If shareholders are in any doubt, a review of the company’s articles of association will highlight the need for protection.
Every company will have a memorandum and articles of association. The memorandum is an outward looking document stating the company name, registered office and what it will do. In contrast, the articles of association set out the rules for the running of the company’s internal affairs. So they’ll deal with issues like transferring and selling shares.
The Companies Act 2006 contains provision for the Secretary of State to prescribe model articles which the company may adopt in whole or part. These model articles are now set out in the Companies (Model Articles) Regulations 2008 but only apply to companies formed on or after 1 October 2009. For companies formed before this the previous table A articles set out in the Companies Act 1985 may apply.
‘The directors may refuse to register the transfer of a share which is not fully paid to a person of whom they do not approve ...’
This means that if a shareholder becomes critically ill or dies, then they could sell their shares, if fully paid, to an external third party even if this was against the wishes of the other shareholders. It may be difficult to get a realistic price for the shares in view of their lack of marketability. And, it could take months or even years to conclude a sale to a third party investor.
Alternatively, the spouse or family of the deceased might decide to keep the shares and become involved in the business. This could be just as unwelcome for the other shareholders.
Many companies will have incorporated a ‘pre-emption’ clause which gives the other shareholders the first opportunity to buy the shares of the critically ill or deceased. This may not offer the protection intended though. For example, how is the ‘pre-emption’ price per share to be calculated? Is it realistic for the outgoing shareholder and if it’s a fair value how will the others raise the funds to buy out the shares?
Borrowing is an option, but this would be done against the backdrop of a potentially traumatic period in time where the company has lost someone who is perhaps key to the business. Any lender would take this into account when deciding whether to lend.
A shareholder protection arrangement resolves these problems. Funds would be available when they were needed, on the death and/or critical illness of a shareholder. The sudden loss of a key shareholder can disrupt a company, but shareholder protection will minimise this interruption to the business. The shareholder or their family will quickly receive the true worth of their shares to alleviate these anxious times.
There are three main methods:
Each is dealt with in turn, but firstly we’ll look at how the shares should be valued.
Valuing an unquoted company is difficult. Key professionals, principally the company accountants, should determine the most appropriate valuation method to use after reviewing the articles of association to highlight any restrictions on the transfer of shares.
The size of the shareholding itself will be a factor, with a minority holding being less valuable than a majority holding. The shareholders may however, decide to disregard any discount for a minority shareholding and instead value each shareholder’s interest as a simple proportion of the total value.
There are three commonly used ways to value an unquoted company:
In this scenario, each shareholder takes out an own life plan for the value of their shares. This plan is then written under business trust for their co-shareholders.
The aim is that if one of the shareholders suffers a critical illness or dies, then the others will receive the funds from the trust to buy their shares. If the shareholder has died, the personal representatives would distribute the sale proceeds in accordance with the deceased’s will or rules of intestacy.
A discretionary trust which includes the settlor as a beneficiary allows a shareholder who is leaving while their plan is still live to take that plan with them, that is, have the plan assigned from the trustees to themselves as beneficiary.
The person covered, as settlor of the trust, will be an automatic trustee and the additional trustees appointed will normally include the other shareholders taking part in the protection arrangement.
Because the trust is discretionary, it can adapt to changing circumstances (for example, if a new shareholder joins the arrangement or an existing shareholder leaves). Similarly, trustees can be changed.
The trustees may appoint funds to any of the beneficiaries. The discretionary beneficiaries are restricted to the shareholders, including the settlor.
A form of shareholder agreement is necessary, this may be a separate shareholder agreement or it may be incorporated into the articles of association.
This is sometimes referred to as a double option agreement. It gives the surviving shareholders the option to buy the shares from the personal representatives.
If either side wants to exercise their option, the other party must comply. Options can only be exercised after death and there will be a specific option period.
No. If someone dies owning shares in an unquoted trading company, 100% business property relief may be available for IHT purposes provided those shares have been held for at least two years. Shares dealt on the alternative investment market (AIM) are treated as unquoted.
Business property relief will still be available despite the estate getting cash for the shares under the terms of a cross option agreement. That’s because options can only be exercised after death and the sale of the shares only becomes binding once an option has been exercised.
Since there’s no binding agreement to sell at the date of death, business property relief is preserved. This was confirmed by HMRC in September 1996 in an article (Law Society Gazette, 4) where they stated that an option won’t constitute a binding contract for sale unless it has been exercised at the time of death. This view supports the decision in a 1991 case J. Sainsbury plc vs. O’Connor which illustrates that a contract is unenforceable and so not binding in the sense of IHTA 1984 unless a party to it can claim specific performance.
An option for surviving shareholders to buy a deceased shareholder’s interest is not exercisable until after death and so unenforceable until then. It follows that, immediately before death, the surviving shareholders’ option doesn’t constitute a binding contract for sale.
Business property relief would be denied.
While they’re all still alive, the shareholders will enter into an agreement where, on the death of one of them, the remaining shareholders must buy the shareholding and the estate must sell. A life cover will be taken out to finance the purchase.
The reason they won’t get business property relief is because HMRC takes the view that at time of death a binding contract is in position where the shares will be sold by the estate and cash will come in. So, the shareholder hasn’t left shares in a private limited company for their beneficiaries but a lump sum of cash – and cash is fully subject to IHT.
A critically ill shareholder may not be able to contribute to the company and may want to retire.
Their fellow shareholders will need finance to buy the shares.
Where a business trust is being used, a plan that includes critical illness cover will be written under trust in the same way as a plan with only life cover.
Instead of a cross option agreement, the shareholders may decide to set up a single option agreement. The reason for this is that with a cross option agreement the other shareholders could insist that the critically ill shareholder sells their shares following a pay-out on critical illness. This could be against the wishes of the shareholder who may feel they’re able to recover and return to the business.
A forced sale of shares could result in a capital gains tax liability and potentially a future IHT liability for the outgoing shareholder because they’ll have cash when they die. These shares may otherwise have qualified for IHT business property relief.
If they want to keep their shareholding, the others have no option to insist that they sell. However, in some cases the shareholders may prefer to have a double option agreement for critical illness, so that they can buy out the critically ill person if they feel they’re no longer fit and able to continue.
In this situation we have a shareholder whose plan has been paid out after suffering a critical illness but they’ve decided not to sell.
We recommend the proceeds to be kept within the trust until the succession issue is resolved.
Although they might be tempted to give the critically ill shareholder some or all of the proceeds, the purpose of the plan was to provide proceeds to buy out a shareholder following critical illness or death. What if they suffer a second critical illness? Where will the money come from to buy them out? Similarly, the plan may have been for life or critical illness. The plan will only pay out on the earlier occurrence of critical illness. If the shareholder then dies, where is the money to buy the shares from their estate?
Another reason for not distributing the proceeds when the shares are not being sold is because it would involve proceeds being used for a non-commercial purpose.
This could demonstrate to HMRC that the shareholder protection arrangement is not fully commercial. Which means IHT implications could arise in the future.
It’s important to be aware of the potential impact of the pre-owned asset tax charge (POAT) which came into effect on 6 April 2005.
This is a charge to income tax which applies where someone can benefit from an asset they used to own. The new charge is designed to counter IHT planning arrangements that bypass the gift with reservation of benefit provisions yet still allow the settlor to benefit from the asset given away. The tax charge applies to the annual benefit they enjoy. The method of valuing the annual benefit varies depending on the type of asset.
However, no tax charge will arise where the annual benefit is £5,000 or less. If it’s more than £5,000, it’s added to the individual’s other income for the tax year and is subject to tax at their marginal rate.
Unfortunately, using business trusts for shareholder protection purposes falls foul of these provisions since they include the settlor as a potential beneficiary (by virtue of them being a shareholder in the business).
The trust is not caught by the gift with reservation of benefit provisions as it’s part of a commercial arrangement. However, the POAT charge does apply as there’s no similar exclusion under the new legislation.
In most cases though, any annual benefit would be within the limit of £5,000. Since the trust asset is a life plan, the annual benefit will be calculated as 4% (this is the official rate of interest, which may be subject to change) of the ‘open market value’ of the plan. While the person covered is in good health the open market value should be negligible, so the charge should not apply.
Where it may become an issue for the settlor is if they suffer from a critical or terminal illness and the funds sit in the trust for any length of time (for example if they decide not to sell their shares in the company). In that case the value of the trust fund will be considerably higher and so 4% may exceed the limit.
Any potential tax charges can be avoided if the settlor is removed as a potential beneficiary from the trust. There may also be IHT implications as discussed in our article, shareholder protection - tax implications.
There are circumstances where a typical cross option agreement won’t be appropriate. For example, where two sets of spouses are shareholders in a business and one spouse from each set is more involved in the business than the others.
Consider the following:
Dougie, Tanya, Anne and Jim are each 25% shareholders in a company. Dougie and Anne are more active in the business than Tanya and Jim. If either Dougie and Anne were to leave the business through death or critical illness, their respective spouses would want to leave too, even though they could stay in the business. However, if Tanya or Jim were to die, Dougie or Anne would want to receive their spouse’s shares and continue running the business.
Generally, cover would be arranged on the lives of Dougie and Anne, with the sums assured equal to the total combined value of their shareholdings and their spouses’. For example, if Dougie’s shares are worth £250,000 and Tanya’s shares are worth £250,000, the total amount of cover on Dougie’s life will be £500,000.
As the shares of Tanya and Anne would pass to their surviving spouses in their wills, there’s no need for protection on their lives.
A bespoke cross option agreement would be put in place to enable Anne and Jim (or just Anne if Jim dies first) to buy Dougie and Tanya’s shares on Dougie’s death or critical illness and the opposite in respect of Anne’s shares.
The clients’ solicitor will usually draft the cross option agreement and help the clients make sure that their wills are up to date.
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.