Protection trusts for business owners

It is an unfortunate fact that whilst mortality rates in England and Wales fell steadily from 1995 to 2011 and then plateaued until 2019, the last two years have seen the highest rise in deaths since WWII. According to data published by the Office for National Statistics (ONS) last January, mortality for 2021 as a whole was 6.9% higher than 2019, although 5.7% lower than in 2020. Another interesting stat is that in 2021, while mortality for ages 65+ was 7.1% lower than in 2020, mortality for under-65s was around 3.1% higher than in 2020.

These rather grim stats could provide encouragement to discuss the life assurance needs of clients, especially those who own their businesses.

ADVISING BUSINESS OWNERS

Individuals owning and running their own businesses have special protection needs: clearly they need to protect the financial wellbeing of their family but they will also need to consider protecting the value and even the viability of their business, so an adviser will be looking to advise on business continuation and business succession should the owner die prematurely and perhaps unexpectedly.

There are three key issues that must be determined before any advice on protection, let alone any trust for protection needs, can be given:

First is to categorise the business, i.e. which type of business is it for legal and tax purposes: is the client a sole trader or running their business as a limited company or, is he/she a partner in a conventional partnership or a member of a limited liability partnership (LLP)?

The second is whether the business has a value independent of the owner, or whether it is perhaps a professional practice wholly dependent on the skill/expertise of the owner which will die with him/her.

The third, assuming the answer to the second question is that the business does have an independent value, is whether the business is a family business (with succession assured) or not. Let’s now consider the individual client categories.

SOLE TRADERS

Here, in most cases, the business and personal protection need will be identical. So, if we are considering protection in the event of death, we’d be looking for life cover for the benefit of the family/dependants. Such life cover policy should be written under a suitable “personal trust” for the beneficiaries, typically a discretionary trust or an absolute trust if the client is certain of their beneficiaries. 

Protection in the event of serious (terminal/critical) illness will normally be included and any benefits arising on critical illness or terminal illness would normally be held for the benefit of the client (under a so-called “split trust”). Alternatively, a critical illness policy may be taken out separately from the life cover, without any trust. 

If the business has an independent value, i.e. will not die with the client, then business succession needs to be considered: who, if anyone, will continue? If family succession is secured then there will be no need to consider further protection. However, it may be that, say, only one of the children will continue the business and so the business is left under the client’s will to that child. There may then be a need to compensate the other child(ren) for their loss of that inheritance. And such compensation will usually be best provided by a life policy in trust for those other children. 

What if no family members will take over the business? Would the business be sold? Or would there be a possibility of the employees buying out the business from the client’s estate? If the latter, how would such a buy-out be funded? Here a possibility of some form of "employee trust" (holding a life policy on the life of the owner) may be considered.

BUSINESSES RUN AS A LIMITED COMPANY

A sole trader can of course also run their business as a limited company, as you only need one shareholder to set up a company. In such a case the considerations will be similar to those above for sole traders, although you’d be looking at passing the shares on death (assuming the business does not die with the owner), rather than say business assets. 

The situation will become rather different where there are two or more shareholders. If the company is a family business, so that succession in favour of those who are involved is secured, it may again be necessary to provide compensation for any children, etc., who are not involved in the business (using a life policy in trust for the benefit of those not involved). 

If there are two or more non-related shareholders, the issue of business succession on death or disability/serious illness of any of them will need to be considered. This will usually involve an option agreement for share purchase, with the surviving/continuing shareholders purchasing the shares of the deceased/incapacitated shareholder, and with the funding for this provided via life/critical illness/terminal illness cover in trust for those effecting the purchase. This is where the so-called “business trusts” come into their own. See below for full details. 

If the owner is key to the business (as will normally be the case), there will also be a key person cover need. In most cases, for limited companies, a company owned policy will be effected to cover this need, and no trust will be needed. In some cases, key person cover can also be effected using a business trust – see below for when this may be suitable. 

Apart from business cover, the business owner who will, in this scenario, typically be a shareholding director, is also likely to need protection cover for the benefit of his/her family. As there will be an “employer/employee” relationship in such a case, the most tax effective way to do this is via a Relevant Life Policy (RLP) which will normally come with a special integrated “RLP trust”, given that, to qualify as a RLP, the classes of beneficiary are restricted and this is best provided using a trust specially designed for this type of plan.

Businesses run as a partnership

 First, we need to distinguish between conventional partnerships and LLPs. Unlike a conventional partnership an LLP is a corporate body but for the purpose of business ownership and succession it makes no difference, as you effectively look through the LLP structure. 

So, if you are considering business succession, the arrangement will be equivalent to the one mentioned above between shareholders, i.e. using an option agreement and funding via life cover in a business trust (see below for full details). 

If all of the partners/LLP members in the business are key, and especially if they are also effecting cover to fund partnership share purchase, it should be possible for key person cover to be added on to the cover needed for share purchase in the same way as for shareholding directors. However, in all other cases, especially where not all the partners are key, business trusts will not be appropriate.  

If the key person is one of the partners, it will be usual for the key partner to effect a policy on their own life in trust for the partners. This “partnership trust” will be a different trust from a business trust and it will provide that the policy is held as partnership property, i.e. on the firm’s balance sheet with the trustees of the life policy holding as bare trustees for the partners for the time being. Such a trust can also be used when the key person in a partnership is an employee of the partnership. 

A partnership in Scotland is a separate legal person and so a key person policy can be effected by the firm itself (no trust needed). The same will apply to a LLP. 

You may come across partnerships that have an automatic accrual agreement  under which a partner’s business interest will pass automatically to the surviving/continuing partners on death or retirement. To the extent that partnership goodwill/capital accrues automatically to the continuing partners on death, there will be a need to provide compensation to the deceased partner’s family (or to the retiring partner if the accrual occurs on critical illness)  using life policies in "personal trusts". 

BUSINESS TRUSTS

By business trust we mean a trust used by owners of a business (be it partners in a partnership, members of a LLP or shareholding directors of a private limited company) in connection with life assurance and/or critical illness cover policies effected to fund share purchase in the event of one of them dying or becoming critically ill.

Whilst most business trusts will include similar provisions as to beneficial clauses, some trusts will be fully discretionary trusts and others will be interest in possession trusts. In addition, some will include the settlor as a potential beneficiary and others will not, and some will include automatic reversion to the settlor in the event of him/her leaving the business, others will not. 

A feature of these trusts is that they are used by business partners/co-shareholders dealing with each other at arm’s length, on a commercial basis. In such circumstances, no gifts are involved and so it is possible for the settlor of each trust to be a potential beneficiary under the trust, without this bringing the arrangement into the gift with reservation of benefit (GWR) provisions (there may be pre-owned assets tax (POAT) consequences but that would be unusual in connection with any pure protection policy with no surrender value). This may be useful if the settlor leaves the business otherwise than through death or critical illness covered by the policy, as the policy can then revert back to him/her – sometimes this will happen automatically, in other cases (depending on the trust provisions) the trustees may have to make an appointment in his/her favour.

Some important points in connection with business trusts are:

• It is essential that the trust is effected only at the time the policy is applied for and not later, in order to avoid unwanted and potentially expensive capital gains tax implications.
• To ensure that the arrangement is on a commercial basis, only the individuals who enter into the arrangements, and each of whom effects a policy under a similar trust, should be beneficiaries under the trust. For this reason, such a trust cannot be used for key person cover unless all the parties are key persons. 
• Each individual should contribute an amount to the overall cost of the premiums under the policies that reflects the benefits that may be received under the trusts. If there is a large disparity in premium payments in respect of the individual owners’ policies, a form of premium “equalisation” may be necessary. 
• As the trust is treated as “relevant property” this means that potential inheritance tax (IHT) charges may apply every ten years and when payments are made out of the trust (despite there being no gifts involved), although this is unlikely to be relevant in most cases.

Comment 

So, there you have it. There is no uniform “business owner”, there is a variety of protection needs and there is a variety of trusts that are available depending on the particular business type and the particular need. It is essential that an adviser is familiar with all those trusts to be able to recommend a right one for each client.