Business succession planning is relevant to sole proprietors, partnerships, limited liability partnerships (LLPs) and limited companies. It is geared towards setting up a business protection arrangement to provide for the smooth transfer of a business interest in the event of a business owner’s departure from the business whether on death, critical illness or disability, planned or otherwise; and at the same time ensuring that appropriate financial compensation is provided to the deceased’s family (on death) or the incapacitated owner (eg in the event of critical illness). In general, the implications for sole proprietors are different from those which apply for those who own a business with others.
In this article we consider the position under those types of business which have more than one owner – a partnership, LLP or limited company. Also, we focus on the fundamentally important part of a business protection arrangement, the agreement for sale/purchase which enables the owners of a business to purchase the business interest of a co-owner who has died, is critically ill or disabled.
For inheritance tax (IHT) efficiency the agreement for the purchase of a business interest will take the form of an option agreement.
The reason for having an option agreement is that if there is a binding sale agreement which would mean that a purchase would take place, say on death, this can have adverse IHT implications. This is because where the terms of an agreement are obligatory HMRC would regard such an agreement as forming a binding contract for sale which will make the transfer of the business interest ineligible for IHT business property relief.
Bearing in mind that business property relief now applies to most qualifying business interests at the rate of 100%, subject to only a two year period of ownership, it is imperative that the availability of this relief is not jeopardised. Naturally, it would not matter when it is planned for the business interest to pass to a spouse or registered civil partner but circumstances can change so that even this outcome cannot be guaranteed.
Fortunately, the preservation of business property relief can be achieved by the use of an option agreement.
The option agreement
HMRC Capital Taxes (formerly the Capital Taxes Office) accepts that a double (or cross) option agreement is not a binding contract for sale and does not prejudice business property relief (Statement of Practice SP12/80). This is so, even though the effective result of the double option agreement is that, as long as one party to the agreement exercises their right to sell or purchase, the other party will be bound to comply. Unless both parties decide not to exercise their options, the practical effect of the agreement is the same as a buy and sell agreement but eligibility for business property relief is retained.
The Inland Revenue was asked for comments on several possible wordings for agreements in an exchange of correspondence between it and the accountancy bodies in 1984, in which guidelines were formulated as to the circumstances in which business property relief was accepted as being available. There is a specific reference to a ‘double option agreement entered into under which the surviving…[shareholders]…have an option to buy (a call option) and the personal representatives an option to sell (a put option), such options to be exercised within a stated period after the…[shareholder’s]…death.’
Sometimes, it is felt that there may be a stronger argument in favour of the option agreement not being binding if the option periods for purchase and sale are not identical, for example, an option to sell for six months, and an option to buy for 3 months from the date of death. This is so as to reinforce the contention that the agreement is truly an option agreement and not a ‘de-facto’ binding agreement. There is nothing, however, in the correspondence with the Inland Revenue to indicate that it would attach any particular importance to the length of the option period.
There was concern that the decision in Spiro -v- Glencrown (1991) provided authority for an option to be a contract for sale thereby resulting in no business property relief being available. Early in 1996, the Capital Taxes Office confirmed that there had been no change in their opinion regarding SP12/80 and that the case would not be cited as an authority for an option constituting a binding contract for sale.
The more recent case of Griffin -v- Citibank Investments Ltd (2000) provides an even stronger argument that a put and call option in identical terms together do not constitute a single bilateral contract. The case had nothing to do with arrangements for share purchase between shareholders but it did concern two identical options and for this reason is of particular relevance.
Citibank Investments Ltd (CIL) in December 1994 sought an investment that would generate funds in the form of capital gains rather than as income liable to corporation tax. CIL purchased two FTSE linked options, on terms that all transactions entered into on reliance of the purchase agreement formed a single transaction. Corporation tax was then assessed for 1994, 1995 and 1996 on the gains arising from the two option contracts. On appeal to the Special Commissioners, CIL contended successfully that the gains arising from the options fell to be treated as capital gains rather than as profits or gains chargeable to tax under Schedule D. The Inland Revenue then appealed the Commissioners´ decision which was dismissed.
It is therefore generally now considered that the Griffin case puts an end to the speculation in relation to whether or not a binding contract for sale exists in respect of relevant business property for inheritance tax, that a put and call option in identical terms together constitutes a single bilateral contract. This relatively little reported case is therefore of considerable importance to financial advisers particularly those offering advice on business protection arrangements.
Given that using double/ cross option agreements is also well established and accepted practice it is not thought that there is a significant risk of the General Anti-Abuse Rule (GAAR) applying.
Double option agreement
In most cases a double option agreement will be used to secure the purchase of a business interest following death. A double option agreement for the purchase of a business owner’s interest on death will provide that if a business owner dies the surviving business owners will have an option to buy and the personal representatives of the deceased business owner will have an option to sell the deceased’s business interest.
The options will, typically, be exercisable within specified periods, eg. 3 or 6 months from death, so as to reinforce the fact that the agreement is a genuine option agreement and not, in effect, a binding agreement. As explained above, a binding agreement would prejudice the availability of IHT business property relief. The agreement can specify the proportion of the deceased business owner’s interest that each surviving business owner is to purchase - usually this will reflect the proportions in which they will continue to own the business.
For a partnership, a double option agreement may be incorporated in the partnership deed or it can be separate, but it must not conflict with the partnership deed. For a company the double option agreement must not conflict with the company’s Articles of Association and for an LLP it must not conflict with the membership agreement.
The single option agreement
A single option agreement is generally used for the purchase of a business interest taking place in the event of a business owner retiring as a result of critical illness/disability. It is an agreement which gives the critically ill/disabled business owner an option to sell his interest in the business but there is no corresponding option to buy given to his co-owners. If the critically ill/disabled business owner exercises his option, his co-owners will be obliged to purchase.
For practical reasons it is usual to extend the option period to one or perhaps even two years from the date of diagnosis of critical illness/disability or the date of payment of benefits under a critical illness/disability policy. This is so as to give the critically ill/disabled business owner sufficient time to assess the extent of his illness/disability or his future involvement in the business and his continued ownership of an interest in the business.
Except for the option period, in all other respects the terms of the single option agreement will be similar to the double option agreement in the section above.
Other aspects of option agreements
An option agreement would also normally incorporate various other provisions concerning the agreement as to value as well as various administrative provisions. Unless a fixed price or formula for the value of a business interest is adopted, the agreement would normally provide for the appointment of the valuer who will usually be a practising accountant appointed by all the parties or one appointed at the instance of the party exercising the option.