If you own a business with another shareholder or partner, the death of that co-owner can have a huge impact on the surviving owners and the business itself. This is because the death of a co-owner is often unexpected and it leaves the surviving owners either having to find the funds to purchase the deceased’s shares back (assuming they have the right to do so) or risk the shares passing under the deceased’s will to a potential undesirable. Furthermore, if the deceased owner worked in the business, it may be that there are additional operational costs which can be significant.
A well-established way of protecting against this scenario is to take out business protection life policies backed up with cross-options and this may be something your insurance broker, relationship manager or financial adviser may have talked to you about.
In summary, where a shareholder or partner (i.e. business owner) dies, life policies supported by cross-options enable the surviving business owners to fund the buyback of the deceased owner’s shares/interest in the business using the proceeds of the life policy which will ultimately be paid to the deceased owner’s estate. This approach removes the burden on the surviving owners of having to find the finance to purchase the deceased owner’s shares at short notice while also ensuring that the deceased’s estate gets value for their share/interest in the business.
How it usually works
Each owner of the business takes out a life policy (which can come in various forms) which will pay out a specific amount on the death of a co-owner. The value of the life policies should ideally reflect the value of each owner’s share or interest in the business (which should be reviewed periodically to account for fluctuations in the value of the business). For tax purposes, life policies are sometimes written into trust. Alternatively, the company itself may take out a life policy over the lives of the owners in which case the policy value may be increased to cover the purchase of the shares and the operational costs of replacing the deceased owner.
In addition to the life policies, cross-options are put in place (either in a standalone agreement or in a shareholder agreement). It is the cross-option provisions which provide the mechanism for the purchase of the deceased owner’s shares/interest. The cross-options have to be drafted and structured very carefully so as to minimise the risk of unexpected tax charges arising on the death of an owner.
In summary, the cross-option provisions should operate as follows: –
- On the death of a business owner, the surviving owners (or company) will have the option to force the deceased owner’s personal representatives to sell their shares/interest in the business to the surviving owners (or company).
- Conversely, the personal representatives of the deceased owner will have the option to force the surviving owners (or company) to purchase the deceased owner’s shares/interest.
- Once an option has been exercised, completion of the sale and purchase of the deceased owner’s shares/interest in the business should occur within a set period and be subject to certain conditions (for example, receipt of the grant of probate and life policy proceeds).
In terms of setting the price for a deceased owner’s shares/interest this can be either a fixed amount or linked to the proceeds of the relevant life policy.
When implementing cross-options to support life policies, there are a number of important considerations which will depend on the circumstances and the business owners’ objectives and wishes. As mentioned above, thought should also be given to revaluation of the business and policy amounts (for instance, a periodic business valuation with an obligation to amend the life polices in line with any change in valuation accordingly).
As term life policies are often taken out for the purpose of business protection, thought should be given as to what happens if an owner becomes uninsurable at the expiry of the term or if the premiums become commercially unjustifiable. Consideration should also be given to what happens if a co-owner does something to invalidate their insurance, leaving a shortfall when it comes to the policy pay out.
Most insurance companies often have their own standard cross-option agreements but the “one-size fits all” approach often doesn’t meet everyone’s objectives and wishes. If you are considering taking out business protection life policies then you should seek legal advice as to the terms and operation of the cross-options.
For more information, contact BHW’s corporate team on 0116 289 7000 or email email@example.com.