Will your business survive the death of a shareholder?
If you own shares in a private company, you probably have a reasonable idea of what would happen to those shares on your death. It may be covered in your Will or your Shareholders’ Agreement. But do those documents provide a solution that can really be relied on to work in practice? Will they really help your family members and also allow the surviving shareholders to steady the ship when you are no longer around?
A fundamental aspect of estate planning is to have an up-to-date Will in place (see our recent blog on Wills for business owners here). If you own shares in a company, then it is likely that this would be expressly referred to in your Will. However, it may not make sense for the shares to pass to your family members – they may have neither the appetite nor the expertise to take over responsibility for your business. You could, of course, simply leave your shares to your co-shareholders – but then you would be depriving your family members, or any other beneficiaries under your Will, from a potentially valuable portion of your estate.
You may also have a Shareholders’ Agreement, which may expressly deal with what happens on the death of a shareholder. We often see provisions in Shareholders’ Agreements which give the surviving shareholders a right to purchase a deceased shareholder’s shares for a fair market value. This way, the deceased shareholder’s estate will receive a fair payment for the shares. But what if the surviving shareholders simply don’t want to buy the shares or, perhaps more plausibly, don’t have the available funds to pay a fair value for the deceased’s shares?
One particularly useful way of dealing with these issues is by using a Cross-Option Agreement. This gives the surviving shareholders an opportunity to purchase the deceased’s shares before they are transferred to any third parties. It also gives the deceased’s family members some assurance that they will receive a fair payment for the shares.
Under a Cross-Option Agreement, each shareholder’s shares will be subject to a ‘call option’ and a ‘put option’. The call option is a right (but not an obligation) for the surviving shareholders to purchase the deceased’s shares from his/her estate. The put option, on the other hand, is a right (but, again, not an obligation) for the deceased’s estate to require the surviving shareholders to buy the deceased’s shares. In short, if either ‘side’ wants the shares to be transferred to the surviving shareholders, then this can be made to happen.
The reason that the cross-options must create rights, but not obligations, is to ensure that any entitlement to business property relief (BPR) from inheritance tax is not lost. BPR can potentially provide 100% relief from inheritance tax, and so can be hugely valuable to business owners.
Another key feature of a Cross-Option Agreement is that it usually requires each shareholder to have in place a life insurance policy, which is written in trust for the other shareholders. The insurance premiums can be paid for by the company itself but note that such payments may be treated as a benefit in kind and may therefore incur both income tax and NIC liabilities. The alternative is simply for the shareholders to pay the relevant life insurance premiums themselves.
When a shareholder dies, because the life insurance policy is written in trust, the surviving shareholders have access to the insurance proceeds and can use these to buy the deceased’s shares. Because of the put option, the deceased’s estate can prevent the surviving shareholders from simply hanging on to that money (which would be a risk if you simply rely on a ‘standard’ Shareholders’ Agreement with no cross-option arrangements in place as well).
However, a Cross-Option Agreement is not always the answer. For example, it may prove too expensive for one or more of the shareholders to obtain an appropriate level of life insurance. Therefore, it will always be sensible to consider the alternatives carefully – one size doesn’t fit all – and, equally importantly, to keep your arrangements under review as the business progresses and your personal circumstances change.