New business ventures
require startup capital to purchase assets and necessary equipment that is
crucial to start and run the business and to cover important expenses to ensure
its success. Often business owners will loan their own funds to the company to
cover these startup and running costs. This is because owners either do not
want any external stakeholders involved in the business or go to the bank for a
loan where they would need to stand surety and pay interest on the loan.
These loans are
reflected as long-term liabilities of the business and the repayment of these
loans to be done at an indefinable future date. In the event of the untimely
death of the owner/lender, the executor of the deceased estate will call up the
loan. The risk that the business presents itself in the event of the owner’s
death is that there may be liquidity issues when the business needs to repay
the loan, or the business simply cannot repay the loan and therefore be forced
to potentially sell income-generating assets or risk insolvency.
What can be done to avoid this risk?
The most cost-effective
way to avoid liquidity and insolvency risk in the event of the loan being
called up is to apply for a life policy on the life of the owner/lender. The
business will own and pay the premiums of this policy and receive the proceeds
in the event of death. An agreement should be put in place between the
lender/owner and the business to ensure that the proceeds are used to settle
any debt. The policy can also make provision for permanent disability and
critical illness in terms of settling the debt.
Another alternative for
the business to settle the loan is to start an investment for the owner whereby
repayment of the loan can be made either as a lumpsum or on a regular basis
overtime. This can assist the lender with lowering the stress of not being able
to retire with enough retirement savings.
Tax and policy proceeds considerations.
In terms of Section
11(w)(ii) the premiums of this policy cannot be tax deductible for the business
because the policyholder is not insuring the owner/lender against any operating
or income loss but rather the purpose is the repayment of capital. It therefore
does not comply with the requirements of Section 11(w)(ii) and the premiums are
not tax deductible. Because the premiums were not tax deductible the policy
proceeds will not be taxable, and the full amount of the policy proceeds will
be payable. In addition, because the payment to the lender by the business was
repayment of a capital amount the lender will also not be taxed on the amount
repaid.
For estate duty purposes
the policy will be a deemed asset in the deceased estate as it cannot be argued
that the policy was not taken out to protect the estate of the deceased or that
the deceased did not have any role in taking out the policy. Because of this
inclusion it is advisable to gross up the sum assured by 20% or 25% depending
on the size of the estate to cover for estate duty payable.
Loan accounts and Buy and Sells
One consideration to
better structure the loan account policies is to look at including the loan
account in the buy and sell agreement. The benefit of doing this, where the
value of the shares and the loan account is included, is that upon one of the
shareholders death the remaining shareholder will receive the shares in the
business as well as the loan thereby not affecting the balance sheet of the
business as only the lender changes as the liability will now be seen as
settled.
Another benefit of this
is that now the remaining shareholder can allow for capital extraction without
incurring any income tax liability. By including the loan account in the buy
and sell agreement the proceeds can now potentially be exempt from Estate Duty
if all requirements in Section 3[3][a] [iA] are met. By doing this you have
mitigated liquidity risks within the business and saved in estate duty.
Source: moneyweb