The trust and taxation-related article in the previous issue
highlighted the key points to bear in mind in connection with
business protection trusts used in business succession
In this article we review the steps to be taken by a limited
company that wishes to set up a business succession arrangement to
ensure that, on death or serious illness of a shareholder, the
surviving shareholders have the opportunity to purchase the shares
of the deceased/ill shareholder so that the control of the company
remains with them.
We review the position in the form of a case study involving
Bass Fishmongers Ltd.
Bass Fishmongers Ltd was established in 1991 by Alf. Alf
gradually diluted his shareholding by making gifts to his son Mike
and selling shares to Pete and Steve. By 2016, the
shareholdings in the company are as follows:-
Mike - 40%
Alf (Mike's father) - 10%
Pete - 25%
Steve - 25%
Alf is no longer actively involved in the business and is not
interested in acquiring more shares in the company eg. on the death
of a co-shareholder.
All four shareholders are keen that they personally and the
business do not suffer the financial difficulties that can arise on
the death or serious illness of a shareholder. The current
value of Bass Fishmongers Ltd is £2.5 million which is mainly
goodwill. The company does not currently pay a
The directors/shareholders have stated that they wish to
establish a financial plan which can help them to overcome any
financial difficulties that could arise in the event of any of them
dying or suffering a serious illness. In particular, they
wish to deal with a tax-efficient transition of shares to the
surviving shareholders on death.
In order to organise this, it will be necessary to:
(1) Identify the need
for cover and quantify it.
(2) Consider a
suitable plan to provide for share purchase (business succession)
using, where appropriate, life assurance policies, trusts, share
purchase agreements and Wills. This plan would need to take
account of Alf's position as regards his 10% shareholding.
(3) Consider any appropriate
planning that they will need to undertake with regard to their
Wills to accommodate a share purchase arrangement.
Identifying the need for cover and quantifying
In any share purchase arrangement, there is a need to put cover
in place so that cash will be available for shareholders to buy the
shares of a deceased shareholder. This could normally be
satisfied by a suitable life assurance policy written to the
shareholder's retirement age.
One of the key aspects to a successful share purchase
arrangement is to place a current value on the shareholding in the
business. The valuation of shares in a private limited
company is a complicated process. A good starting point for
this would be to ask the current owners of the business how much
they would currently sell the business for. This will give a
good indication of the high end of its current value. If they
cannot agree on this, an independent valuation could be taken from
an accountant who is experienced in such matters.
In this case, Mike, Pete and Steve have put a value of £2.5
million on the business. The value of Alf's smaller minority
shareholding will be hugely discounted and it is therefore likely
that this will only be worth about £50,000. This means that
if a straight proportion of the residual value is used, Mike, Pete
and Steve's shares are worth £816,666 each. In practice, the
market value of a minority holding will always carry a discount and
the parties will need to agree a value between themselves.
A suitable plan
A successful share purchase arrangement will be made up of four
limbs - a testamentary disposal of the shares via a Will, a cross
option agreement, a life policy and a trust of the policy. In
more detail each will comprise of the following:
- A Will - a suitable Will provision is necessary to deal with
the transfer of the shares on death. A Will gives some degree
of certainty over who will benefit from the shares or the proceeds
of sale of the shares on death. It will also avoid any delays which
could arise on an intestacy and give the opportunity for ongoing
inheritance tax (IHT) planning by using a by-pass trust.
- An option agreement - this will deal with the purchase/sale of
the shares on a shareholder's death. Following the death of a
shareholder their personal representatives will have an option to
sell and the surviving shareholders an option to buy the deceased
shareholder's shares. In the event of either side exercising
their option, the other side will be bound. The option
periods for buying and selling will be slightly
- A life policy on the life of each shareholder for a sum assured
equal to the value of the shares. This provides the cash to
fund the purchase.
- A trust of the life policy ensures that the proceeds of the
policy are paid tax efficiently to the continuing shareholders to
enable them to purchase the shares from the deceased's
estate. The trust would normally be a business trust on
either a flexible (power of appointment interest in possession)
basis or a discretionary trust basis. The named default
beneficiaries would be the other current shareholders in the
business but all the shareholders would be discretionary
beneficiaries. This would enable the trust and the
arrangement to cope with any future changes in shareholders. Alf
will not be participating in the arrangement and so will not be a
beneficiary under the trusts.
The tax implications of the share purchase arrangement are as
(i) Premium payments
Although there will be a distinct premium payable on the policy
of each director, total premium payments are the collective
responsibility of the director/shareholders. No income tax relief
will be available. If the company pays premiums on the
director/shareholders' behalf, this will give rise to an income tax
(and NICs) charge on the basis they are additional
Premium payments will not give rise to gifts for IHT purposes
provided the arrangement is commercial.
(ii) Sum assured
On the basis that the policies in question are protection
policies, so have no surrender value, then in the event of the life
assured's death there will be no chargeable event gain - even if
the policy is a non-qualifying policy.
The payment of the policy proceeds to the trustees of the trust
will not give rise to income tax or inheritance tax. Whilst
the later distribution of the proceeds by the trustees to the
surviving director/shareholders could give rise to an IHT exit
charge, this is very unlikely. For such a charge to arise,
there would have needed to have been an IHT charge at the last
ten-year anniversary (or when the policy was placed in trust) and
this would only have been the case if the life assured had died
before or was in serious ill health at that ten-year
The IHT gift with reservation rules will not apply provided the
arrangement is on a commercial basis. The income tax
pre-owned assets tax (POAT) rules could, in theory, apply but
should have little impact unless a claim arises and money is held
within the trust.
Double option agreement
(i) Establishing the agreement
Provided the amount payable under the double option agreement
equates to the current market value of the shares, there should be
no IHT/ CGT implications at that time.
(ii) Exercise of the option
The purchase of the deceased's shares would give rise to a
disposal of the shares for CGT purposes. However, as those shares
will be revalued at their market value on the deceased's death, and
the purchase price is likely to be for a similar amount, it is
unlikely that any taxable capital gains will arise.
The deceased shareholder's shares will normally pass to the
beneficiary under their Will free of IHT because of 100% business
property relief. A double option agreement does not count as
a binding contract for sale and so business property relief should
still be available. There would be no CGT at that time
because of the revaluation of the shares on death.
Given that no dividends are being paid, and he no longer
actively works for the company, Alf's shareholding probably
represents more of an emotional link that he has to the company
following his earlier involvement rather than an actively managed
The company does not pay a dividend and, given the size of his
shareholding, Alf could not compel them to make a dividend payment.
Therefore, this shareholding has little value in his hands.
Given that Alf is not to be directly involved in the future of the
company, he should not be included in any share purchase
arrangement. Indeed, to ensure that he cannot benefit as a
shareholder under the trusts and policies of his co-shareholders,
the trust should restrict beneficiaries to only those who are
taking part in the share purchase arrangement.
Now may therefore be a good time for Mike, Pete and Steve to
consider making an offer to buy Alf's shares and so acquire
ownership of the whole company between them.
How this could be achieved will depend on the financial position
of the company and the amount Alf would want for his shareholding.
If a personal purchase was likely and they had to borrow money to
achieve this, any interest paid on the borrowing should qualify for
income tax relief.
If the company has cash available it could buy back the shares
and cancel them leaving the other three shareholders with a
proportionately larger interest in the company.
The valuation of shares
As mentioned previously, this can be a difficult area because
the valuation of shares in a private company can be a very
subjective issue. If the shareholders cannot agree on a price
then they could consult an accountant (with share valuation
experience) for a valuation. The valuation will dictate the
level of life assurance cover required under the life policies.
The initial value of the shareholding (as confirmed by the
double option agreement) will indicate the initial level of cover
required. But the arrangement needs to be able to cope with
changes in the value of shares. This would normally be dealt with
in the double option agreement. Two approaches are possible,
- the valuation is based on the market value of the shares;
- the double option agreement is based on a fixed value that
needs to be confirmed by the shareholders from time to time and
which, if it is not confirmed, reverts to market value
A fixed valuation gives the benefit of certainty - as it gears
up the life cover required, although it can lead to CGT and IHT
implications if the fixed value gets seriously out of line with the
real market value.
If it was desired to include an element of business protection
(e.g. keyperson cover) within the arrangement, the level of cover
could be increased on each shareholder/director's life. On a
director/shareholder's death the surplus funds (i.e. over and above
that needed for share purchase) could be lent to the company by the
surviving director/shareholders. Once the company had resumed
normal trading, the company could repay those loans without any tax
liability on the director/shareholders.
The arrangement can also be tailored to deal with share purchase
or business protection on a director/shareholder suffering a
serious/critical illness. The major difference here is that
in order to give the ill director/shareholder maximum security, any
purchase of shares should be governed by a single option agreement
in favour of the ill director/shareholder i.e. they should not be
forced to sell against their will.