Rosalind Pearson discusses some of the taxation issues a company needs to think about when putting t...
Rosalind Pearson discusses some of the taxation issues a company needs to think about when putting together a business protection plan Business protection planning is about safeguarding the financial future of a business - in particular, small to medium-sized businesses. There are many ways this can be done, but fundamentally what is required is to make sure that the right money ends up in the right hands at the right time.
This overview looks at some of the issues that need to be considered when putting in place trust provisions, and what tax implications might arise. Using the format of well recognised key features documents, the types of businesses covered are shareholder and partnership protection and keyperson insurance. These are defined as follows:
l Keyperson is where the business is heavily reliant on the skills and talents of one person or very few people.
l A limited company (shareholding) is defined by S1(2a) of the Companies Act 1985 as "a company having the liability of its members limited by the Memorandum to the amount, if any, unpaid on the shares respectively held by them".
l A Partnership is defined by S1 of the Partnership Act 1890 as the "relationship which exists between persons carrying on business in common with a view to profit."
Key features
l To place the right money in the right hands at the right time.
l To ensure the future running of the business in the event of death or serious illness.
l To provide funds to buy in replacement skills or replace loss of profits if a key person dies or becomes seriously ill.
l To provide money for any remaining partners or shareholders to buy out any share of the business on death, critical illness or disability.
Your commitment
l To take out appropriate life, critical illness or income protection cover sufficient to cover potential liabilities and replace loss of profits.
l To ensure the right arrangement and trust provisions are in place and reflect the intentions of the business.
Risk factors
l If the correct trust arrangement is not in place there could be tax liabilities.
l A business could suffer financially and become vulnerable, particularly if there is a heavy reliance on the skills of a few key individuals.
Your questions answered
Why is business protection beneficial to the business?
Because it helps to ensure the future and continuity of the business. Death or critical illness can give rise to a range of difficulties. For example:
l On death, the deceased's share of the business will form part of their estate for the benefit of the family. The surviving owners, however, may wish to keep overall control of the business and not have part vested in the deceased's beneficiaries.
l The deceased's beneficiaries may not wish to have an interest in a business they know little about - they may prefer cash.
l In the case of critical illness, the critically ill owner might not be fit enough to return to work and may wish to sell their share in the business.
In each of these scenarios, the remaining parties in the business have need of funds to enable them to purchase the interest in the business. Business protection arrangements can help to meet these objectives.
What are the key things that need to be considered?
The most appropriate arrangement will depend on the individual circumstances of the business. The key questions that need to be considered are:
l Does the arrangement provide the cash to those who need it?
l Is the cost spread evenly?
l Is the arrangement flexible enough to cope with future changes in the business?
l Is it tax efficient with regard to inheritance tax, capital gains tax and income tax?
l What are the component parts of a business protection arrangement?
First of all there needs to be an appropriate legal framework. This normally takes the form of a business protection trust. Usually, the purpose of a trust is to identify beneficiaries. A business trust is often used when the 'owner' (that is, a partner or a shareholder) wishes to effect a policy that will provide the co-owners with funds in the event of death, critical illness or total disability.
This will give the co-owners cash that can be used to either buy out the deceased's partnership interest or company shares from the estate.
How does the trust work in practice?
In most cases, all the owners will take part in the arrangement and each will effect a policy in trust for the others. In the case of business protection, the trust does not actually name the eventual beneficiaries or specify the shares in which they will benefit, as this gives flexibility if the future needs of the business move on.
However, there are occasions where the beneficial provisions need to be spelt out, to reflect the precise circumstances of the business, for example where the shares in the business are not equal. It is important that only those co-owners who take part in the business protection arrangement should benefit - this maintains the 'at arms length' nature necessary to mitigate inheritance tax.
What other agreements form part of the business protection arrangement?
If a purchase is to take place, this will normally be made under the powers contained in the partnership agreement or company's Articles of Association. Alternatively, a separate agreement may be used. The most often used arrangements are the double option agreement and the single option agreement.
What is a double option agreement?
Under this agreement, the surviving partners or shareholders have the option to buy the deceased's share of the business within a specified period of time. During that period, the estate has a duty not to sell the share to any other party. In addition, they have an option to insist on purchase by the surviving partners or shareholders. The key point about this type of arrangement is that both parties can also agree not to exercise the option.
For example, a legal practice loses one of its partners. Their daughter is already working for the practice and is considered suitable as a partner. As the daughter is to be offered a partnership, neither invokes the double option agreement on her parent's death, as the share of the business remains with the family. Double option agreements are considered more tax efficient and flexible than buy and sell agreements (which do not give any option to buy or sell) and automatic accrual methods.
What is a single option agreement and when is it most appropriate to use it?
These are most suitable for use where the partners wish to purchase critical illness benefits. This gives the critically ill partner the option to sell their shares to the remaining partners within a period of time after payment of the policy proceeds. There is, however, no option for the remaining partners to force the other partner to sell.
The key point is that the critically ill owner is in control. It gives the afflicted shareholder the right to trigger the agreement depending on how serious the critical illness is. If the illness is serious and a return to work is not expected, the other shareholders will be obliged to buy them out using the proceeds of the critical illness policy. Alternatively, the option need not be exercised. The cash will then be held in trust.
What happens in the case of keyperson cover?
In addition to the business buy-out need, there is also a need to compensate the business for loss of profits if the owner of a private business dies or becomes seriously ill. This can be achieved by increasing the sums assured under the attaching life and critical illness policies. Surplus funds above that needed for the business buy-out are then available to the co-owners to inject into the business.
What are the tax implications?
The table above highlights some key considerations when setting up business protection arrangements.
Rosalind Pearson is personal finance research and planning manager at Swiss Life UK
