Business protection - Shareholder protection - Tax implications
How can a business trust be used to help with tax planning? In this article we discuss the advantages in using a trust and how shareholder premiums can be equalised.
- A business trust is discretionary.
- The beneficiaries of the trust will be the others taking part in the share protection arrangement.
- Non-participants shouldn’t be able to benefit from the trust.
- The flexible nature of the trust means it can deal with changing circumstances (that is, joiners and leavers).
- Typically those involved in the share protection arrangement will be trustees. The trust should be accompanied by an agreement governing the transfer of the shares. Typically this will be a cross option agreement on death and single option on critical illness.
- If the settlor suffers a critical illness and doesn’t want to sell their shares, the proceeds are best kept in and reinvested within the trust until the succession issue is resolved.
The trust should be set up at outset.
Inheritance tax implications of the business trust
A business trust is a discretionary trust which means if a new shareholder arrives they can join the share protection arrangement and become a beneficiary of these earlier trusts. The person covered can be a potential beneficiary and the trust won’t be treated as a gift with reservation. Having the person covered as a potential beneficiary means that if they were to leave the company, the plan can be assigned out of the trust to the beneficiary. They can then use it for personal purposes.
The reason the trust doesn’t give rise to a gift with reservation is that where each shareholder takes out a plan and writes it under trust for the other shareholders with an appropriate option agreement in force, this represents a reciprocal commercial arrangement. So there’s no element of gratuity or gifting.
What are the implications of using a discretionary business trust?
The trust is subject to the ‘relevant property’ regime applying to discretionary trusts. This can result in immediate inheritance tax (IHT) payable on lifetime transfers into trust plus ‘periodic’ charges at every 10th anniversary and ‘exit’ charges on capital distributed between 10-year anniversaries. However, in a business context the payment of premiums won’t be treated as gifts or lifetime transfers where they’re made as part of a proper commercial arrangement.
Typically, the 10th anniversary charges won’t apply for life cover given that following a death claim, the funds will normally be paid out of the trust immediately to the other shareholders. As result, funds are rarely sitting in trust at a 10th anniversary. In the unlikely event that they are, then the excess (or indeed the value of the life cover should the individual be in very poor health at that time) over the available nil rate band will be subject to IHT at 6% on current rates.
A more common scenario would be a case where a shareholder with critical illness cover chooses not to sell their shares and the critical illness proceeds stay in trust beyond the 10th anniversary. If so, periodic and exit charges might well arise unless the trustees decided to release the funds from the trust and for the other shareholders to then hold this money personally.
Can more be done to improve on or reinforce the commerciality?
Yes. Shareholder premiums can be ‘equalised’. This means each shareholder pays a commercial amount relative to their expected benefit. If premiums are not equalised, the differing amounts paid (caused by differences in age, health and size of stake in the company) could be deemed gifts which introduces IHT implications. As a result, gift with reservation implications could arise, given that the specimen business trust includes the settlor as a potential beneficiary.
If this is the case, premiums might be deemed gifts for IHT purposes. In practice, they may fall within the individual’s annual IHT exemption, or normal expenditure out of income exemption.
The sum paid into the trust on death could be subject to IHT under the gift with reservation principles. In contrast, a properly commercial arrangement would be free of IHT. Simply using a gift trust rather than a business trust as a means of avoiding gift with reservation issues is unlikely to succeed. This is because a discretionary gift trust would include beneficiaries who are not shareholders and so the trust would not be commercial and may then give rise to a gift with reservation by associated operations.
A simple illustration of the need for equalisation would be a company with 2 x 50% shareholders. Each takes out a plan in trust for the other, but shareholder A’s premiums are considerably more than shareholder B’s because of A’s age and health. In this example, A is paying more but is less likely to benefit from the arrangement as they’re more likely to die.
So A is effectively making gifts to B which means there could be gift with reservation implications on death. In this scenario, premium equalisation would simply involve B paying A’s premium and vice versa.
In this way each would be incurring costs relative to their expected benefit. The people concerned should agree how they want to settle these differences. For example, they may process the adjustments through their directors’ loan accounts with the company, or even a suitably documented transfer through their personal bank accounts.
If more than two people are involved, a mathematical calculation can be used. For example, if there are three shareholders taking part, the formula shown below could be used to work out shareholder A’s equalised share of premiums to be paid. The same principle would be applied for shareholders B and C.
Left hand side of sum:
Sum assured on A times B's premium divided by the total sum assured - sum assured on B
Right hand of sum
Sum assured on A times C's premium divided by the total sum assured minus sum assured on C
Can I put an existing plan into the business trust?
Although it can be done, there are some implications you should be aware of.
Proceeds from protection plans are not subject to capital gains tax unless the plan is in second hand ownership and the second hand owner acquired the plan for money or money’s worth. Where a plan is
put into trust it will be in second hand ownership. So it’s important to make sure the transfer into trust is not for money or money’s worth.
In a business protection arrangement, no money is being paid, but could it be construed as a transfer for money’s worth? Because each shareholder is assigning their plan into trust, in return for the others doing likewise, this could be viewed as a money’s worth transaction. So it could benefit your client to set up the trust before the plan goes on risk.
Life of another plans owned by shareholders
Each shareholder takes out a plan on the life of their co-shareholders. In one respect this is very simple as it doesn’t involve a trust. And there’s no premium equalisation involved as the shareholders are not paying premiums reflecting their personal circumstances.
What problems arise from life of another plans?
Firstly, it could mean having many plans. For example, a four shareholder company could need 12 plans, that is, shareholder A takes out plans on each of the lives of B, C and D, and so on. This arrangement is inflexible where shareholders join or leave.
Broadly, those plans are most suitable for companies with two shareholders where it’s unlikely that new shareholders will become involved. Even with a two-shareholder company, life of another might cause problems where critical illness is involved.
Consider the case of shareholder A who has a Life or Critical Illness Cover on shareholder B. If B were to suffer a critical illness, A would receive the proceeds as plan owner. If B decides to sell, B transfers his or her shares to A in return for the proceeds.
But what if B has a single option and decides to remain a shareholder? A is then left with the proceeds in their own personal estate. This could cause potential IHT issues in A’s estate. So this is not as attractive as the trust solution where the proceeds may be kept within the security of the trust.
The information provided is based on our current understanding of the relevant legislation and regulations and may be subject to alteration as a result of changes in legislation or practice. Also it may not reflect the options available under a specific product which may not be as wide as legislations and regulations allow.
All references to taxation are based on our understanding of current taxation law and practice and may be affected by future changes in legislation and the individual circumstances of the investor.