Standard Life ezine - Business Protection case study – Standard Life Protection & Healthcare Ezine

Standard Life's Protection & Healthcare newsletter for advisers

Issue 2: Nov 2006

In this example we look at how partners in a business can protect the company in case one of them dies. Between them, A, B, C & D own the business. We’ll assume the business is a limited company, and they are shareholders, although of course the same principles will apply to a partnership.

When a shareholder (or a partner) dies, there can be serious implications for the surviving owners, as well as for his dependents. This is because the deceased’s interest in the business is passed to his estate. This could mean that:

The remaining owners losing some degree of control of their business.
Someone else may now be entitled to a share in the profits of the business, but who isn’t able to contribute towards it.
The new owner may also wish to sell their interest, perhaps to a competitor. They may prefer to have received cash, and want to sell their interest, but will they be able to find a buyer?
The surviving owners may not have the funds to buy the interest.

One possible solution would be to have a cross option arrangement in place which would ensure that on a shareholder’s death:

The survivors have an option to purchase his or her shares from the estate (which becomes binding on the estate if exercised), and
The estate has an option to sell the shares to the surviving owners (which becomes binding on the state if exercised), and
Funds are provided through life assurance to facilitate the purchase.

How the cross option works
The cross option agreement is a formal agreement between business owners which deals with what may happen to their share of the business on their death (and possibly in the event of them becoming terminally or critically ill).

A typical agreement will also:

Specify the proportions in which the survivors buy the deceased’s interest
Oblige all parties to effect and maintain suitable life assurance policies
State how a share in the business is to be valued on sale
State what will happen if the proceeds payable under the life policy are greater or less than the value of the share in the business.

Standard Life’s specimen agreement is available at www.adviserzone.com. It should be stressed that this should be examined by the shareholders’ own legal advisers; it may contain provisions which are not compatible with their own articles of association.

In what proportion will the shares be purchased?
This is something that must be agreed amongst the shareholders and documented in the agreement.

On the death of one shareholder, the survivors may simply buy equal shares in the deceased’s interest. More commonly, the survivors will buy the deceased’s shares in the proportion that corresponds to their ownership of the remaining shares (this is the method specified in our draft agreement). Thus, if there are four equal shareholders and one dies, the survivors will buy a third of the shares each.

Our shareholders happen to own shares as follows:
A owns 40 shares
B owns 30 shares
C owns 20 shares
D owns 10 shares

On death of a shareholder, the survivors buy the shares as follows:

Hence, on the death of A, the 40 shares would be purchased as follows:

How much life cover is required?
Each shareholder must be covered so that on their death, there is sufficient money available for the survivors to buy their shares. Each shareholder will therefore normally be covered for the market value of their full shareholding.

It must be remembered that you cannot accurately value a shareholding either by proportioning the overall value of the company, or by multiplying up the value of one share. As an example, the market value of a 51% controlling interest is greater than that of a 49% interest, by a greater margin than 2% of the shares might suggest.

It isn’t possible to give guidelines on how to value a company or shareholding; this is best left to the clients’ accountant or a professional valuer.

The beneficiaries and the relevant percentages of the sum assured are entered into a business trust, a specimen of which is also available on our web site.

Taxation
Because all the life policies were written in trust, they don’t form part of the respective settlors’ estates. No Income Tax or Capital Gains Tax is payable on the proceeds. The shares may qualify for Business Property Relief (BPR) on the death of a shareholder, and this will not be affected by a cross option agreement.

On the subsequent sale, Capital Gains Tax may be payable in respect of any increase in value after death.

Tax and legislation are liable to change. This information is based on our current understanding of law and HM Revenue & Customs practice as at 13 November 2006. No guarantees are given regarding the effectiveness of any arrangement entered into on the basis of these comments. The adviser is responsible for advice given, not Standard Life.

Further information on taxation of business protection arrangements can be found in the Standard Life's Life Life Briefing number 33 and Life Briefing number 67.

Other methods
There are other business protection arrangements, outlined in our Life Briefing number 17 Company buy-back of shares, and Life Briefing number 36 Automatic accrual arrangements (partnerships).

Further information
Briefings covering various aspects of business protection are available on Techzone, along with specimen cross-option agreements and business trusts etc.