I was recently asked to give a presentation for Business and Estate Planning Specialists. This company specialises in selling risk insurance for businesses and individuals. They had asked that I explain to their team the taxation implications for various forms of life insurance policies.
One issue that was discussed is why it is so important to structure life insurance policies properly when preparing Business Wills or Buy/Sell Agreements.
Is Life insurance a Capital Gains Tax asset?
The Capital Gains Tax legislation treats insurance policies as a Capital Gains Tax asset, and the payment of the insurance proceeds as a disposal of the asset.
Capital Gains Tax asset a Chose-in-action
The definition of a Capital Gains Tax asset includes a “chose-in-action”. A chose-in-action is a contractual promise to do something or to pay something. An insurance policy is a chose-in-action as it is a contractual promise by the insurer to pay the amount insured upon the occurrence of an event (ie. death). This asset will be disposed upon the performance of the contract (ie. the payment of the insurance proceeds). This results in the disposal of a Capital Gains Tax asset.
Now that it is established that an insurance policy is a Capital Gains Tax asset, careful consideration needs to be given as to whether any of the Capital Gains Tax exemptions apply.
Capital Gains Tax exemptions
Death benefits will only be exempt from Capital Gains Tax where the recipient is either:
(a) The original beneficial owner – this can include two or more people such as the case when policies are owned by business partners over each other, and can also include a company or trust; or
(b) Acquired the interest in the policy for nil consideration.
The term “original beneficial owner” has also been stated by the ATO to be the first person who:
(a) At the time the policy is effected, holds the rights under the policy; and
(b) Possesses all the normal incidents of beneficial ownership.
Ownership of policies by surviving business owners
It is very important that if insurance policies are owned by surviving business owners, there are no changes to the ownership of the business between the time that the policy was taken out, and the death of the deceased owner.
The reason for this is that if new owners are introduced into the business, and those owners wish to take advantage of the insurance policy, the definition of “original beneficial owner” may not be met as:
(a) That person would not have been the original beneficial owner; and
(b) If money was paid to purchase the share in the business, and the interest in that life insurance policy, there would not have been an “acquisition in the interest of the policy for nil consideration”.
It is therefore essential that if new owners are introduced into the business, that the existing policies are terminated and new policies entered into.
Ownership by deceased Estate
If insurance policies are owned by the deceased Estate, the deceased Estate would be the “original beneficial owner” and the estate would be exempt from Capital Gains Tax in relation to the life insurance proceeds.
However, for Capital Gains Tax purposes, the estate would be deemed to have disposed of the interest in the business, at a deemed market value, and would have to pay Capital Gains Tax on the capital gain realised upon their disposal of the interest in the business.
It is essential that when drafting Business Wills, careful consideration is given to the ownership of life insurance policies so that unwanted Capital Gains Tax consequences are not brought about.
Please do not hesitate to contact me if you would like to discuss any aspect relating to Business Succession, Business Wills, Estate Planning, or the ownership of life insurance policies.
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