TT113: Shareholder Protection
A familiar format
Being a limited company is the vehicle of choice for many business people. It is familiar to customers and suppliers and provides limited liability. Many businesses are owner-managed entities, with the company acting as the trading vehicle for the business owners in the longer term.
In many small to medium businesses the shareholders are the founders and driving force behind the business. As these businesses grow the need to plan for a variety of exit strategies is often overlooked.
Some exit strategies are relatively straightforward and many business owners plan for the possible sale of the business on their retirement. It is equally likely they will plan for the retirement of just one of the owners if there is more than one. Management buy-outs are often favoured.
However, planning for other situations is often less thorough, and can lead to nasty surprises:
- If one of the business owners dies unexpectedly under what rules will the business continue to operate?
- Who will become the new co-shareholder of the remaining business owners? This might be determined by the late shareholder’s Will alone!
- Are the directors empowered to block such a transfer of shares if they do not see eye-to-eye with the new shareholder?
- What value will be put on the shares should the late shareholder’s beneficiaries wish to sell the shares to the remaining shareholders?
- If the new shareholders want to retain their shares, will they get any dividend?
- Will the new shareholders be entitled to appoint a board member?
As can be seen, the list of potential problems could go on and on! The problems could impact negatively on either the late shareholder’s family or on the remaining shareholders with equally unpredictable consequences.
A sensible plan
Business owners should consider entering into shareholder protection arrangements. This involves a legally binding agreement that, should one of the shareholders die, ensures the process for the subsequent sale of the shares to the surviving shareholders is planned for. It also provides that the shareholders will ensure there is sufficient life assurance in place to pay out enough funds to enable the surviving shareholders to buy the shares of the late shareholder from their estate.
The major tax advantage from this arrangement is that the shares in a trading company will be exempt from Inheritance Tax in the estate of the deceased shareholder, but they benefit from a Capital Gains Tax uplift in their base cost. This means that the beneficiaries inherit the shares at today’s market value and, should they sell them shortly thereafter under this agreement, there is no tax payable.
Barnes Roffe Topical Tips:
- The legal agreement should work both ways, allowing either the deceased’s executors or the surviving shareholder to force the sale of the shares.
- The life cover must be taken out and written in trust so that on the death of one shareholder the proceeds are paid to the surviving shareholders.
- The legal agreement must not be a binding obligation to sell the shares, but create an option for both parties to trigger the sale should they wish to. This avoids the pitfall that if the contract directly converts shares to cash then HM Revenue & Customs will argue that the cash is subject to Inheritance Tax.
- An annual review should take place where an informal valuation is agreed between the shareholders and the insurance cover increased as necessary.
- More than two shareholders can be considered in such an agreement.
- Beware of the important difference between Shareholder Protection and Keyman Insurance (Topical Tip 52 refers).