Two people build a business together over fifteen years. One of them dies on a Tuesday.
By Friday, the surviving owner is in business with his late partner’s widow. She has no experience in the industry, no interest in running it, and a mortgage. She wants to be paid out. He has no cash to pay her, the bank will not lend against a business that has just lost half its management, and the personal guarantee he signed four years ago is now the only thing holding the facility together.
Everyone in this scenario is behaving reasonably. Nobody planned for it because it felt morbid and there was always something more urgent. The tool that would have solved it costs a few thousand dollars a year and takes about two months to put in place.
This guide explains what buy/sell agreements and key person cover actually do, why the ownership structure of the insurance matters more than the amount, and where the tax traps sit.
Two different problems
These are frequently confused, and they solve different things.
| Buy/sell cover | Key person cover | |
|---|---|---|
| The problem | Transferring an owner’s equity when they die or become disabled | The business losing the profits or capital that person generated |
| Who is paid | The outgoing owner or their estate, in exchange for the equity | The business |
| Typically owned by | Each owner personally, or an insurance trust | The business entity |
| Premiums deductible? | Generally no | Depends on the purpose. See below. |
| Needs a legal agreement? | Yes, essential | No, but the purpose should be documented |
Most businesses with two or more owners need both. They are not alternatives.
What a buy/sell agreement actually does
A buy/sell agreement, sometimes called a business succession agreement, is a contract between the owners setting out what happens to an owner’s interest when a trigger event occurs. It has two halves, and both are necessary.
The legal agreement creates the obligation to transfer and the obligation to buy, sets out how the business is valued, and defines what counts as a trigger. The funding, usually insurance, provides the money to complete the purchase without the continuing owners having to find it.
An agreement without funding is a promise nobody can keep. Funding without an agreement is a lump of money with no obligation attached to it, and in the absence of a properly drafted agreement, insurance proceeds may simply be treated as personal cover rather than business succession funding.
Trigger events
Death is the obvious one and is usually an automatic trigger. Total and permanent disability is equally important and more common. Trauma or critical illness is sometimes included, and needs more thought, because someone who has a heart attack may well return to the business. Trauma triggers are often drafted so that the options cannot be exercised until a defined period has passed or a test about the person’s capacity to continue has been satisfied.
Voluntary exit and retirement can also be dealt with in the agreement, though these are generally not insurable events and need a different funding mechanism.
Put and call options, and a timing trap
The standard mechanism is a pair of options. The outgoing owner or their estate holds a put option compelling the continuing owners to buy. The continuing owners hold a call option compelling the outgoing owner or estate to sell. Together they make the transfer certain in both directions, whatever anyone feels about it at the time.
The drafting detail matters. If the options are exercisable from the moment the agreement is signed, there is a risk that signing the agreement itself is treated as the disposal for capital gains tax and duty purposes, rather than the trigger event years later. Properly drafted agreements make the options exercisable only on a trigger event. This is a legal drafting question and a genuine reason not to use a template.
Valuation
The agreement has to say how the business is valued, and the realistic options are an agreed value reviewed at set intervals, a formula such as a multiple of earnings, or an independent valuation or arbitrator at the time.
Whichever is used, the insurance needs to keep pace. A business valued at $2 million with $1.2 million of cover creates a shortfall that has to come from somewhere, and the somewhere is usually the continuing owners’ pockets or a bank. Reviewing the cover against the value annually is the least glamorous and most valuable maintenance task in this whole area.
Ownership structure decides the tax
This is the part that gets missed, and it is where the money is.
Two provisions of the tax law do the work, and they do not line up neatly.
- Section 118-300 ITAA 1997 disregards a capital gain on life insurance proceeds where they are received by the original beneficial owner of the policy, or by someone who acquired the interest for no consideration. The ATO’s position is that this applies to death benefits, with terminal illness benefits treated the same way.
- Section 118-37 ITAA 1997 deals with non-death benefits such as TPD and trauma, and exempts them only where they are received by the injured person or a relative.
The asymmetry is the trap. A structure that works perfectly for a death benefit can produce an assessable gain on a TPD or trauma benefit, because a business partner is not a relative.
| Structure | How it works | Key considerations |
|---|---|---|
| Self-ownership | Each owner holds a policy on their own life. On a trigger event, the proceeds go to them or their estate, and the agreement obliges the transfer of equity. | The most common structure. Satisfies both exemptions. Simple and portable if someone leaves. Complications where owners hold their business interest through a company, trust or spouse rather than personally. |
| Cross-ownership | Each owner holds a policy on each other owner’s life. Proceeds go to the continuing owners, who pay the estate for the equity. | Death benefits are usually fine. TPD and trauma proceeds received by a co-owner who is not a relative can be assessable. Also becomes unwieldy beyond two or three owners. |
| Insurance trust | A trustee holds the policies, with the insured persons beneficially entitled. | Preserves the exemptions, allows the sum insured to be reallocated between purposes, and can consolidate several purposes into one policy per insured. More set-up cost and an ongoing trustee role. |
| Business or company ownership | The entity owns the policies. | Common for key person cover. Generally unsuitable for buy/sell, since proceeds received by the entity do not attract the personal exemptions. |
| Superannuation ownership | A super fund trustee holds the cover. | Generally unsuitable for buy/sell funding. Proceeds must be released as a superannuation benefit to a dependant or the estate rather than paid to business partners, and own occupation TPD and trauma cannot be held in super. |
There is one more structural point worth stating plainly. The insurance ownership has to match who actually owns the equity. If your interest in the business is held by a family trust or a company rather than by you personally, self-ownership of the policy does not automatically line up, and the agreement and the ownership need to be designed together. Our guide on how each wealth structure works covers the underlying ownership question.
Premiums for buy/sell purpose cover are generally not tax deductible, because the purpose is capital in nature.
Key person cover: the purpose decides everything
Key person insurance protects the business against the loss of someone whose absence would materially damage it. That might be an owner, but it might equally be a lead salesperson, a technical specialist, or the person who holds the licence the business trades under.
The tax treatment turns entirely on the purpose of the cover, and it is broadly the reverse of what people expect.
| Revenue purpose | Capital purpose | |
|---|---|---|
| What it funds | Lost profits, recruitment and training costs, keeping the lights on during the transition | Repaying debt, replacing capital, funding a buyout, protecting the balance sheet |
| Premiums | Generally deductible | Generally not deductible |
| Proceeds | Generally assessable | Generally not assessable |
Two practical consequences. First, you cannot have it both ways: deductible premiums come with assessable proceeds. Second, and more importantly, the purpose needs to be documented at the time the cover is put in place, usually by a board or partners’ minute setting out what the policy is for. Deciding after a claim what the purpose was is not a strategy, and the ATO’s interest in the question arrives at exactly that point.
Where a business needs both, the cover can be split into separate policies or clearly apportioned, so the revenue and capital components are dealt with correctly. That is an accountant’s call, made before the policy is issued.
Debt and personal guarantees
This is the most commonly overlooked exposure of the three.
Most small business borrowing is personally guaranteed, and often secured against the family home. If an owner dies, the guarantee does not die with them. It becomes a liability of their estate, and the lender may reassess or call in the facility precisely when the business is least able to refinance.
Debt protection cover, sized to the business borrowings and structured to line up with who has given the guarantees, is usually cheaper than people expect and is the piece most likely to prevent a family home being lost. It should be reviewed every time facilities change.
The mistakes we see
- An agreement with no funding, or funding with no agreement. Each is half a solution and neither works alone.
- Cover that stopped tracking value. The agreement was written when the business was worth $800,000 and nobody updated it as it grew to $3 million.
- Ownership that does not match the equity. The policy is personally owned but the business interest sits in a trust, or vice versa.
- Cross-ownership without considering TPD and trauma. The structure works for the event everyone thinks about and fails for the ones that are statistically more likely.
- Buy/sell cover held inside superannuation. The proceeds cannot generally be paid to the people who need them.
- Trauma triggers that fire too early. An owner is compelled to sell after an illness they fully recover from.
- Nothing at all. Still the most common position among Australian small businesses with more than one owner.
Getting it done
- Agree the value and the method for updating it. Everything else depends on this number.
- Decide the triggers, including how a trauma event is handled and whether voluntary exit is covered.
- Choose the ownership structure with the tax consequences modelled, not assumed, and with your actual equity ownership in view.
- Have the agreement drafted by a solicitor. The option mechanics and the drafting that avoids an early disposal event are not template territory.
- Apply for the cover and get it accepted before signing anything that assumes it exists. Underwriting outcomes are not guaranteed, and our guides on occupation classes and exclusions and loadings explain why terms can differ from what was expected.
- Document the purpose of any key person cover by minute at inception.
- Review annually against the current value, the current debt and the current ownership.
Expect the whole process to take a couple of months, mostly waiting on underwriting. Start it when things are calm, because you cannot start it when they are not.
Where Professional Advice Adds Value
This is genuinely a three-adviser job, and the coordination is where it usually falls over. The solicitor drafts the agreement. The accountant confirms the tax position and the valuation method. The financial adviser structures and arranges the cover so that it matches both.
At Money Path our part is the funding side and the coordination. That means sizing the cover against a real valuation rather than a guess, choosing an ownership structure that survives both the death and the disability scenarios, getting the cover underwritten and accepted before the agreement is signed, and making sure the key person purpose is documented at the right time rather than reconstructed later. It also means reviewing it, which is the step that most often does not happen and the one that quietly turns a good arrangement into an inadequate one.
For owners thinking further ahead, this work sits alongside a planned exit rather than replacing it, and our guide on financial planning before, during and after a business exit covers that path. Where personal estate planning intersects, as it always does for business owners, our guides on testamentary and family trusts and estate planning are the starting points. A buy/sell agreement and a will need to say consistent things, and surprisingly often they do not.
Frequently asked questions
What is a buy/sell agreement?
A contract between business owners setting out what happens to an owner’s interest if they die, become totally and permanently disabled, or in some cases suffer a serious illness. It defines the trigger events, how the business is valued, and the obligation to buy and sell, usually through put and call options. It is normally funded by insurance.
What is the difference between buy/sell and key person insurance?
Buy/sell cover funds the transfer of an owner’s equity and is paid to the outgoing owner or their estate. Key person cover compensates the business itself for the loss of someone important, and is paid to the business. Most businesses with more than one owner need both, plus cover for any business debt.
Are buy/sell insurance premiums tax deductible?
Generally no, because the purpose is capital in nature. Key person cover is different: premiums for revenue purpose cover are generally deductible with the proceeds generally assessable, while capital purpose premiums are generally not deductible and the proceeds generally not assessable. The purpose should be documented when the cover is arranged.
Who should own the buy/sell insurance policies?
Self-ownership, where each owner holds a policy on their own life, is the most common structure and satisfies the relevant capital gains tax exemptions. An insurance trust is a common alternative. Cross-ownership can create a tax problem for TPD and trauma benefits, and superannuation ownership is generally unsuitable for buy/sell funding.
Why can cross-ownership create a tax problem?
Because death benefits and non-death benefits are treated differently. Life insurance proceeds are generally exempt when received by the original beneficial owner, but TPD and trauma proceeds are exempt only when received by the injured person or a relative. A business partner is not a relative, so a cross-owned TPD or trauma benefit can produce an assessable gain.
What happens if we have no agreement and an owner dies?
The deceased owner’s interest passes to their estate, which usually means their spouse or children become your co-owners. They may want to be paid out, sell to a third party, or remain involved. The continuing owners have no right to compel a sale and no funds to buy, and any personally guaranteed business debt becomes a liability of the deceased’s estate.
How often should a buy/sell arrangement be reviewed?
At least annually, and whenever the business value, the ownership, or the borrowings change materially. The most common failure is not a badly drafted agreement but a well drafted one funded at a value the business passed years ago.
Taking the next step
If you own a business with someone else and there is no buy/sell agreement in place, that is the gap to close first. If there is one, the useful question is when it was last reviewed and whether the cover still matches what the business is worth today.
Neither question takes long to answer, and both are considerably easier to deal with now than in the week everything changes.
General advice warning: This article contains general information only. It does not take into account your objectives, financial situation or needs, and it is not legal or tax advice. The taxation treatment of insurance proceeds and premiums depends on the specific structure, purpose and documentation of the arrangement and on your circumstances, and the provisions summarised here are simplified. Buy/sell agreements are legal documents that should be drafted by a solicitor, and the tax position should be confirmed by a registered tax agent. Seek personal advice from a licensed financial adviser before taking out, changing or cancelling insurance.
