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Estate planning for business owners can often fall down the priority list of ‘things to do’ when building the business consumes all of their time.

In our article on shareholder agreements, we mentioned how such an agreement could cover what would happen if there was untimely death of a shareholder.  In this article, we look at this issue in a little more detail and how this should form part of a business owner’s overall personal estate planning strategy.

Estate planning for business owners and entrepreneurs can often fall down the priority list of ‘things to do’ when building and securing the business consumes all of their time. It is easy to put off such plans but the effect of an unexpected illness or bereavement can be devastating not only for the family of the business owner but also for the future prospects of the business and their business partners/fellow shareholders.

What happens when a shareholder dies?

If specific provisions have not been included in the articles of association of a company or in a shareholder or partnership agreement the shares of a deceased business owner will pass in accordance with the deceased’s Will or under the intestacy rules.

This may mean family members with no knowledge of the business being required to become involved in unfamiliar business decision-making at the very time when they are least able to cope it. They will be faced with having to apply for a Grant of Representation and completing inheritance tax forms which will involve them needing to insist on a valuation of the business, all of which takes time and expense.

From the business’ perspective, surviving directors/partners may become frustrated or even resentful in having to deal with the deceased’s family with whom they have no business relationship.

The articles shareholder/partnership agreements

These issues can be alleviated by incorporating specific provisions into bespoke articles of association and/or a shareholder/partnership agreement which could set out the procedure to be followed if a shareholder or partner dies. This may involve compulsory transfer provisions, rights of pre-emption (deceased’s shares must be offered to the remaining shareholders or the company before they can be offered to anyone else) and also introduce a method of valuing a business share to be sold.

What happens if a sole shareholder dies? If a company uses the standard articles and has a sole director and shareholder then while the shares will pass to their personal representatives, there will be no surviving officer who can manage the company. This difficulty was illustrated in the High Court case of Kings Court Trust Ltd v Lancashire Cleaning Services Limited, which was reported last year. The personal representatives had to make an application to the court to enable them to manage the company, which needed to pay its employees and creditors.

Cross option agreements

An additional or alternative protective mechanism is to put in place a cross option agreement. Under this sort of agreement, business owners grant each other options which will come into effect on a death. Both parties may then exercise the cross option agreement which means that:

  • The deceased business owner’s personal representatives can ‘force’ the surviving co-owners to buy the deceased’s interest in the business and/or
  • The surviving business owners can ‘force’ the personal representatives to sell the deceased’s interest to them.

Cross option agreements are often supported by a life policy for each owner that is held in trust for the benefit of the others. The policy pays out on death and enables the surviving business owner (or the business itself, assuming that there are distributable reserves) to buy the deceased’s interest in the business without causing a financial crisis for the business and at the same time releasing immediate cash to the deceased’s family. The agreement will set out how the value price of the interest is to be ascertained which, for simplicity, is often agreed to be the amount of the insurance cover which needs to reviewed regularly as a result.

Tax efficient Wills

The reason why business owners put in place cross option agreements as opposed to more formal contracts to buy and sell shares or compulsory transfer provisions in the company’s articles is often related to inheritance tax planning.

Inheritance tax is charged on the value of a deceased person’s estate to the extent it exceeds £325,000. An interest in a trading business held for more than two years, however, qualifies for Business Property Relief (BPR) from inheritance tax and that relief is given at 100%. This relief can be extremely valuable and although investment activities are barred, there is no minimum level of shareholding, such as there is, for example, for entrepreneurs’ relief from capital gains tax. It will be important to show that the business is not holding cash in excess of its business requirements and that any investment activity is not a significant part of the business’ operation.

HMRC take the view that if there is a binding obligation to buy shares on the death of a business owner then BPR will be denied — the argument being that the deceased effectively only has an interest in the proceeds of sale rather than in the business itself. Cross option agreements however, because they are worded as options, circumvent this problem.

If cross options have been put in place to ensure that business property relief is available, it is important for the business owners then to ensure that their Wills take advantage of the tax planning opportunity which BPR provides. For a married business owner, consideration should be given to passing down the interest in the business to the next generation immediately on first death rather than it being passed to the surviving spouse. If that is not practical or desired, a discretionary trust could be used as a means of providing flexibility while still ensuring the relief is maximised.

It is imperative to consider what will happen to the business after the death of the business owner. If there is another member of the family lined up to take over then this will dictate how the business interest will be dealt with. Quite commonly, however, a married couple may have no real idea what will happen to the business if the owner dies unexpectedly. This is where the flexibility of a discretionary trust in a Will can be particularly useful. The effect of tax planning can be seen in the example below.

Scenario A — Simple Will

James holds a 100% shareholding in Quidditch Supplies Trading Limited — a company valued at £2M. He and his wife Lily receive dividends and James’ salary and this forms the bulk of their income.

James dies in May 2018 leaving everything (including the shares) to his wife. The shares are sold three years later for £2M.

Lily invests the proceeds of sale to provide her with an income to replace the dividends and salary that has been lost on James’ death.

Lily dies in 2020 leaving her entire estate to James and Lily’s only son, Harry. Inheritance tax is paid on the £2M.

Scenario B — Wills incorporating discretionary trust

James leaves his shares to a discretionary trust. The shares are sold after his death and the trustees decide to invest the money to provide an income for Lily. After Lily’s death the remaining funds in the trust are appointed to Harry/Harry’s children. There is an inheritance tax exit charge based on a maximum of 6% on the proceeds distributed. The £2M did not form part of Lily’s estate.

There is a downside for a discretionary trust holding shares. The trustees would be obliged to ensure that they are monitoring the business as an investment. The Will, however, could give powers to the trustees to delegate some of the duties they owe to appropriately qualified managers appointed to ensure that the beneficiaries of the trust’s interests are protected.

Key man insurance

Cross option agreements work well when there are other shareholders or business partners who can enter into the agreement as there is a mutual benefit both to the family and the joint owners.

Key man insurance or key person insurance is a way for a business to insure itself against the financial loss it would suffer if a key person in their business died or was diagnosed with a specified critical illness during the length of the policy. This does not have to be a business owner but it could be.

It is essentially life assurance (or life assurance and critical illness cover) taken out to cover the life of a key person within a business. The policy is owned and paid for by the employer, so any pay out is payable to the employer. The rationale would be that a lump sum of cash could help the business survive as it deals with falling sales and profit, increasing workloads for remaining staff and the hiring of new employee(s).

Incapacity and Lasting Powers of Attorney (LPA)

Wills and life policies can cover what happens on the death of a business owner but the running of a business could be equally threatened be an owner becoming ill or losing physical or mental capacity on a temporary or permanent basis.

To cover such an eventuality, a business owner may look to put in place an LPA. By doing so a business owner can authorise or empower another person to make financial and business decisions on their behalf.

Historically, general powers of attorney were used when a business owner was going abroad. However, the problem with a general power is that it fails if a business owner loses the mental capacity to make their own decisions, which is one of the very times it is most needed. This is where an LPA comes in as it lasts or remains valid even if the business owner has lost mental capacity.

There are two types of LPA: one covering decisions upon property and financial affairs and the other covering decisions upon health and welfare. An LPA for property and financial affairs can cover decisions upon all property: both personal and business.

When do Lasting Powers of Attorney Apply?

Lasting Powers of Attorney are regulated by the Office of the Public Guardian (the OPG). They must be registered with the OPG before they can be used by the attorneys. It is important that a business owner making an LPA registers it with the OPG as soon as it is made so that it can be used by the attorneys immediately if needed. The attorneys may need to act quickly and the process of registering an LPA takes around four to six weeks.

Why do business owners need a Lasting Power of Attorney?

If a business owner is incapacitated and does not have an LPA it may not be possible for anyone do deal with the property and finances of the business. If employees and suppliers are not paid or debtors chased, the business may soon be in jeopardy. The business owner’s family — in all likelihood the spouse or partner — would have to apply to the Court of Protection to become their deputy. However, such applications can take many months and by then it may well be too late.

What are business LPAs?

As mentioned, an LPA for property and financial affairs can cover both personal and business property. However, it may be better to appoint different attorneys to deal with them or to have two separate LPAs.

The business owner’s spouse or partner may have had little or no involvement in the business and so it may be more appropriate to appoint an alternative attorney who has the necessary skills and experience.

An attorney should be someone the business owner trusts to act in his or her best interests. It may be that there is another family member who is involved in the business and who can act as attorney or that the business owner has faith in the other directors or shareholders.

However, if the prosperity or financial security of the business owner’s family depends upon the business, they may want any appointment to be a joint one with their spouse or partner or require that certain decisions can only be made jointly with them.

This article is part of a series looking at issues arising for Owner Managed Businesses. Read our article on group ownership structures and the factors to consider when deciding on which structure to adopt.

For more guidance on making your business future-proof, contact our experts in business succession planning.