You can lead a horse to water…

In December 2022, the authors were panellists at STEP’s Special Interest Group Spotlight Sessions in London. The topic was mental incapacity; specifically, how it affects business owners or clients with significant wealth in their own name, in companies, trusts or partnerships. The discussion was built around a case study that centred on the owners of an international family business and the various issues arising between the various family members when one of the owners, Anthony, lost mental capacity following a stroke. During the event, one participant suggested the case study used was made up, as it was too complex. Indeed, standing on the outside, it might make a good plot for a movie, and names had been changed to protect the innocent. However, the case study was based on a combination of real facts such that, for advisors, the scenario could be all too real.

This article aims to help advisors minimise clients’ risk around future mental or physical incapacity. Advice usually only arises around significant events, so clients can struggle to accept that future risks are a real possibility. Such advice might involve an appropriate will, an enduring, durable or lasting power of attorney, or entities that hold wealth and their structure and operation (such as a trust or a company operating a business). With no action taken, the consequence can be forced intervention. Government agencies, business partners, spouses, family, creditors or the courts can become involved. Professional fees can rise rapidly, alongside the loss of productive time as a business falls into paralysis and loss of earnings, compromising people’s livelihoods.

The following advice provides various options about typical risks. This should provide the advisor with choices, so enabling one’s client to prepare effectively. It also includes likely costs and achievable time frames. Other factors are cultural inputs, including religious beliefs, social values, saving face, taking risks and embarrassment. The client’s own knowledge will also be a factor. Has the client experienced first-hand a course of action being recommended? People will have roles to play in future scenarios discussed, so careful consideration should be given as to why they may be chosen. How old is the individual? Do they have the skillset to perform the anticipated tasks? What is their place in society and in the family? What about their trustworthiness and motivation? What is their involvement in family and business affairs? All conflicts of interest should be identified early and minimised.

Funding the risk

Funding the risk may be achieved by budgeting well and understanding the needs of the business, stakeholders and family. Employees, including family, should be paid a reasonable salary and/or wages.

For business affairs, the use of insurance may be advisable or necessary. Most types of insurance are based around quantifiable risk. For instance, actuaries can only assess an actual risk assessed. The risk should be ascertained by identifying liabilities, including loans by way of mortgage, loans to other parties, hire purchase, guarantees given and expected family costs like education of children. When getting insurance, clients must consider who is covered and who will be the beneficial owner. If it is a life policy, it may pay out while the covered person is alive, even if a diagnosis of terminal cancer did not eventuate. Trauma or disability insurance pays out on the proof of a physical event, such as a heart attack. Some policies can have combined life and trauma disability and income protection, and payouts can stream differently by agreement. What are the tax consequences? Is estate duty applicable? Is the premium deductible and will it be tax paid on payout?

Insurance over an individual for life, trauma, disability or income can pay out and benefit where:

• The owner is the insured (individual) and pays out to themselves and their estate on death.
• The owner is the spouse (individual) and, by paying them direct, the payout bypasses the estate and can be used to pay family costs, such as the loan on the family home.
• The trustees are of a family trust, with funds to be ring-fenced and held for family or other beneficiaries.
• The owners and the insured are shareholders and principals of the business, and use a buy-sell agreement as a way to continue the business and pay out the family of the insured.[1] This removes the former shareholder and their family from subsequent interference in the business. The buy-sell agreement can be funded by real assets as well. Typically, it needs to be funded by at least 30 per cent of the assessed payout value of the shares, whether market-attributed fair value or fixed. If it is not funded, there is no point having an agreement, as no agreement is the default position. Each shareholder funds it themselves (not a company expense), usually from their company current account, so the proceeds belong to the shareholders and not the company. This activates in the case of a physical event, which could be death or a trauma claim and the insured can no longer work in the business. Shareholders have then contracted to each other usually to pay out over three to five years to the insured, the shareholder’s deceased estate (family) or to a trust. An event of physical or mental incapacity preventing the shareholder working in the business for more than, say, three months can activate the agreement. If shareholders have surplus, they can use the proceeds to reinvest in the company. If the shareholder returns to work and the agreement is not activated, then the insurance cover paid out can flow through to the shareholder. The buy-sell agreement allows an orderly time for the company and its shareholders to work through issues and eliminates property relationship issue claims by the family of the former shareholder. It also gives certainty to the family of the leaving shareholder.
• The company business for key person insurance premiums were paid as a deductible expense, but it is the company that received the proceeds from the insurance. The intent is replacement of the lost individual by hiring a new replacement in their field. It can take 6–18 months to get paid out. In practice, company directors may use the funds received to instead pay back loans, pay creditors, buy new stock, spend to increase production or marketing.

If cashflow is not an issue, clients should be advised to fund the risk in line with what can be afforded by putting it aside and out of reach to reduce temptation.

Superannuation, pension and/or share schemes, as part of remuneration for long-term staff and directors, can engender loyalty. In larger family companies, schemes where shares are held long term and produce dividends can be an excellent part of intergenerational wealth transfer plans. Endowment policies with both a cash value and a life component can be taken out over staff or family and future loans can be leveraged against them if funds are needed.

Conclusion

We are often advised to live in the moment and it is, therefore, unsurprising that business owners wish to concentrate on the ‘here and now’ rather than worrying about a future event that they hope will never happen.

However, as the family of Anthony in our case study found out to his cost, not planning for the possibility of losing capacity while one is still able to can bring much financial hardship and heartache later on.

Forward planning in the business and asset context has specific considerations as to whom clients would want to run the business in the event they cannot themselves, or indeed if they want an exit strategy (in which case, how that is funded will need careful thought), but options are available.