Should a key shareholder become incapacitated or die, what happens to their shares can be a matter o...
Should a key shareholder become incapacitated or die, what happens to their shares can be a matter of great importance to a small business. Ian Gaynor-Kirk considers the insurance solutions Small to medium-sized companies are one of the major employers and wealth creators in the UK economy. Open the business pages of the phone directory for your local area and you will find thousands of them in all areas of commerce.
These companies are vulnerable. They rely far more on their shareholders than bigger companies, with the role of management and ownership held by only a few individuals.
The loss of one of these individuals through death or incapacity may deprive the company of a driving force, leading to loss of profit; or interference from the family of one of the shareholders may prevent the surviving shareholders from running the company properly. This could cause the company to be sold off, wound up or fail.
Should the worse happen, a shareholder who has invested time and hard work into a company will want their family to benefit from that hard work by receiving a fair payment for their shareholding. The surviving shareholders will wish to continue to control and run the company. It is therefore important that, should a shareholder become incapacitated or die, plans are in place for the remaining shareholders to be able to buy their incapacitated or dead colleague's shares.
Such plans generally include a written agreement, commonly known as a 'cross option' agreement, which is formed by a 'sell' option for the shareholder in the event of death or incapacity and a 'buy' option for the other parties in the event of death only. The exercise of the 'sell' option will require the other parties to buy the dead or incapacitated shareholder's shares. The 'buy' option will require the deceased shareholder's personal representatives to sell the deceased's shareholding to the other parties.
Money will be needed to pay for the shares and this will generally be provided by life assurance in the event of death and by critical illness insurance for incapacity. Self-insurance could be considered if large enough reserves are available.
There are two widely used solutions.
The company solution
Under this scheme, each shareholder enters into a cross-option agreement with the company. If that shareholder then dies or becomes incapacitated then the company purchases their shares which then become unissued share capital.
With this solution, the surviving shareholders own no more shares than they did before, but they own a greater proportion of the issued shares. If, for example, there was a company with 90 issued shares - with three shareholders owning 30 shares each - and one died and their shares were bought by the company, the survivors would have half of the remaining issued shares each, but still own only 30 shares.
The life assurance and critical illness policy would be taken out on the shareholder by the company, but the premiums would not be tax deductible for the company. There would also be no tax assessment on the shareholder.
There are a number of Companies Act 1985 conditions to be satisfied before a purchase can take place from capital. They include:
l The company's Articles of Association will need to permit the purchase.
l A private company must use distributable profits to purchase the shares before it can resort to capital.
l The directors must make a statutory declaration stating that they can see no grounds on which the company would be unable to pay its debts or continue as a going concern for a period of at least one year after the purchase. This must be supported by an auditor's report.
l A special resolution authorising the purchase of the shares out of capital with the approval of 75% of the remaining members present, and voting should be passed within one week of the statutory declaration.
l Within one week of the special resolution a notice must be placed in the London Gazette making creditors aware that the payment out of capital is to be made. It must give the creditors a chance to apply to the court to cancel the resolution. At the same time, a similar advertisement has to be placed in a national newspaper and a copy of the statutory declaration and the auditor's report must be delivered to the Registrar of Companies.
l The share purchase must take place between five and seven weeks from the date of the special resolution.
l Form 169 - Return by a company purchasing its own shares - must be delivered to the Registrar of Companies within 28 days from the date shares purchased by the company are delivered to it.
The trust solution
The other solution is for the shareholders to enter into a cross option agreement together. If a shareholder dies or becomes incapacitated, then the surviving shareholders purchase their shares.
The life and critical illness policies would be taken out by each shareholder on their own life under trust for the benefit of the other shareholders. The premiums would be paid by the shareholder from their owned taxed income, or if the company pays the premium on the shareholder's behalf it will be assessed for income tax and possibly national insurance on the benefit.
On death or incapacity the sum assured would be paid to the trustees, who pass the proceeds to the surviving shareholders free of taxation. It can then be used to pay for the shares.
Trust vs company
The key difference between these two options is cost. While premiums for either solution will be the same, it is the tax treatment that determines the net cost.
If the company takes out a policy and pays the premiums on the life of a shareholder (the company route), the premiums will not be tax deductible for the company. There will also be no tax assessment on the shareholder.
If the trust route is chosen the amounts to be paid by the company to the shareholder(s) for premium payments will usually be tax deductible but will also be subject to income tax and, possibly, national insurance in the hands of the shareholder.
For example, in a company with profits of £300,000 or less, the following would occur. Under the company route, each £100 available in the company pre-tax will be reduced by £20 corporation tax to £80 before it is available to spend on premiums. Under the trust solution the premium will either be paid from the shareholder's taxed income or by the company on the shareholder's behalf, in which case it will then be tax assessable on the shareholder.
Assuming the employer's NIC is 12.2% and is to be met from the available £100, then an amount of £89.13 will be available to distribute as salary. Both the salary (£89.13) and the employer's national insurance (£10.87) would be deductible for corporation tax.
Income tax would be payable on the salary together with employee's national insurance (depending on salary levels). For a higher rate taxpayer (over the upper earnings for NIC limit) a net sum of £53.48 would be available to spend on premiums. For a basic rate taxpayer (10% Class 1 NIC) an amount of £59.72 would be available to meet the life policy premiums. In most cases, the cost of a given level of cover will be minimised if the company route is chosen. The exception may be if the company's profits exceed £300,000 and the shareholder is a basic rate or non-taxpayer, as the corporation tax rate will exceed the basic rate.
The main objection to the company route is that if at the time of a claim a company is heavily in debt or not financially robust then it may not be able to make the share purchase. This argument makes the assumption that the trust route would be unaffected by financial difficulties with the company. This is not necessarily true. To avoid the granting of the options which form the cross option agreement being taxed they will normally use the market value of the shares at the time of a claim as the purchase price.
Any company that has debts that could compromise a share purchase under the company route would probably have a weak market value share price. So the sale of the deceased's shares may not gain their dependants much value.
Two other points to bear in mind. First, for the company route the shareholder must have held the shares for five years or more, and this applies independently to each set of shares they acquire. Second, the company route will benefit all shareholders in proportion to their shareholding, including 'minor' and 'outside' shareholders. If the major shareholders do not wish other shareholders to benefit then the trust route may be more appropriate.
The company route is generally lower cost with a simpler initial structure than the trust route. It will not, of course, be appropriate in all circumstances, but it is worth consideration.
Ian Gaynor-Kirk is senior marketing technician at Scottish Provident
