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Future Liability Plan

Planning for future expenses is vital for the running of a successful business. Often the business does not have the cash or immediate liquidity at its disposal to meet these expenses. A future liability plan is geared at ensuring that the business pre-funds for these expenses in a systematic manner, through an investment vehicle such as an endowment policy. Future expenses, or liabilities, may include the following:

  • Replacement of depreciating assets
  • Settlement of liabilities such as:
    • Overdrafts
    • Mortgage bonds
    • Credit loan accounts
    • Redeemable preference shares
  • Expansion of the business or purchase of capital assets such as a premises
  • The need for the business to have capital to buy a business owner out upon retirement or some other pre-determined date.

Why is it important from the business’s perspective to have a future liability plan in place?

  • Depreciating capital assets need to be replaced periodically, and this can come at a great expense. It may be difficult for the business to obtain full financing for the cost of the asset, and the interest rate charged may also be prohibitively high. By saving for the cost of the asset on an on-going basis, the business may not have to obtain finance at all, or may be able to reduce the finance required, and accordingly the interest charged.
  • When the business obtains finance, whether it is to replace depreciating assets, or to expand the business operation, more often than not the business owners are called upon to stand surety, which exposes their personal estates to the risk that the business is unable to settle the debt. If the need to obtain finance can be minimised, then the business owners’ personal estates are also protected
  • By investing outside of the business, there is a diversification of risk and an uncoupling of the growth on this particular investment from the growth in the business.

The structure of the future liability plan:

The business contributes to an endowment policy,(or it could contribute to a unit trust or some other suitable investment vehicle) on a regular recurring basis, or if it is in the position to do so, it makes a large single premium into an endowment policy or sinking fund policy or other suitable investment vehicle. In the case of an endowment or sinking fund policy, the term of the investment should be five years. The reason for this being that certain legislative restrictions apply with regards to the access of the investments in the first five years. There should be multiple lives assured on the endowment policy to ensure that it continues, and also to prevent the proceeds of the policy becoming deemed property in the estate of the deceased. At the end of the five year period, the business may access the proceeds of the policy as and when it sees fit.

If the business is a company, then it should conclude a board resolution indicating the decision and reason for the company taking out this particular policy.

Payment of premiums:

The business will pay the premiums in respect of the life insurance policies that have been effected.

The Income tax consequences:

The premiums made will not be tax deductible and accordingly the proceeds will pay out tax free.

Four Fund Approach

In terms of the Income Tax Act growth on investments by companies or close corporations in endowment or sinking fund policies, will be taxed in terms of the so called four fund approach. At this point in time, all interest and net rental income will be taxed at 28%, while capital gains will be taxed at an effective 14%. The tax levied will depend upon the type of assets class invested in. This taxation process takes place at the insurer and places no tax responsibility on the investor (the business). The proceeds paid out by the insurer therefore are not subject to tax in the business’s hands.

Estate duty consequences:

An endowment policy, which is a 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. In performing the business needs analysis, I will take into account whether or not the business is a family company in relation to the life assured and if so, I will include the potential estate duty in my proposal

Furthermore, only domestic life insurance policies which become due and recoverable on the death of the life assured are included in that person’s estate for estate duty purposes. That means that if there are multiple lives assured on the endowment policy then the proceeds will attract estate duty only at the death of the last dying life assured. Sinking fund policies will not attract estate duty and the same goes for unit trust and other suitable investments as these will be company owned. Therefore, if correctly structured, estate duty should not be applicable in the future liability scenario

If due to unforeseen circumstances, such as simultaneous death of all the lives assured, the policy does attract estate duty, then because the payer and beneficiary of the policy are both the same person (i.e. 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 Future Liability Plan:

  • Establish the extent of the future liability i.e. quantify the amount of cash required at the end of the specified term.
  • Establish the financial commitment needed in order to ensure that this capital is available at the end of the term- the amount that needs to be saved,
  • Ideally a risk profile analysis should be conducted in order to determine the business’s appetite for risk and which portfolios the contributions should be invested in.
  • All the necessary documents to obtain the relevant life office must be completed

A future liability plan, using an endowment or other alternative investment vehicle, is the ideal way of providing for future expenses or liabilities incurred by the business, and thereby ensures the continuity of the business as well.