Many business owners, often having spent a lifetime building up their business, are keen to ensure that on their death, where possible, the business can continue, with the right management in place. Equally important to them is that the value of their interest in the business can be realised for the benefit of their family and loved ones, in a tax efficient way.

There are, of course, a range of planning solutions available when considering business succession. The most appropriate solution, in any given case, will depend on a variety of factors including the size and structure of the business, the value of the business owner's interest in the business, who else is involved in the running of the business and their respective roles.

One solution, commonly referred to as 'Cross Option Planning' is particularly relevant to owner managed businesses. While similar principles apply to businesses run as partnerships, this article's primary focus is on private limited companies.

What happens if no planning is put in place?

The unexpected death of a business owner can have devastating consequences not only for their family, but also for the future of the business and any fellow shareholders.

The deceased's shares in the business will generally pass to their estate to be dealt with in accordance with their Will (or if there is no Will, in accordance with the intestacy laws) and in these circumstances there are generally two options for those inheriting the shares:

  1. To realise the value of the shares by selling them, or
  2. To retain the shares (subject only to the articles of association of the company and the terms of any shareholders agreement which may limit who can be a shareholder in the company).

Both options can be problematic:

  • Selling the shares - those inheriting the shares (typically the family) may not easily be able to find a willing buyer with sufficient cash funds to buy the shares. This may leave the shareholder's family in a precarious financial position, at the worst possible time
  • Keeping the shares - if the family retain the shares, this may cause friction with those running the business, potentially having to involve them in decision making, when they may know little about the business, and at a time when the business (as well as the family) is struggling to deal with the bereavement.

How might Cross Option Planning help?

This form of planning envisages that all the shareholders grant each other options over their shares, which are exercisable on death. In the event of a shareholder's death, the surviving shareholders are given the right to buy the deceased shareholder's shares at an agreed price (the Call Option) but if they do not exercise that option, the deceased shareholder's estate is given the right to compel the other shareholders to buy the shares (the Put Option).

That's all well and good, but where does the cash to fund the share purchase come from?

Each shareholder also takes out a life insurance policy normally for a fixed term, equivalent to the value of their shares or interest in the business. A trust arrangement over the life policy is set up directing that the proceeds be paid out to the surviving shareholders which guarantees that they will have cash available in the form of the life policy proceeds to buy the shares.

The end result is a win-win: The shares are returned to the surviving business owners so they are able to run the business (without unwanted interference) and the beneficiaries of the shares are able to easily divest themselves of the shares, whilst realising the full value of the business interest.

How is Cross Option Planning put in place

As you may have gathered, this form of planning involves a number of distinct elements and business owners will need advice on the following:

  • Cross Option Agreement: this will need to be negotiated and agreed between the shareholders and will cover the mechanics of what happens to the shares on the death of a shareholder. It will need to address:
    • The purchase price for the shares – a valuation method is agreed at the outset which will ordinarily provide a fixed value for the shares. This enables the correct level of life cover to be put in place at least initially, although this should be kept under review, (say every 3 years), as the value of the business may fluctuate upwards or downwards in the years ahead
    • The grant of the options – and whether this is to be over all or just some of the shares
    • The option period – how long this should last and what should happen to any dividends paid on the option shares during this period
    • The mechanics of completion, including registration of the share transfers and what happens on failure to complete
    • The life policy – the obligation to take out and maintain life assurance (ordinarily in an agreed form)
  • Life Policy: The life policy will ordinarily be for a fixed term ending at the same time as the Cross Option Agreement, so as to avoid any problems which might arise if, for example, one of the parties became uninsurable
  • Declaration of Trust: The life policy is 'written in trust' with the trustees holding it on a fully flexible basis, for the benefit of a number of potential beneficiaries, which will include the surviving shareholders (as well as family members and descendants). The trustees would ordinarily be the surviving shareholders who are required to act unanimously and in good faith. Whilst the trustees are required to consider the position of all the potential beneficiaries under the trust, they will generally be able to distribute the policy proceeds to themselves to fund the purchase of the deceased's shares. An express provision in the trust deed, enabling the trustees to benefit is, of course, advisable
  • The company's Articles of Association: These should be reviewed, as should any shareholders agreement, as changes may need to be made to facilitate the cross option arrangements
  • Wills: The shareholders' Wills should be reviewed to take account of the planning, as well as the Wills of any family members holding shares in the business.

The tax implications

This form of cross option planning, if structured properly, is inheritance tax (IHT) efficient. Whilst the detail is outside the scope of this note, the key tax implications are as follows:

Business Property Relief

Shares in an unquoted trading (rather than investment) business which are held for more than two years will generally qualify for 100% business property relief from inheritance tax (IHT). This is an extremely valuable relief but it will be lost if the shares are subject to a binding contract for sale at the date of death. Therefore it is crucial that any cross option agreement is drafted carefully to ensure it is just that, i.e. an option to buy rather than an obligation to buy, which would defeat the planning!

Taxation of Trusts

A trust is essential to ensure that the policy proceeds are not included in the deceased shareholder's estate for IHT purposes. The trust will not come into play unless the shareholder dies within the specified term, at which point the trustees should take professional advice, as trusts are subject to their own special IHT regime.

Conclusion

The death of a business owner will inevitably impact the business, but, as demonstrated, cross option planning may offer a neat solution which protects both the business and the shareholder's family.

There are, of course, variations on this theme of planning and the right solution in any scenario will depend on the particular circumstances. While the cross option planning concept is relatively straightforward, there are a number of technical issues which require careful negotiation to ensure the arrangements achieve the desired result.

Our team has a wealth of experience in working with business owners and their other professional advisors, supporting them to make the right decisions for their businesses, and their families, while ensuring that any planning put in place is practical, streamlined and tax effective.