Two partners, default cover and no buy-sell agreement
Daniel, 46, and Sarah, 52, are equal partners in a landscaping business with turnover of $3.4 million and net assets of $2.1 million. Both belong to the same industry superannuation fund and rely on its default cover: three units of death cover and two units of TPD, described in the member booklet as payable when the member is unlikely ever again to work in a role 'for which they are reasonably suited by education, training or experience'. Daniel has a degenerative back condition, has cut his site hours and draws about $185,000 a year as a partnership distribution rather than a salary. Neither partner has a buy-sell agreement or any insurance outside superannuation. Sarah injured her knee two years ago and has never mentioned it on an insurance application because she has never completed one. The partnership accountant has asked whether the business should pay for cover instead of the partners.
1. Explain why the existing default cover is unlikely to protect Daniel, and where own-occupation TPD and income protection can and cannot be held and funded.
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TPD. The default definition is an 'any occupation' test. Daniel's value to the business is quoting, client management and supervising jobs; a back injury that ends site work would very likely leave him suited to those duties, so the policy would not pay at the point he most needs it. Own-occupation TPD cannot be offered inside superannuation (the SIS Regulations have excluded it for funds since 1 July 2014), so it must be owned personally or by a company or trust. Premiums are not deductible, but the benefit is paid as capital, tax-free, which is what a buy-out needs.
Income protection. Inside superannuation the benefit is capped at 75% of income, cannot be released while Daniel is still employed (even on reduced duties), is paid as taxable income and cannot be commuted. Outside superannuation, a policy with a 30- or 60-day waiting period and a benefit period to age 65 can replace roughly 70% of income plus superannuation contributions, and the benefit is tax-free where the premiums are not claimed as a deduction. Because Daniel's income is a partnership distribution, the insurer will want two to three years of personal and partnership returns and an accountant's letter; the policy should be owned by Daniel personally so the benefit replaces his income, not the firm's revenue.
Structure the package so each risk sits where it works: own-occupation TPD and income protection outside superannuation, death cover either place depending on cost and estate needs.
2. Advise on how a buy-sell arrangement should be documented and funded for a two-partner business, including ownership of policies and tax treatment of the proceeds.
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There is no agreement, so on Daniel's death or disablement his interest passes under his will to his estate - leaving Sarah in business with Daniel's spouse, who may have neither the interest nor the skill to run it, and no money to buy her out.
Structure.
- A written buy-sell (put and call option) deed with an agreed valuation formula - for example a multiple of maintainable EBITDA, reviewed annually - and defined trigger events: death, TPD, trauma, permanent departure, divorce, bankruptcy.
- Cross-insurance funding: each partner owns a life and TPD policy on the other's life. On death the survivor receives the proceeds personally and uses them to pay the estate for the deceased's interest. The proceeds are capital, not assessable income.
- Self-ownership would pay into the deceased's own estate, which may then refuse to sell or to sell on the agreed terms; company ownership creates different CGT and access issues and should generally be avoided unless the company also holds the shares.
- Premiums are not deductible under any of these structures because the proceeds are capital.
- Cover should be set to the expected buy-out price at review, not to a round number; over-insurance wastes premium and can invite scrutiny.
Tax and exit. With net assets of $2.1 million, which is under the $6 million net asset value threshold, the CGT small business concessions may be available on an eventual sale. The deed should specify who bears CGT and how any retirement exemption is allocated.
Immediate gap. Add business expenses insurance and key person cover now, so revenue lost while Daniel is off is funded while the long-term deed is negotiated.
3. Sarah's knee injury has never been disclosed because she has never been asked. What are the disclosure and underwriting issues, and what should be done before any cover is replaced?
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The rule. Since 5 October 2021 consumer insurance has been governed by the duty to take reasonable care not to make a misrepresentation (s 20B, Insurance Contracts Act). Sarah has not breached anything yet because she has not been asked - but she must not sign an application or declaration that misstates her knee injury. If she does, the insurer may avoid the contract or reduce a claim under s 28.
The process.
- Take a full history: date of injury, diagnosis, treatment, time off work, recurrence, current symptoms and restrictions.
- Do not cancel or reduce the industry fund cover before replacement cover is issued. Default group cover usually applies its own pre-existing condition rules, often a 12-month exclusion, so continuity is critical.
- Submit a pre-assessment or a fully disclosed application to two or three insurers to compare exclusion, loading and standard terms.
- Make clear the answers are Sarah's own; the adviser must not complete health questions for her.
- If a policy issues with a knee exclusion, confirm in writing that both partners understand the resulting hole in the buy-sell funding and consider funding it another way, such as a higher death sum insured or a payment plan from business cashflow.
Commercially, the risk for Sarah is greater than the risk for Daniel: Daniel's condition is known and will be underwritten, while Sarah's is unknown to any insurer and could invalidate a claim just when the buy-sell is triggered.