Business assurance is vital for anyone who runs their own business. It is, however, a broad term for products designed to cover a multitude of needs, from putting golden handcuffs on essential employees, to ensuring that your dependants will not be forced to hold a fire sale of your business if you die. Personal Finance looks at 10 things you need to know about business assurance. This is part one of a two-part feature.
In most cases, business assurance is risk and/or investment assurance taken out to protect a business from potentially dire financial consequences should someone who is essential to its operation die, or become disabled. This person could be an owner of the business, a director or an employee.
Business assurance can also be used to prevent a key employee from leaving to work for a competitor. In this case, a policy is taken out that will mature in the future to the financial benefit of the employee.
The purpose of business assurance is to ensure that a business remains a going concern after an unplanned event, and that an owner and his or her dependants are protected against financial hardship.
For example, if a business has an overdraft, which is secured by the owner, directors or partners in their personal capacities, the owner, directors or partners will want to ensure that the loan will be repaid when they die, without any adverse consequences for their dependants (through a depleted estate) or the business. The solution is life risk assurance, which will ensure that neither your dependants nor your business will be in dire straits as a result of your death.
There are life assurance products to cover various scenarios and needs. Each product, however, has different tax consequences that you must take into account. The ownership structure of a business will also determine the type of assurance required.
Kate Moodley, the business development manager at Momentum, says every business consists of three distinct parties: the business (management), the owner, and the employees. All the parties have their own risks and financial needs that must be covered by a business assurance product.
When setting up a business, you need to consider carefully the financial risks that you and your family may face, and what measures you can take to negate those risks. One of the most important aspects to consider is how you structure the ownership of the business, because this will determine the type of business assurance you will need.
The various ways to structure a business are:
This is a business owned by one person in his or her own name. The business is not considered to be a separate juristic person (legal entity); the owner and the business are considered to be the same person. In other words, the debts and obligations of the business are considered to be those of the owner and vice versa.
All the profits of the business accrue to the owner, and are subject to income tax at his or her marginal rate of income tax.
The owner can sell the business at any time.
Hein Daffue, of Sanlam Life Law Services, says on the owner's death, the business is included in his or her estate, and is either sold by the executor or passed on to the owner's heirs.
The value of the business will be subject to estate duty and capital gains tax (CGT) on death.
Sole proprietorships are often established by professionals or the owners of small businesses.
This is an ownership association of between two and 20 people. A partnership is not considered to be a separate juristic person from the owners. However, the partners contribute to what is called a partnership estate, which is separate from the personal estates of each of the partners.
The profits of the business are divided proportionally among the partners according to a partnership agreement. Likewise, the partners are also jointly and severally liable for the debts of the partnership.
Partnerships dissolve for a number of reasons, including the death, insolvency or retirement of one of the partners.
The profits of the partnership are added to any other income each partner receives, and each partner is taxed as an individual taxpayer on his or her share of the profits, whether or not the partner withdraws the profit from the business.
A partner's share in the partnership is subject to estate duty in the hands of the partner's estate.
A partnership structure is favoured by groups of professionals who go into business together, because it is simple to establish and because the partners are jointly and severally liable for the debts of the partnership and to clients.
A CC is a separate legal entity that can acquire rights and take on obligations in its own name, but which is owned by its members, who must be natural persons (therefore a company cannot own a CC), with the single exception of a testamentary trust (which is established on the death of a member). The members of a CC are obliged to have a fiduciary relationship with the CC. This, among other things, means they must avoid conflicts between their personal interests and those of the CC.
The members are often the managers of the CC. It is important to note that in a CC there is no legal separation between management and ownership.
The profits are owned by the CC and are distributed to the members in terms of the CC's association agreement. The members have a limited liability for the debts of the CC, subject to a number of provisos, such as becoming personally liable if they conduct business recklessly or with gross negligence.
A CC has perpetual succession. This means it is not dissolved on the death of one of the members. A CC pays income tax in its own right at 29 percent. When a CC member dies, the deceased member's share is subject to estate duty and CGT.
As with a CC, a company is a separate legal entity that can acquire rights and take on obligations in its own name, but which is owned by its shareholders, who can be natural or juristic persons (that is, another company).
The shareholders own shares, but have no obligation to the management of the company, unless they are also appointed as directors.
The profits belong to the company, which decides how they will be distributed. The debts also belong to the company and not the shareholders. However, in the case of smaller companies, the directors, who are often the main shareholders, also stand surety for the company's debts.
A company pays income tax in its own right at a current flat rate of 29 percent of taxable income. Shares held at the death of a shareholder are subject to estate duty and CGT.
This is not an ownership structure, but a tax structure that gives owners of small businesses tax breaks.
Daffue says a small business corporation is defined in the Income Tax Act and can be either a CC or a private company.
To qualify as a small business corporation, the gross income of the company may not exceed R6 million in a tax year. Small business corporations have their own income tax rates. They pay no tax on income up to R35 000; tax of 10 percent on taxable income of between R35 001 and R250 000; and tax of 29 percent on taxable income of more than R250 000.
Individual members or shareholders qualify for a CGT exemption on a capital gain of up to R500 000 made on the sale of a small business corporation, provided the value of the business does not exceed R5 million when you die, retire (after the age of 55) or sell the business because of ill-health.
All the above structures have different implications for the financial planning of an owner or a shareholder. For example, a sole proprietor will have more tax and other obligations at death than a shareholder in a company. The sole proprietor needs to ensure that any debts, including income tax and CGT owed by the business, can be paid at death, or his or her dependants could be left destitute.
Once you have decided how to structure your business, it is then not a simple matter of taking a stab at how much life assurance you may need to cover all the possible risks.
The consequences of each business structure and the financial risks need to be carefully considered to establish how much risk life assurance you need.
For example, your business, particularly a sole proprietorship or partnership, will have to be valued regularly, the cash flow will have to be assessed to determine levels of debt, and capital investment borrowings will have to be added to the mix. In addition, you will have to factor in the tax obligations.
The life assurance needs of most companies and CCs are met through what are called company-owned policies (also called business policies). In most cases, a company or CC takes out a policy on the life of a member, director or key employee. Sole proprietors have to cover their risks through individual life policies, unless they are covering an employee.
Company-owned policies have different tax implications from individual life policies, for both the employer and the employee for whom the risk assurance is required.
Moodley says there are two types of company-owned policies:
(also known as regulation policies), where the premiums are deductible against the employer's taxable income, but where the benefits are taxable. The implication of the benefits being taxed is that, when calculating the total payout that will be received, the shortfall due to tax must be taken into account, and the total value of the assurance benefit - in other words, the assured value - must be increased.
, where the premiums are not deductible against the employer's taxable income, but where the benefits are paid out tax-free.
You also need to be aware that company-owned conforming policies have different tax implications depending on when the policy was taken out.
In the case of any conforming policy issued before June 1982, a company can deduct all the premiums paid against taxable income if certain conditions are met. These conditions, which apply to conforming policies issued before and after June 1982, are:
- The policy must be the property of the employer;
- The policy must be on the life of an employee or a director;
- Only the employer is entitled to receive any benefit paid out;
- The premiums must have been paid;
- The policy must meet the requirements of the Long Term Insurance Act; and
- Loans or advances can only be made against the policy if:
* It is included in the taxpayer's gross income for the year in which the advance or loan is made; and
* The loan or advance was made to obtain money required for the purposes of the business as a result of the employee or director falling ill, becoming infirm, incapacitated, retiring or leaving the business.
In June 1982, new regulations were issued in terms of the Income Tax Act that laid down additional conditions that must be met by conforming policies. A company-owned conforming policy must meet the following conditions:
- It must be issued in the name of one person and no substitution or change of the person is permitted.
- The premiums must be paid at regular intervals.
- The life risk cover against death and disability (minimum benefit) cannot be less than 80 percent multiplied by the number of years of the policy multiplied by the lowest annual premium payable.
- The premiums may not be increased by more than 15 percent of the total premiums paid in the preceding year. These increases are ignored when calculating the minimum death benefit. The full increase is allocated to investment.
- A minimum benefit must be payable on the death of the life assured at any time while the policy is in force. For example, if you want life cover on a 20-year term policy, and the lowest premium is R1 200, the sum insured cannot be less than 80 percent of R1 200 times 20 years, which equals R19 200.
- Premiums are limited to a maximum of 10 percent of an employee's pay during the year in which the tax deduction is claimed.
Daffue says in all four ownership structures (listed in point 2), employers who take out company-owned policies on the lives of employees qualify for a tax deduction on the premiums. However, premiums on policies taken out on the life of a partner in a partnership or on the life of a sole proprietor do not qualify for a tax deduction.
Companies and CCs can qualify for a tax deduction on the premiums paid if the policy is taken out on the life of an employee or a member of the CC, or a director or shareholder in the case of a company.
If the partnership or CC, as an employer, does not want the policy to be tax-deductible, it has to arrange that the policy issued by the long-term insurer contains a provision that makes it impossible to qualify in terms of the requirements of the Income Tax Act. This can be done by substituting the person assured with any other person.
Daffue says it is important to get proper tax advice to ensure there are no unexpected tax implications for employees or members during their service of employment with a partnership or CC as an employer.
Solly Keetse, a senior adviser at Old Mutual retail legal services, says it is important to note that if an employer does not claim the premiums of a conforming policy against taxable income, the benefits will still be taxable.
In terms of the Income Tax Act, there is one exception to the general rule that sole proprietors and partners in a partnership cannot claim the premiums for business assurance policies on their lives as a tax deduction.
Sole proprietors and partners often have a greater need for life assurance than members of CCs or the shareholders or directors of companies. This is because sole proprietors and partners are personally liable if anything goes wrong with their businesses. This risk extends beyond that of the business going bankrupt.
For example, if the family home is registered in the name of the sole owner or partner, there is a risk of it being lost if the business is in trouble.
Daffue says the single exception where a sole proprietor and a partner can take out a conforming policy is with what is called an income protection policy. This is a policy that pays a benefit if the life insured suffers loss of income due to illness, injury, disability or unemployment.
Moodley points out that as the premiums paid on an income protection policy are deductible from the taxable income of an individual, the income paid (the benefit) will be taxable in the hands of the recipient. The obverse is that if you do not claim the premiums against taxable income (that is, it is a non-conforming policy), the benefit should be tax-free in your hands.
The company best known for selling income protection policies to the professional market, in which many people operate either as sole proprietors or partners, is the Professional Provident Society (PPS).
PPS started out providing income protection (called sickness protection by PPS) to its founding members, who were pharmacists. It has since expanded to cover almost anyone who has a four-year tertiary qualification. PPS has a range of life assurance products and investment options on offer. Other life assurance companies have since also moved into this market.
Moodley says some income protection policies include benefits such as cover for the payment of fixed overhead expenses incurred in running your business.
Apart from income protection when you are too sick to work, you may want life cover. This is to ensure that on death any debts you may have, including estate duty, CGT and funeral expenses, are paid. The premiums for these other assurance products are not tax-deductible, but the benefits are paid out tax-free.
All your business protection plans must overlay your own personal financial needs, goals and commitments to your dependants.
Click here to read part two of this feature.