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November 14, 2017

BUSINESS MATTERS: PROTECTING YOUR BUSINESS AGAINST SHAREHOLDER DEATH - KEEP YOUR OPTIONS OPEN

Benjamin Franklin was clearly on the money when he said that "nothing is certain, except death and taxes". Neither thought is one we like to pay much heed to however disastrous fallouts can occur if a proper plan hasn’t been put in place before the unavoidable happens and a shareholder (having duly paid his taxes!) passes away. By failing to prepare, you are preparing to fail. Credit once again to Mr Franklin.


The Problem
A deceased shareholder’s business interest forms part of their estate and will ultimately pass to their beneficiaries, similar to any other personal asset. This can and (unfortunately) often will mean that the direction and overall running of a business is in the hands of people who are not associated or familar with it. 

There are a number of potential problems with this:

• Beneficiaries may not understand how to run the business and may not even be inclined to try, perhaps feeling overwhelmed by their new-found responsibilities. However, these same trustees will be entitled to a share of the future profits and capital growth.
• Surviving shareholders will be forced to consult with or perhaps even seek approval from people they may not even know as regards decisions for a business they may have spent a lifetime building.
• Beneficiaries, having been bereaved, will likely require that profits from the business are distributed as dividends which may not be the best decision for the business.
• Surviving shareholders might wish to buy out the beneficiaries but may not have the resources to do so. Valuations of the business interests can also differ wildly and it may be difficult for beneficiaries to sell the business interest elsewhere if there is no market for it, essentially leaving the beneficiaries with a share of a business they cannot sell and have no understanding of how to run.

All in all, it’s a recipe for disaster which can place extreme stress on relationships and ultimately result in disputes.

The Solution: Cross-Option Agreements

A cross-option agreement is the simultaneous grant of "put and call" options and its principles are simple: each shareholder agrees that upon his death his fellow shareholders have the option, but not the obligation, of buying his shares (the ‘call option’) and that his personal representatives on his death have the option, but not the obligation, of selling his shares to the surviving shareholders (the ‘put option.’) The methodology for valuing the business interest will be set out in the cross-option agreement and is usually based on market value. 

At the same time, each shareholder takes out a life policy written in trust for the surviving shareholders to use to pay for the deceased’s business interest under the put and call options.

Structuring matters in this way mean that it is possible to ensure that the deceased shareholder’s business interest is entitled to business property relief which can provide up to 100 percent relief from inheritance tax. Since the proceeds of the deceased shareholder’s life policy are written in trust for the surviving shareholders, they fall outside of the deceased’s estate and will not be subject to inheritance tax.

This arrangement is a straightforward and inexpensive ‘win-win’ solution for all, provided that the person drafting the cross-option agreement appreciates the importance of ensuring that it does not fall foul of certain inheritance tax provisions since business property relief would then in all likelihood be payable.
A properly-drafted cross-option agreement coupled with associated life policies not only ensures that a business can continue during a time of upheaval without suffering the detriments and uncertainties that the death of a shareholder can bring, but it will also serve to provide a tax efficient and minimally disruptive mechanism by which a deceased shareholder’s beneficiaries can extract value from a business.

If you would like to discuss how cross-option arrangements can safeguard your business then please contact Leanne Thomas or any member of the Corporate Team at Greenaway Scott.

This article was first published on Business Wales on the 16th November 2017

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