Ensuring stability and continuity in unforeseen circumstances
For business owners, it is essential to protect your company and ensure its stability and continuity in unforeseen circumstances. Shareholder and partnership protection offers a solution to safeguard the financial health and continuity of your business.
What is shareholder and partnership protection?
Shareholder and partnership protection is an agreement among shareholding directors or partners in a business, often supported by life cover. Its purpose is to ensure that, in the event of a shareholder’s or partner’s death or a diagnosis of critical illness, sufficient funds are available for the surviving partners or directors to purchase the shares of the deceased.
This arrangement ensures that:
• The remaining partners or directors retain control of the business.
• The value of the deceased’s interest in the business is passed to their chosen beneficiaries in the most tax-efficient manner possible.
Why is this protection important?
Without a shareholder and partnership protection agreement, several issues could arise:
• The deceased’s shares could pass to someone without interest or experience in the business.
• The survivors may lack the funds to buy the shares.
• A new majority shareholder could destabilise the company by selling their take or influencing decisions.
By implementing this form of protection, these risks are mitigated, creating financial stability and clarity for all parties involved.
How does shareholder and partnership protection work?
Initial agreement and options
The shareholding directors or partners enter into an agreement that gives both parties the option to buy or sell shares rather than creating a legally binding obligation beforehand. This is crucial for tax-efficiency, particularly for claiming relief from Inheritance Tax (IHT).
However, the Chancellor’s Budget on 30 October 2024 contained a proposal far reaching changes to IHT, including a significant restriction on the application of Business Property Relief (BPR), which will take effect on 6 April 2026.
Starting 6 April 2026, significant changes are coming to the way Business Property Relief (BPR) and Agricultural Property Relief (APR) work for IHT, and it’s crucial to understand what this means. Under the new rules, BPR will still provide relief at 100% for qualifying assets, but only up to a maximum value of £1 million. This limit also applies collectively to assets qualifying for APR at 100%. If the value of these assets exceeds £1 million, the portion above this threshold will only qualify for relief at 50%. This means half of the value over £1 million will not be protected from IHT and will instead be taxed at the standard 40% rate.
Any qualifying assets above the £1 million limit will effectively face reduced tax relief, resulting in an “effective rate” of 20% on their excess value. For example, if the assets are worth £1.5 million, the first £1 million would be fully exempt, the next £500,000 would qualify for 50% relief, and the remaining 50% of this excess would be taxed at 40%. It’s also worth noting that shares listed on the Alternative Investment Market (AIM) are now affected by this change, as they will no longer qualify for 100% relief regardless of their value.
These changes could significantly impact businesses and estates, particularly for those with assets that heavily rely on these reliefs to mitigate IHT. It’s an opportune time to review your plans and consider seeking professional advice to ensure your estate is structured to fully benefit from the available reliefs before the changes take effect.
For instance:
• The surviving business partners have the option to buy the shares owned by the deceased.
• The deceased’s executors have the option to sell those shares.
When one party exercises the option, it creates a binding contract. However, no binding contract exists until the option is exercised. This type of arrangement is typically set up through a cross-option agreement.
Understanding cross-option agreements
A cross-option agreement, also known as a “double option” or “put and call” agreement, ensures proper arrangements are in place if a business owner dies or becomes critically ill.
Key features include:
• It is not legally binding regarding the sale of shares until exercised.
• It enables all parties to plan for share transfer in a tax-efficient manner.
For example, if a shareholder unexpectedly passes away:
• The surviving shareholders can exercise their option to buy the shares.
• The deceased’s estate can exercise its option to sell the shares.
This ensures a smooth transition without disrupting the company’s operations. Importantly, the agreement’s non-binding nature before the options are exercised helps provide tax benefits.
Life assurance and funding the agreement
The financial aspect of buying the deceased’s shares often requires careful planning. This is where life assurance policies come into play. Each shareholder or partner takes out a policy on their own life, with the other partners or the business as beneficiaries.
When a claim is made (e.g., due to death), the payout provides the necessary funds to buy the deceased’s shares.
Example:
• A business has three equal shareholders.
• One shareholder passes away unexpectedly.
• Through the cross-option agreement, the surviving two shareholders exercise their right to purchase the deceased’s shares.
• The life assurance payout funds the transaction, ensuring the deceased’s family receives the value of the shares while the business remains under the control of the survivors.
Other protection options available
While shareholder and partnership protection is ideal for safeguarding shares, additional protection measures can help ensure broader financial security.
1. Life cover
This is a basic option that provides a lump sum to the business or nominated beneficiaries if a person covered under the policy passes away.
Benefits:
• Straightforward to set up.
• Offers financial support to cover share purchases or other business continuity needs.
2. Critical illness cover
This cover offers a payout if a covered individual is diagnosed with a specified serious illness. It ensures financial stability during difficult times when a key person cannot work.
Key Features:
• Helps cover essential costs or loss of revenue.
• Can prevent financial strain on both the individual and the business.
3. Combined life and critical illness cover
For comprehensive protection, combined cover ensures a payout either in the event of death or a specified critical illness. This offers flexibility based on different potential outcomes.
4. Relevant life cover
A relevant life policy is a tax-efficient life assurance option for business owners seeking to provide cover for key employees without using a group life scheme. This is intended for Death in Service type cover to benefit the employee’s family in the event that he/she passes away during employment. This cannot be used for Shareholder protection.
How it works:
• Set up by the employer for an individual employee.
• Ensures their dependents receive funds in the event of their death.
• The premiums may qualify as a business expense for tax purposes, offering further financial incentives.
5. Policies that pay a regular income
Certain policies are tailored to pay a regular income in case of sickness or incapacity, providing essential financial support during recovery periods.
Safeguards your company and benefits all involved
Shareholder and partnership protection is an invaluable tool for business owners. It not only provides financial security but also ensures that your business remains under the control of trusted partners during challenging times.
By combining legal agreements like cross-option arrangements with appropriate life assurance, you can create a robust plan that safeguards your company and benefits everyone involved.
