Partnership and Shareholder Protection

Shareholder protectionWhilst most partners in a business or shareholders are encouraged to have a partnership or shareholders agreement so that, in the event of death or serious illness, there is a clear plan of what will happen to the individuals share of (shares in) the business to allow for efficient and effective business continuity. This is often where the sensible planning stops.

Having the agreement is great, knowing that if a shareholder dies that the business will offer to buy back the shares is very sensible, very few businesses want a grieving spouse as a new shareholder who often knows little about the actual business let alone has the skills to be useful. But if the company does not have the capital to buy the shares and borrowing can be very difficult when a key person has died. How can such a plan be exercised?

The vital step that is often overlooked is to provide an insurance plan that will give the remaining partners or company the necessary funds to purchase the deceased shares.

Business partners, directors or members of a Limited Liability Partnership can each arrange a policy which pays out to the surviving business associates. Each policy is written under trust and subject to a cross option agreement or suitable arrangement (see below). On death or serious illness the proceeds are then paid to the trustees who then pass the money to the beneficiaries (remaining partners/shareholders) who can use the money to buy the deceased’s share of the business from his/her estate.

The agreement for share(s) purchase will take the form of either a double (cross) option or a single option agreement between the partners or shareholding directors.

Double Option Agreement

Here both parties have the option to buy or sell the company shares. Upon the death of a partner/shareholder, the surviving shareholders have the option to buy the deceased’s shares from the deceased’s legal personal representatives. Additionally, the personal representatives have the option to sell the deceased’s shareholding to the remaining shareholders.

If either party exercises their option the other party must comply, but as this does not constitute a binding contract for sale IHT business property relief should be available, provided the deceased’s shareholding meets the relevant criteria for the relief.

The agreement will specify how long the option to buy or sell lasts for – typically this might be for a period of three months from the date of the grant of probate.

In the context of a shareholder suffering a critical illness, it would be possible to draft a double option agreement to become effective only in defined circumstances – for example in the event of total or permanent disability or the inability to carry out usual business activities for a specified period of time.

Single Option Agreement

This type of agreement will usually be used in the event that a partner/shareholder suffers a critical illness and provides the critically ill shareholder with the option to sell their shares to their co-shareholders. Crucially there is no corresponding option for the remaining shareholders to purchase the shares. As the critically ill shareholder may fully recover and intend to return to work they retain control over their shareholding and can’t be forced to sell.

An appropriate pre-determined period during which the option to sell can be exercised might be twelve months from when the critical illness claim is admitted.

How Much Cover

It’s important that the level of cover chosen reflects the value of the share(s). As this is likely to alter over time it is important for the business to review the value of the business and therefore the value of each partners share or shareholders shares.

 Example:

ElectricsRUs Ltd is a family run business offering electrical services and is owned by four shareholders in equal shares, David and his wife Sandra and their two married sons Mark and Rob. Sandra has no interest in the business and would like her shares to pass to David on her death without value. In the event that David dies, he would want Mark and Rob to purchase both his and Sandra’s shareholdings. Both Mark and Rob would want the remaining shareholding directors to purchase their shareholding in the event of their death. The company has recently been valued at £2m.

To achieve these objectives, the following planning is required:

  • Each shareholder’s Will is structured to leave the shares to their spouse on death.
  • David takes out an own life policy for £1m and writes it under a business trust for the benefit of Mark and Rob.
  • Mark and Rob each take out own life policies for £500k and write them under business trusts for the benefit of the remaining shareholders but excluding Sandra.
  • A double option agreement is established to reflect their requirements. If David dies his shares will pass to Sandra who will have the option to sell these to Mark and Rob, together with her own shares. Mark and Rob also have the option to purchase the two shareholdings. The level of cover under David’s policy provides the funds to achieve this. If Mark or Rob dies, their legal personal representatives have the option to sell the shares to the remaining shareholding directors who have a reciprocal option to purchase the shares.

Paying the Premiums

If the business pays for the cover on behalf of the shareholder, the business is able to deduct the expense for Corporation Tax purposes because it is effectively fulfilling the shareholders responsibility to pay. The business will also incur a liability for National Insurance Contributions paid on behalf of the shareholding director, but this will also be a deductible expense. In this instance, the shareholder will be assessed for Income Tax and National Insurance contributions on that benefit, which will be grossed-up appropriately as a benefit-in-kind.

If the shareholder pays for their own cover, they will pay from their taxed income.

In terms of other taxes and the premiums, if the arrangements are regarded as a commercial transaction (with no element of gift), there will be no Inheritance Tax on premium payments.

When a claim is made

There is normally no Capital Gains Tax payable on the claim benefits. However, the beneficiaries of the deceased’s estate could be liable if there is an increase in the value of the shares between death and sale. A Capital Gains Tax liability may also arise in the event of the sale of a director’s shares due to critical illness.

Provided the cover is part of a commercial arrangement (with suitable trust), benefits will normally be payable to the trustees and will be free from Inheritance Tax (as the trust does not form part of the deceased’s estate).

 

If you have any questions or queries on this topic, please feel free to leave a comment or contact us here.

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