Pitfalls of standing surety for company debt

● A small company often needs to borrow money from the bank or run an overdraft. In both cases the bank will normally require one or more directors to sign surety for the debt. What most directors don’t appreciate is that if they die, the bank will immediately call up the loan. Your company and your personal estate could be left with serious liquidity and solvency problems.

If you are a director who has stood surety, you should have a life policy in place to cover the debt and provide cash to pay it off in the event of your death. The policy should be owned and paid for by the company. This is known as a contingent liability policy, which comes with a lot of tricky issues:

Tax

Many financial advisers are not aware that there was an amendment made to the Income Tax Act (section 11(w)) with effect from March 1 2015, and from this date such company-owned contingent liability policies are no longer tax-deductible.

If you are a director and know your company has such a policy, you should check that the company is not inadvertently claiming such a deduction in breach of the Income Tax Act. If the company has been claiming since March 1 2015, it needs to sort this out with the South African Revenue Service.

A company-owned keyman policy, to cover a key individual and provide for their replacement on death, and not a surety, is still deductible.

Estate Duty

A bigger problem is that this contingent liability policy is almost always subject to estate duty. It occurs by virtue of a section in the Estate Duty Act (section 3(3)(a)), which brings into the deceased estate what is known as a deemed asset, “any amount due and recoverable under any policy of insurance which is a domestic policy upon the life of the deceased . . .”

This means a policy on the life of the deceased triggers estate duty, even if the proceeds pay to a third party or outside the estate. Although there is an exemption in the Estate Duty Act for certain types of company-owned policies (section 3(3)(a)(ii)), the exemption does not apply where the proceeds have been paid into the deceased estate, or benefit a relative of the deceased.

Where the policy is being used to cover the suretyship of a director, SARS is of the view that the deceased estate benefits from the policy on the director’s death, because the policy proceeds are being used to cancel the underlying debt. This releases the deceased estate from its suretyship. The policy is therefore subject to estate duty.

This means the policy amount needs to be increased to cover the estate duty, or else there will not be enough money to pay off the suretyship or loan after the duty is deducted. If you have a contingent liability policy in place to cover a loan/suretyship, you must ensure that estate duty is catered for in the policy as well.

The final trick here is although estate duty is 20%, the policy can’t simply be increased by 20% to cover the duty, as that extra 20% itself attracts estate duty and will still leave a short payout after duty is deducted. The cover must be increased by 25% (the formula used is to divide the required amount by 0.8) to ensure that after duty is paid there is sufficient money to settle the full debt.

An example to illustrate this: X is a director of a company which has an overdraft of R1-million he has signed surety for. The policy to cover this on his death needs to be for R1.25-million, as after the 20% estate duty is deducted, the company is left with R1-million to settle the suretyship.

Contract to ensure debt is paid off

It is all very well having a policy in place to cover a company debt that you as a director have signed surety for, but if you die, what guarantee do you have that the company will actually use the policy proceeds to settle the company debt?

It is essential that a contract is signed between yourself and the company, obliging it to use the proceeds of the policy to settle the debt you stood surety for. That is the only way to ensure your estate will be protected on death.

A contingent liability policy is usually subject to estate duty