A recent case reinforces the benefits gained from solicitors, accountants and IFAs working together, says Scott Gallacher

In small, privately owned companies, there are usually only a small handful of shareholders – normally they are the directors, and often also the people actually running the company day-to-day.

But what if someone dies? How should the death of such a shareholder be dealt with?

Ideally, their shares should be passed quickly and easily to the surviving directors (rather than passing by default to the deceased’s family). Pre-planning for this eventuality helps remove the danger of trading being disrupted, or of uncertainties and disputes arising between the surviving shareholders and the executors.

This pre-planning, although not especially complex, must be implemented in exactly the right way in order to avoid unintended consequences years down the line. Knowing this, an accountancy practice who we work with closely recently asked us to review the arrangements for one of their corporate clients. Their concerns turned out to be justified – and the case will help illustrate some of the key pitfalls to look out for.

Problems and pitfalls

The accountant had valued the company at £800,000, owned equally by the two shareholding directors. ?The directors, two years ago, had asked their adviser to put arrangements in place so that: (a) were one of them to die, the surviving director would have the option to buy the shares of the deceased director; and, (b) that the surviving director would have the wherewithal to do so, using the payout from a life assurance plan.

• On the basis that each director should be covered for £400,000, director A had been advised to take a £200,000 plan (topping up a pre-existing £200,000 plan which would now be pressed into service for this new purpose).

• Director B had no cover, so he was advised to take out a new £400,000 life assurance policy.

Unfortunately, none of these plans were right. The pre-existing plan, it transpired, was owned by the company, not the director – it was a ‘keyman’ plan intended to give a cash injection to the company on the death of a key employee. Useful in itself, perhaps, but of no help at all with the director’s purchase of his late partner’s shareholdings.

The two later plans were of the right type, but had not been placed in trust. This meant that, first, there was no mechanism for that money to pass to the one who needed it – the surviving director. Second, it meant that the proceeds would simply fall into the deceased director’s estate which, in the case of one of the two (who was unmarried), would mean a huge – and unnecessary – inheritance tax bill.

Noticeable by its absence was any form of agreement in respect of the share purchase. Of course, some people are happy to trust that their deceased co-director’s executors and family will be cooperative – but experience shows that it’s at times like this that a touch of pre-arranged formality can be most valuable.

The fourth and final point is the use of the pre-existing policy. Even if it had been of the right kind to be included, the fact that it was a pre-existing plan taken out for another purpose means that it shouldn’t be used.

HMRC’s interpretation of policies placed into trust as part of these arrangements is complex, but the result is that any payout could be made subject to an 18 per cent or 28 per cent capital gains tax. Although HMRC rarely pursues this actively, it remains a real danger – and what’s more, a danger that could only ever be known when it was too late to remedy.

Getting it right

The cornerstone is the agreement: specifically a ‘cross-option agreement’. This is specially structured so that there is no binding arrangement for the shares to pass from one to the other on death. However, the agreement becomes binding if, after death, ?the survivor exercises his option to buy, or the executors of the deceased exercise their option to ?sell, to the survivor.

The fact that the arrangement isn’t binding until after death is important because otherwise the shares would suffer an inheritance tax charge of 40 per cent.

The best way to meet the requirement is to effect life assurance policies that will pay the money on death. If it eventually turns out not to have been needed (as of course everybody hopes), then the only loss will have been the cost of the premiums over ?the term. These total premium costs can be thought of as the cost of ensuring peace of mind and security until retirement.

In order that on the death of one director, the money would be available to the other, each should take out a policy that covers his or her own life, ?but then place each in a trust for the other. We normally recommend that on each plan, the trustees should be the directors themselves, plus another independent third party, such as the company solicitor or accountant.

The trusts ensure that any payout is made ?available only to the survivor and only for the ?purpose of buying the deceased’s shares. The independent third party acts to make sure that the survivor uses the proceeds for the share purchase and not any other purpose.

For both the agreement and the trusts, a client could use the sample agreements provided by life assurance companies, which are suitable for ?many cases. However, we would prefer to liaise ?with the client’s own solicitors to draw up ?appropriate documents tailored to their own ?specific requirements.

Case to case

The specific type of life cover will vary from ?case to case in line with the client’s requirements. ?In the case highlighted here, cover was required only up to the older director’s planned retirement age at ?65, at which time the younger director would also want to retire from the business. We therefore recommended eight-year level term life assurance plans of £400,000 each.

This kind of insurance simply pays out a set amount should death occur within a set term. After the term, the plan just finishes; there is no money back. Not only is this the simplest and most cost effective kind of life assurance plan, but in this particular case, is also perfectly suited to director’s requirements – so we did not have to consider other, more expensive forms of cover.

Although this particular case covers what would happen in the event of death, it’s worth noting that it doesn’t cater for what would happen in the event of an illness or disability, which could still have a very damaging effect on the business and might prompt the wish for one director to buy the shares of another.

It is possible to take insurance that would help protect the directors against this risk – and for the agreement to cover this eventuality – but unfortunately it tends to be much more expensive. ?(In the case outlined here, the directors preferred to leave this point and keep the costs down.)

This area is one that demonstrates nicely the advantages of a client’s advisers liaising closely and all contributing to a common goal:

• the accountant recognised the potential problem and assessed the company value;

• the solicitor prepared deeds and agreements, and made sure they fitted with the company’s articles;

• the financial adviser reviewed the existing problem, interpreted the tax issues and implemented the new plans.

With all three professional advisers working together, a potentially dangerous situation was remedied and a thoroughly satisfied client was reminded of the value of professional support and advice.

Scott Gallacher is a director at Rowley Turton independent financial advisers. He can be contacted on scott@rowleyturton.com. For more information see  www.rowleyturton.com