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Bob Fraser MBE, MBA, MA, FPFS TEP outlines possible solutions to the financial problems faced by companies on the death or retirement of a director shareholder, and their tax consequences.

Introduction

Companies may face major problems on the death or retirement of a shareholding director if funds are not immediately available to purchase the holding of the outgoing director. The following is a guide to a suggested solution that uses life assurance policies written in trust. The policies will provide funds at the right time, and by using Cross Option or Buy and Sell Agreements ensure the wishes of all parties are carried out. This article outlines the main tax implications. However, by its nature, it cannot be complete and those considering action should seek individual advice.

Death of a Shareholder

The death of a co-shareholder is an obvious problem for surviving shareholders, not only because of the immediate impact on the business but also because beneficiaries of the deceased may (subject to any restrictions in the company's Memorandum and Articles of Association) be able to exercise a degree of control over the company. The interests of new shareholders will not necessarily coincide with those of the survivors. This is especially true where an unknown person with little experience of the business acquires shares.

A related problem may arise if a number of beneficiaries receive a controlling interest in shares. The balance of control could shift to prejudice the position of existing shareholders.

From the point of view of dependants, there is no general obligation for a company to provide them with benefits, including income and pensions. Unless the inherited shareholding is large enough to ensure sufficient votes can be exercised to provide the new shareholder with these benefits, it is possible that, in addition to restrictions which may prevent the realisation of capital, they will receive no income. It is, therefore, in the interests of both the surviving shareholders and the deceased's beneficiaries to make provision for these circumstances.

Retirement of a Shareholder

Similar considerations apply where a shareholder retires and wishes to realise his or her interest in the business.

Where the company's Memorandum and Articles allow, it may be possible to effect a sale. However, those continuing in the business may find it difficult to meet the immediate expense of purchasing the retiring person's holding. Where a third party is able to make the purchase, there is a danger that he or she will not fit in with the continuing shareholders.

The Solution

Providing Funds

By providing a lump sum on death or retirement using appropriate life assurance contracts, co-shareholders will be in a position to purchase immediately the shares of a deceased or retiring shareholder. Types of contract include term assurance and whole of life policies, as well as endowments and unit linked savings policies maturing at selected retirement dates.

Trusts

Life assurance policies should be arranged by each shareholder on his or her own life and written under a trust for the others, to ensure the proceeds pass directly to the intended recipients and do not form part of the life assured's estate. Trust arrangements should be flexible to allow for alterations when shares are bought, sold or transferred as other individuals leave or join the company. It is thus an ongoing plan and if not required for share purchase, it is possible to transfer the trust fund to the life assured.

To allow this, it is essential that all those entering the arrangement do so on a commercial basis (there must be no element of gift between the parties). The person setting up the trust can then be a potential beneficiary, without contravening the Inheritance Tax "Gift with Reservation" rules.

Commercial Terms

There are no strict rules to determine whether or not an arrangement is made on commercial terms. Each case will depend upon its own facts. Generally each shareholder must be party to the arrangement. Premiums do not necessarily have to be divided equally between the shareholders. As an alternative, payments could be made dependent upon the ratio in which each shareholder would benefit from the sum assured.

It may be difficult to show that the arrangement is commercial if co-shareholders include immediate family (spouses and children) although schemes where, for example, brothers (with separate families) are in business together may still work.

Under no circumstances should persons other than the shareholders (for example a shareholder's own children) be included as potential beneficiaries under the trust arrangement.

Purchase Agreements

In addition to the above it is necessary to enter an arrangement to ensure and regulate the sale or purchase of shareholdings in the event of a person retiring or dying.

It should be noted that there may be limitations on such arrangements in the company's Memorandum and Articles of Association, in which case it will be necessary to make changes before proceeding.

The following are two suggested methods of ensuring a sale and purchase.

The Cross Option Agreement

A Cross Option Agreement is one where, in the event of a shareholder dying or leaving the company, the estate or shareholder, respectively, has the right to sell, and the remaining shareholders have the right to buy, the outgoing person's shares. Strictly speaking there is no obligation for either party to exercise their option. The agreement does not, therefore, prejudice the availability of Inheritance Tax Business Property Relief in circumstances where the beneficiaries of the deceased are persons other than his or her spouse.

The Buy and Sell Agreement

An alternative is the use of a Buy and Sell Agreement, under which conditions for the sale and purchase of a holding are strictly set out. As there is a binding contract for the sale, the transfer of property to beneficiaries of the estate is treated as one of cash and inheritance tax Business Property Relief is lost.

Both Cross Option and Buy and Sell Agreements should cover methods of share valuation, insurance arrangements and make provision for other likely events. In all cases individual advice is essential.

Taxation

Inheritance Tax

Under the Cross Option method outlined above, Business Property Relief remains available for Inheritance Tax purposes. Relief of up to 100% is potentially available on qualifying Business Property.

Provided the arrangement is made strictly on commercial terms and with no benefit passing from one party to another there will be no Inheritance Tax liability when making premium payments.

Income Tax

The policy proceeds will be paid to the trust beneficiaries free of any personal liability to Income Tax. However, if the policy is non-qualifying (e.g. a single premium bond), there may be a liability to tax at the difference between higher rate and basic rate on any profit element, that is the difference between the surrender value of the policy immediately before it is encashed (on death or surrender) and premiums paid.

Capital Gains Tax

As a general rule policies are exempt from Capital Gains Tax except where acquired for consideration of money or money's worth (i.e. it is not acquired as a gift). It is essential, therefore, to write policies, used for shareholder assurance, in trust from inception.

Company Paying Premiums 

Once a policy has been established (provided it is a commercial arrangement) there is nothing to prevent the company paying premiums on behalf of the shareholder. Payments will be treated as part of the shareholder's salary and will therefore be subject to Income Tax and National Insurance payments. Arrangements may be made to increase the individual's salary in order to cover these additional expenses. For the company, payments made in this way should qualify as an allowable business expense.

Other Solutions

An alternative solution to funding the purchase of a shareholding on death or retirement, is to use life policies purchased by each shareholder on the life of the co-shareholder. Although this is a straightforward method, it offers little flexibility and will not provide a convenient vehicle for taking into account changing circumstances which often affect most companies. We will be pleased to offer advice on this type of arrangement where it is appropriate.

Finally, in limited circumstances it is also possible for a company to purchase its own shares. However, in order to do so, the company must comply with strict procedural and HM Revenue & Customs (HMRC) requirements. Details of these are beyond the scope of this leaflet and individuals taking this course must seek specialist advice.

The above is intended as a general guide to share purchase arrangements. They represent current understanding of UK Law and HMRC practice. In all cases it is essential to take individual advice. In addition, it is important to check that any arrangements to be made are compatible with the Memorandum and Articles of Association of the company. The company's solicitor will be able to do this and advise in relation to Cross Option or Buy and Sell Agreements.