in this area? Can you grant me a licence to reproduce what you say, please?

Answer: Getting a tax lawyer to talk about the softer side of succession planning – thank you, no one has ever asked me to do so. Businesses suffer if they do not plan for a principal’s death or disability. Consequences include:

1. Replacing the outgoing principal with another manager.
When compared to larger businesses, small businesses depend more upon the personal characteristics, abilities and resources of the owner-manager. Such dependency is less in a larger business, especially where the managers have no, or little, ownership in the business or where there is a larger hierarchy of managers and systems. For example, in my publically listed company, Integrated Legal Holdings , if an executive director dies or suffers from a disability then the board, as it sees fit, merely replaces that director. If the director owned shares in the company then the director’s executor may or may not sell the shares on the stock exchange.

2. Further, if the outgoing principal had specific skills or qualifications peculiar to that small business, trade or profession, especially skills that the remaining principals may not possess, then a replacement may need more than just management skills. He or she may also need to possess skills or qualifications specific to that business, trade or profession.

3. Death of a principal may be an act of default on a loan or overdraft facility.
Have a close look at the fine print on any business loans you have. A principal’s death or disability may cause the business loan or overdraft facility to default – even if the business has never missed a payment or fallen behind before.

However, the death of the principal does not have the effect of terminating a continuing guarantee given to a lender. Similarly the death of the principal does not extinguish their obligations as a guarantor. It is often also the case that a principal of the business ceasing to be involved in the business – may also cause the business loan or overdraft facility to default. This may require the business to pay immediately all moneys and interest owing under the loan or overdraft. The risks are greater if the owner’s assets are outside of the business (such as the family home) to secure the loan.

4. The Remaining owners may not want the outgoing owner to be involved in the business anymore.
The remaining owners may not want the outgoing owner (and outgoing principal, if alive) to be involved in further ownership and management of the business. Further, there may be family disputes within the outgoing owner’s family as to who owns, or should own, the estate assets. The remaining owners may not be certain with whom they are to negotiate.

5. Particular issues relating to partnership business structures.
In Australia, partnership structures have additional risks when compared to other business structures. Where the business is a partnership, upon the death of a partner, the partnership is immediately dissolved by force of State and Territorial laws – unless there is an agreement to the contrary. Following the partner’s death, the partnership only remains ‘on foot’ (or operating) to the extent necessary to wind up the business.
In this event, the beneficiaries do not obtain beneficial ownership of any particular partnership asset. It is not possible, without specific agreement, for the beneficiaries to take a discrete portion of any of the partnership assets and dispose of them. In the absence of an agreement, the entire business is terminated and its assets liquidated for each partner to receive their distribution in cash. 

This would not usually be the remaining owners’ desired outcome, as they would have generally continued with the business, if not for the principal’s death. A forced sale of the partnership assets may also not be the outgoing owner’s desired outcome – as the only potential purchaser may be the remaining owners. If there is no other potential purchaser, the remaining owners may acquire the partnership assets for a low cost. Alternatively, rather than seek to acquire the partnership assets, the remaining owner may instead merely start a new business. If there are no willing third party purchasers the partnership assets may have little value.
Further, if the remaining owners continue to operate the partnership after the outgoing principal’s death, the outgoing owner may be entitled to the profits. This is the case even though the outgoing principal did not contribute to the partnership during that period.
Finally, each partner in a partnership is responsible for and has unlimited liability for the actions of the other partners – but only as such actions concern the partnership business.

6. Unsuitable persons (for the business) want to step into the shoes of the outgoing owner.
The outgoing owner (and outgoing principal, if alive) may want to continue to own and manage the business. The outgoing owner may have, for example, a family member (such as an out-of-work child with no qualifications or skills related to the business) ready to step in to replace the outgoing principal. Or, you might find that the deceased principal’s spouse who is not suited to running a business may wish to become involved in a significant way. From the outgoing owner’s perspective, this may be important to help secure the payment of the outgoing principal’s regular ‘salary’ or ‘drawings’. It also allows the outgoing owner to maintain surveillance of the business. The remaining owners may not find that acceptable.

7. Are the remaining owners prepared to do all the work for the outgoing owner’s estate?
A related issue to the above is that the business might continue to be run for the benefit of both families with only one family doing all the work. Therefore, the outgoing owner may be prepared to continue to hold the business interest, the remaining owners, again, may not find that ‘undesirable’.

8. Outgoing owner wants to sell their interest in the business.
Now that the principal is no longer working in the business, the outgoing owner may not want ongoing involvement in the management and ownership of the business. The outgoing owner may wish to sell his or her interest in the business. However, there may be no ready market for part ownership of a small business. It is commonly accepted that the business interest lacks the large ready market that exists for publically traded securities. If a willing purchaser is found, it may be difficult for the outgoing owner to value the interest in the business – especially now that the outgoing principal is no longer working in it.

9. There may be agreed restrictions, between the business partners, on transfer of an interest in the business.
Even if the outgoing owner finds a willing third party purchaser at an agreed purchase price – the sale may be subject to certain restrictions. The opening of USA Zaritsky’s loose-leaf service stated that: Buy-sell agreements are contracts by which the owners of a business (stock-holders or partners) agree to impose certain restrictions on their right to transfer their interest in the business freely to whomever they wish, whenever they wish, and at whatever terms they wish. So too, pre-emptive rights are another common restriction in most standard company constitutions, shareholder’s agreements and unit trust deeds. They require every offer that is acceptable to the outgoing owner, to be first presented to the remaining owners.

The pre-emptive right offer gives the remaining owners a set amount of time to match the agreed price and terms of the offer – or lose that right of purchase. If the remaining owners accept the offer then they acquire the interest in the business instead of the third party purchaser. If the remaining owners do not take up the offer or let it lapse then the outgoing owner is at liberty to sell the business interest to the third party on the same terms of sale. Further, the new co-owner may be intent on harming the remaining principal’s position in the company. In the American case of Agranoff v Miller the court stated that: [the new owner] … in conspiracy with two faithless … fiduciaries … wrongfully obtained his shares … improperly utilized confidential corporate information to which he, as a corporate outsider, had no rightful access; and usurped corporate opportunities that belonged to … [the business].
The business succession plan prevents the sale outside the present ownership group and it is often the paramount reason for using buy-sell agreements. For whatever reason, unrelated people don’t like being forced into a close business relationship with a stranger or competitor.

10. Can the ever powerful Family Court override your diligent planning?
While pre-emptive rights give greater control to the remaining owners, the Family Court may override pre-emptive rights. An American Court has already done so and it may only be a matter of time before the Australian Family Court follows suit. Under section 4AA(1) Family Law Act 1975 Family Court orders relate to not only married couples but also couples in de facto relationships of both the same and opposite sex.

11. Does the outgoing owner have the skills to carry on or negotiate a sale of the business?
The outgoing owner may have had little involvement with the business. With the loss of the principal, the outgoing owner may have limited commercial skills to negotiate a sale and value the business. The perception of the value of the business may be susceptible to emotional complications due to the loss of a spouse and the grieving process. This is especially the case where the potential purchasers are the remaining owners who, ‘in the eyes of the grieving wife, worked the husband to death’.

12. Remaining owners of the business lack finance facilities to purchase the outgoing owner’s interest in the business.
Even if the remaining owners are willing purchasers, they may lack finance and credit facilities to fund the purchase of the outgoing owner’s business interest. The lack of funds is exacerbated if the business’s overdraft facility is withdrawn coupled with the bank threatening to sell the owners’ homes to satisfy the outstanding overdraft (as discussed in point 2 above). Without a source of funds at the required (usually unknown) time, there may be a loss of certainty in the succession plan. As stated in points 3 and 5 above the remaining owners may wish to remove the outgoing owner as quickly as possible after the principal’s death or disability. However, the outgoing owner may be less willing to relinquish the business interest until the full purchase price is paid. Succession planning has decreased certainty if the remaining owners are not able to pay the agreed amount for the purchase to an outgoing owner’s interest in the business. Therefore, a fundamental element of a successful succession plan is how it is funded.

13. Outgoing owner may want to continue receiving an income from the business.
The outgoing owner may wish to continue to receive the outgoing principal’s regular ‘drawings’ or ‘salary’. This may be required to pay for the costs of sending children to private schools, buying food and clothes and meeting the home mortgage repayments.
However, the business (because of the loss of the principal who no longer works in the business, loss of the business loan or other reason) may no longer have sufficient income, according to the remaining principals, to continue to pay the ‘drawings’. There may be confusion as to whether the regular ‘drawings’ are paid because a principal worked in the business (akin to a salary) or because of the ownership in the business by the owner (share of profit, such as a monthly dividend).

The remaining principals may contend that the business makes no ‘profit’, rather it just makes ‘wages’ and if a principal no longer works in the business (for whatever reason) then that principal no longer gets paid. The outgoing owner may disagree, claiming that the monthly drawings were paid to the owners, not to principals and that the principals were never paid a wage or salary. The remaining owners may then argue that such a scheme was merely in place to reduce taxation. A warning for claiming taxation benefits as a reason for anything – Part IVA may apply to make such arrangements illegal or for the participants in such a scheme to pay more tax and penalties.

14. Goodwill of the business attaches to the individuals rather than the trading name.
Putting aside fiduciary obligations of trustees and directors, if the remaining principals decide to ‘jump ship’ especially in a small business the wealth of the business may well follow them via personal goodwill, corporate knowledge and the principals trade or professional knowledge. For example, a baker continues to know how to bake in the new enterprise; the accountant knows the tax law and the client base.

15. Are there problems with life, TPD and Trauma insurance?
It is possible for the owners to take out life, TPD and trauma insurance but fail to enter into any agreement such as a succession plan. If, for example, the insurance is self-owned then upon the principal’s death or disability the outgoing owner receives the insurance proceeds with no legal requirement to treat that insurance as the deemed purchase price. It is then open for the outgoing owner to both take the insurance and then require the remaining owners to pay for the business interest. A second issue relates to a trauma event that does not affect the principal’s ability to continue working in the business. For example, the principal may suffer a minor heart attack and be back at work a few days later with the trauma pay out.

Without an agreement, the parties cannot be sure how to treat the payout. It may be treated as a windfall for the principal, or treated as the payment of a deemed purchase price if the principal subsequently suffers death or a disability. From bitter experience, as a lawyer, the outcome of the principal’s death or disability, from the above 14 points, includes litigation, business insolvency and bankruptcy of the principals, owners and family members, particularly if business debts were guaranteed. The business may be the owners’ main asset and its failure may cause a complete loss of income and a substantial reduction in the owners’ overall wealth. On a wider perspective, the loss of the business may mean the loss of jobs for employees and a loss to the economy. The viability of an otherwise profitable small business may be threatened if a principal dies or suffers from a disability. The consequences may be diminished if the parties put in place an insurance-funded succession plan. The plan includes the remaining owners contractually agreeing to purchase the outgoing owner’s interest in the business if the outgoing principal dies or is disabled. The remaining owners then continue to manage the business without ‘interference’ from the outgoing principal’s family and heirs.

To achieve certainty of funding, the three insurable events – being death, TPD and trauma – insurance policies can be purchased so that the payout matches the purchase price– therefore relieving liquidity problems by creating a market for the decedent’s business interest. Insurance funded succession planning provides certainty that upon the principal’s death or disability funding is available. This has the immediate effect of removing the outgoing principal and owner out of the business. The outgoing owner also receives with certainty the funds in a timely manner. The succession plan deals with what constitutes an appropriate purchase price of the outgoing owner’s interest in the business. The parties can agree the value of the business each year, or set out a formula or mechanism to value the business. Have a frank discussion about business succession planning with your business partners and your financial advisers. When you have agreed between you on a suitable plan – call me to sort out the legal documents required to put your plan into action.

By | 21.11.11

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