Properly drawn business succession agreements provide for death, disability and trauma insurances to be taken out so that funds are available to pay for the equity of a person exiting the business because they have suffered one of those events. However, recent changes to the law have impacted on the terms of such policies and how they should be held.
Up until recently, it has been popular to hold some of the insurances in a person’s self managed superannuation fund (SMSF). But from 1 July 2014, a superannuation fund has only been able to provide an insured benefit to a member in circumstances which satisfy a condition of release. The applicable conditions of release are:
- Death – item 102 of Schedule 1 of the Superannuation Industry Supervision Regulations 1994 ;
- Terminal illness – item 102A;
- Permanent incapacity – item 103; and
- Temporary incapacity – item 109.
Accordingly a SMSF can now only acquire an insurance policy for any of its members where the policy terms and the payout events accord with the above conditions of release.
Death and Terminal Illness cover and SMSFs
As these types of policies will generally comply with the above conditions of release, the 1 July 2014 changes have had little impact on them.
Total and permanent disability cover and SMSFs
From 1 July 2014, a SMSF must only enter into a new total and permanent incapacity (TPD) policy for a member where that policy is an “any occupation” policy.
The relevant definition reads in part that in order to be an “any occupation” policy, the disability insurance benefit must only be payable if “it is unlikely that the person can ever be gainfully employed in a capacity for which he or she is reasonably qualified because of education, training or experience.”
Of course, this can be dangerous because whilst the member may, as a result of the TPD, be unable to perform their duties in the business, they may be able to perform other duties. In such circumstances, no payment under the “any occupation” policy will be made, and the funds required to pay out the exiting partner’s interests in the business will not be available. Depending on the wording of the business succession agreement, this could leave the exiting partner with no equity (because under the agreement it has been transferred to the continuing partners) and no money either.
Accordingly a review of clients’ insurance policies is required to ascertain whether the cover needs to be revised and whether an alternative policy should be put in place.
Some insurance companies have already manufactured insurance products that provide a dual policy where the “own-occupation” component can be owned outside the superannuation fund and the “any-occupation” component can be owned within the superannuation fund.
Regulations have also been introduced to provide specific rates of deductibility for permanent disability premiums. These provisions (inserted into Income Tax Assessment Regulations 1997) provide for the deductibility of total and permanent disability premiums from 67% up to 100%. The range varies depending on whether the TPD policy is an “any occupation” policy or an “own occupation” policy or somewhere in between.
Trauma cover and SMSFs
Whilst the ATO has accepted that a SMSF can own a trauma insurance policy (although various preconditions apply), for over a decade the ATO has maintained that insurance premiums for a trauma insurance policy held within a SMSF are not tax deductible. In addition of course, whilst a trauma event may result in benefits being paid out by an insurance company, if the member has not satisfied a condition of release, then the funds may be trapped within the SMSF and be unable to be used to pay out the exiting partner’s interests in the business. In any event, the 1 July 2014 changes referred to above now generally preclude a SMSF from taking out a trauma policy for the benefit of a member.
Income protection cover and SMSFs
Some business succession agreements historically have also provided for income protection insurance. However, this has tended to be the exception rather than the rule, because the payment period is generally limited to 2 years (although a longer period could apply if approval was received from APRA). Moreover, an individual is able to claim a tax deduction for their income protection insurance premiums personally and this is likely to be at a higher marginal tax rate than that which applies to the SMSF. In addition, income protection insurance policies held outside superannuation have tended to have more extensive benefits available. Furthermore since 1 July 2014, the proceeds of an income protection policy must have terms and conditions which accord with the conditions of release referred to above.
Having regard to all these issues, it is now uncommon for income protection insurance to be held within a SMSF.
Insurance policies and the SMSF Reserve
Of course insurance policies are not necessarily required to pay out benefits if a reserve can be used for the SMSF to self-insure. This may be of benefit if a child of the primary member of the fund (where the child is also a member) is in an accident and temporarily incapacitated but they have no insurance cover. If the fund has a reserve in place, the fund can provide the temporary benefit until the child is back on their feet.
However, the self-insurance for a SMSF is only possible where a fund self-insured by 1 July 2013 and where the insured event occurs up to 1 July 2016. From that time, any insured benefit a SMSF trustee provides must be fully supported by a policy from an insurance company.
Business Insurances and the CGT discount
When considering insurances for business succession, it is also important to take into account the general 50% CGT exemption. This concession is not available if the CGT event or disposal occurs under an agreement made within 12 months of acquiring the asset.
If the SMSF or another entity receives trauma or TPD or life proceeds where they are not the injured party or a relative of the injured party, or if they were not the original beneficial owner of the policy and gave consideration to acquire their interest in the policy, then CGT may apply to the proceeds. Can they claim the 50% CGT discount?
According to the ATO, the relevant asset is the right to collect from the insurer as opposed to anything else and that right is only acquired when the trigger event occurs, and not when the insurance contract is entered into. Therefore, if we are to be guided by the ATO’s opinion, the 12 month holding rule will not be satisfied in most situations.
Our business succession agreements have been the subject of a successful ATO product ruling and deal with a variety of policy holders and beneficiaries and premium payers. This flexibility addresses the fact that this area is one that is constantly in flux. The drafting therefore avoids participants having to recast their agreement every time the issue of deductibility of insurance premiums and the taxation of payouts comes up for political consideration.
The business succession agreements which we have available also extend to insurance trusts, which enable tax-free payments to third parties to be made from insurance proceeds, providing that they would also be tax free if made directly to the beneficiary. The benefit of the beneficiary not receiving the payments directly is that the beneficiary is thereby prevented from hindering or delaying the payment due to the third party for inappropriate reasons.