All businesses incur liabilities and often require credit or financing from financial institutions. It is a standard practice for creditors to request that a business owner or director signs as surety or personal guarantor for the business’s financial obligations to them. This means that the surety becomes personally liable for the business’s debts. If the surety dies or becomes disabled, the creditors could look to his/her personal estate for settlement of the debt.
Why is it important to have a personal liability plan, funded by life insurance, in place?
- If a business owner, who has stood surety, should die or become disabled, the creditors may immediately call up the debt. Often the terms of the suretyship allow the creditor to collect the outstanding debt directly from the estate of the deceased surety, without first having recourse to the business. This means that the deceased’s dependents may be deprived of their inheritance, in part or entirely. The executor would have to try to recover from any other surviving sureties’ and /or the business, their part of the debt. If the business has personal liability insurance on the life of the surety it will then settle the debt up front, and the estate of the deceased will not be exposed to the business’s creditors at all.
- In most instances the creditors require all the business owners to stand surety and hold them jointly and severally liable. This means that they can recover the full amount of the debt from any one business owner, and do not need to try to recover the debt pro-rata from all of the business owners. A personal liability plan therefore needs to be taken out by the business for each and every surety and for the full value of the debt.
- If the creditors view one of the sureties as a key person to the business, on this person’s death they may not only call up the debt, but may also be reluctant to provide any further financing down the line. If the creditors are aware that the business has made provision for the debt to be settled on the death of any one of the sureties it often positively impacts on the creditworthiness of the business going into the future. Having key person insurance in place can also assist with the potential risk that future financing is hindered when a key person dies or becomes disabled.
- By the business providing this cover on the lives of the sureties, it removes a burden from the individual business owners’ shoulders in terms of having to be concerned about the risk their individual estates are being exposed to if they die or become disabled and is a good business practice.
The structure of the personal liability plan:
The business takes out a life insurance policy, possibly including disability cover, on the life of the surety. A personal liability agreement must be entered into, obligating the business to use the proceeds of the policy to first of all settle the outstanding debt. Should there be any funds left over, the business may then use these at its discretion. If the business is a company, then it should also conclude a board resolution indicating the reason for the life insurance policy and confirming its decision to put the cover in place.
Payment of premiums:
The business will pay the premiums in respect of the life insurance policies that have been affected.
The Income tax consequences:
The business, at inception, may elect to claim a tax deduction on the premiums, (the policy will then be termed a “conforming policy”.) The maximum deduction will be limited to the lesser of the premiums or 10% of the life insured’s taxable remuneration. When the policy pays out, the proceeds will be taxable in the business’s hands, at the rate of tax applicable to corporate entities, currently 28%. Note, if the business elects to claim the deduction at inception, it must continue to do so, as SARS will deem it to have claimed the deduction, even if it has not done so.
If the proceeds are taxable, the amount of life covered required will have to be increased to take the income tax into account, in order to ensure that the after tax amount is sufficient to purchase the interest in the business from the deceased business owner’s estate..
The business may, at inception, elect not to claim a tax deduction on the premiums, (the policy will then be termed a “non-conforming” policy) When the policy pays out, there will be no income tax payable on the proceeds.
Estate duty consequences:
The proceeds of the life insurance policy will not attract estate duty, provided that the following requirements are met:
- That the policy was not taken out by or at the instance of the deceased,
- That no premium on such policy was paid or borne by the deceased, and
- that no amount due or recoverable under such policy has been or will be paid into the estate of the deceased and that no such amount has been or will be paid to, or utilized for the benefit of, any relative of the deceased or any person who was wholly or partly dependent for his maintenance upon the de ceased or any company which was at any time a family company in relation to the deceased
A family company is one where the deceased, alone or together with any of his/her family members, was able to exercise effective control over the business. Included in the definition of family member is the spouse of the person or anybody related to him/her or his/her spouse within the third degree. If the business was at any stage a family company in relation to the deceased, then even if this changes in the future, the estate duty exemption will be lost forever.
If there is any doubt whether the above mentioned requirements to qualify for the exemption will be met, provision should be made to increase the life cover. Where the estate duty exemption is not granted, then because the payer and beneficiary of the policy is both the same person (the business) there will be a saving in estate duty, in that the proceeds brought into the estate duty calculation will be reduced by return of premiums plus 6% p.a compound interest.
Steps to be taken in implementing a Personal Liability plan:
- Establish the value of the personal liability – the suretyship signed with the creditor will provide proof of the amount of liability the surety is exposed to, and whether it is joint and several or not.
- Effect life cover and/or disability cover in order meet this need
- A personal liability agreement must be entered into between the business and the surety. It is critical that the personal liability agreement is concluded, as both the signed agreement and life insurance are necessary in order to have a binding and effective personal liability plan.
- All the necessary documents to obtain the life insurance with the relevant life office must be completed.
By putting a personal liability plan together, funded by insurance, the surety can be certain that any business debts for which he has stood surety will be settled immediately upon his death or disability. Not only will the surety’s estate be protected from financial disaster, but so will the business.