Shareholder Protection - Why Have It?
Life cover is always an emotive subject. Why bother with life cover when you will not be the one to benefit?
Any business owner is in business to provide financial security for their family and they would want to ensure that this security is not compromised by either their own untimely death, or that of one of their business partners.
The purpose of shareholder protection is in effect two fold: -
- To ensure that the surviving shareholders can continue to run the company as they wish.
- To provide financial recompense for the value of the shares to the relatives of the deceased shareholder.
Let us assume that we have two directors, Angela and Bob each owning 50% of the business.
If Angela were to suffer premature death what impact would this have on her family and also on Bob?
Angela's family will inherit the shares under her will. (Life gets even more complex if she dies intestate!).
Angela's family are unlikely to want to be involved in the business but clearly will want "fair value" for their shares.
Clearly, their first option is to sell them to Bob.
Would Bob have the necessary capital readily available to purchase the shares at market value? If not, would Bob be able (or indeed willing) to finance the purchase via a new loan / mortgage?
If Bob were not in a position to purchase the shares from Angela's family then they would have to look for a third party buyer.
If successful, Bob could find himself having no control of the company, and having to work with someone who may even be a competitor. Any outside party could severely restrict any plans Bob has, whilst they would be able to grow their other business having effectively removed a competitor from the marketplace.
Alternatively, Bob may just not get on with a new third party, making his working life very difficult.
By having shareholder protection in place, in conjunction with suitable trust and cross option arrangements, the policy proceeds would become available to Bob if Angela should suffer an untimely death. Bob would then have sufficient funds to purchase the shares from Angela's family. Consequently, he would retain control of the company.
Getting the Paper Work Right
Our experience of reviewing existing arrangements has shown that well over 90% of arrangements have errors in the way they have been structured - some of them serious enough to ensure that the planning the business owners had in place would not actually have worked.
Shareholder Protection - Shareholder Agreement / Memorandum and Articles
This document needs to allow you to carry out the shareholder protection strategy. If it is not written correctly then any shareholder protection strategy will fail.
Shareholder Protection - Cross Option Agreements
This is the agreement that deals with the rights to buy / sell shares from directors in the circumstances of death and / or serious ill health. Many of the agreements we see do not work, or have significant flaws in them.
It is imperative that this document is drawn up correctly and meets the current requirements in respect of tax legislation.
Shareholder Protection - Trust Wording
Again an area where we see many difficulties because trusts have been set up incorrectly, or not at all. The trust is essential in order to pass any claim moneys from the protection policy into the hands of the surviving shareholders without incurring an Inheritance Tax or Income Tax liability.
If you do not have all the pieces in place correctly then shareholder protection strategies do not work.
It is also important to ensure it does not fall foul of the new Pre Owned Asset Tax legislation.
Shareholder Protection - Pre Owned Asset Tax
The introduction of the new Pre Owned Asset tax legislation has also had an impact on how new shareholder protection strategies are set up, as well as requiring a detailed and comprehensive review of existing arrangements.
This legislation was implemented in order to tax any asset which was placed in trust to which the settlor either had direct access to, or had the potential to have access to.
Many older business protection arrangements had clauses in their trust deeds enabling the insured business owner to have the policy assigned out of the trust into their personal ownership should they ever leave the business.
This arrangement is likely to be caught by the Pre Owned Asset tax legislation but unfortunately HMRC have been silent on their view as to how they would interpret the legislation in these cases.
This area is a complex one and a tax liability in theory arises in the scenario of a business owner whose health starts to deteriorate and thus a life policy starts to gain an actual value prior to death.
The level of this value and the tax liability due is one that is open to differing interpretations of the value of the policy. This can therefore lead to potentially protracted and difficult discussions with HMRC over potential tax liabilities on.
With all new arrangements we would strongly recommend that the Pre Owned Asset tax issue is avoided by removing the ability to have the life policy assigned out to an individual.
We also look at any existing arrangement with a view to establishing what risk, if any, there is to Pre Owned Asset tax and provide business owners with solutions to those problems.
Shareholder Protection - IHT Implications
The transfer of shares on the death of a shareholder to their family is usually not subject to IHT. This IHT free status would be available for a surviving spouse as well. However, a share option plan ultimately changes the IHT free shares into IHT liable cash.
Whilst this has no impact for the deceased shareholder, it does have an implication for their beneficiaries.
This issue can be mitigated by utilising an additional family trust arrangement in conjunction with the shareholder agreement and cross option agreement.
This is a key issue for Castle Court Consulting and the planning advice we provide to clients.
It is not just about solving the initial problem (in this case, shareholder protection), but also thinking through the implications of the solution on any other third party (the surviving family).
To find out more about how we can review your existing arrangements or implement new ones please email Richard Gough - rdjg@castlecourt.biz.