Corporate guide: life insurance-backed cross option agreements

INTRODUCTION

Many privately-owned companies with a small number of founder or other significant shareholders put in place a shareholders agreement and dovetailed articles of association. These help to ensure that the company is run in an orderly manner and the rights of the shareholders are fairly balanced – see our separate guide "Stakeholders Agreements and Articles of Association for Founder Shareholders".

This guide provides owner managers with a general overview of an overlapping area for consideration – what should happen to the shares of a significant owner manager if he or she dies or becomes critically ill?

If, having considered this guide, you would like to know more (including being put in touch with specialist insurance brokers) or to discuss your own circumstances in greater detail, please speak to your usual contact at Stevens & Bolton or a contact listed at the end of this guide.

WHY CONSIDER PUTTING THESE ARRANGEMENTS IN PLACE?

A personal goal for many owner managers is to build the capital value of their shares and ultimately to realise that capital value through some form of exit, such as the sale of the company or an IPO.

In addition to other personal financial planning, many owner managers seek to address what should happen to their shares if they die before an exit event occurs. It may be considered adequate for the beneficiaries of the deceased’s estate (e.g. a spouse or children) to inherit the shares, but the surviving owner manager shareholders may be concerned about the prospect of finding themselves in business with those family members. Also, the estate of the deceased owner manager may be far more interested in realising a cash amount, rather than being left with high risk illiquid shares. There may be pre-emption rights in a shareholders agreement or articles of association providing that in the event of death the shares of the deceased must be offered to the surviving shareholders, but those surviving shareholders are unlikely to agree to an obligation to fund the purchase of those shares in all circumstances.

For many, the answer lies in insurance-backed cross option arrangements involving all major shareholders.

Structured correctly these provide tax-efficient certainty to the estate of a deceased shareholder and to the surviving owner managers that the shares of the deceased can be acquired by or at the direction of the surviving owner managers (so that those most closely involved with the operation of the business own its shares), including funding of the acquisition with the proceeds of an insurance policy.

HOW ARE TYPICAL CROSS OPTION ARRANGEMENTS STRUCTURED?

The main documents involved are typically:

  • an agreement between the owner manager shareholders containing "put and call" options allowing either the estate of a deceased owner manager or the surviving owner managers to require the purchase of the deceased’s shares by or at the direction of the surviving owner managers;
  • one or more life insurance policies designed to pay out proceeds to be used to fund the purchase of the deceased’s shares; and 
  • a business trust deed establishing a simple trust arrangement to ensure that the life insurance proceeds are paid promptly to the surviving owner managers, allowing them to use those proceeds to buy the shares of the deceased without the proceeds forming part of the inheritance tax estate of the deceased.

In the next section we consider some of the structuring points which should be considered – owner managers should be wary of using standard documents generated by insurance companies. It is important that bespoke specialist advice is obtained, to ensure that this documentation is appropriately tailored and achieves maximum tax efficiency.

SOME ISSUES TO CONSIDER AND FAQs

How is the price to be paid for the shares of the deceased owner manager decided?

While there are a number of other possibilities, the two most common approaches are:

  • agreeing a fixed value to apply for a period and ensuring that insurance to that value is in place; or 
  • providing for a "floating" fair value to be determined at the time of death, on the basis that whatever insurance proceeds there are must be used to purchase shares of the deceased at that value, with a residual right for the surviving owner managers to buy any remaining shares at the fair value if they wish to do so and are able to organise the required further funding.

The benefit of using a fixed value is that for the period specified, everyone is clear about the value and the insurance policies can be put in place to ensure that the fixed value is covered. However, with a growing business, a fixed value can quickly become out of date, and so the fixed value should be reviewed on a regular basis and the levels of insurance cover updated accordingly. The taxation analysis of using a fixed value can be more complicated, as the agreed value may not equate to market value of the deceased’s shares at the relevant time.

Using the floating value approach, the estate of the deceased owner manager has certainty that the shares can only be acquired for an up to date market valuation. If the insurance proceeds have not kept pace with that growing market valuation, the estate can force the surviving shareholders to buy as many of those shares as can be afforded out of the insurance proceeds. While it would be possible to provide that the estate can also force the surviving shareholders to buy the remaining shares, that would not usually be commercially acceptable in view of the possibility that the survivors may not have separate funds to complete the purchase of all shares, and so it would be typical to give the surviving shareholders a right (but not the obligation) to buy the remaining shares. With this route some shares may be left behind with the estate of the deceased owner manager and ultimately end up in the hands of the beneficiaries of his or her will – in practice the surviving shareholders will usually do all they can to ensure that all shares can be acquired, because they will want to see those shares held by those closely aligned with the operation of the business, rather than by unconnected

family members of a former owner manager.

What happens if one of the owner managers suffers a critical illness rather than death?

While this adds an additional layer of complexity, it is possible to address critical illness in the same way as death, with put and call option arrangements and a critical illness insurance policy.

Can the business itself purchase the shares of the deceased owner manager?

It is legally possible for a limited company to purchase its own shares, as long as this is allowed for in the company’s articles of association and certain Companies Act 2006 procedural requirements are complied with. Once shares are bought back by a company, they are cancelled and cease to exist, so the relative percentage shareholdings of all other shareholders increase proportionately. The legal and taxation analysis of this company own share purchase route is more complex and specialist advice is recommended. Most life insurance-backed cross option arrangements are implemented between the owner manager shareholders themselves rather than through a corporate own share purchase route.

What if a significant owner manager leaves the business, other than on death or critical illness?

While documents relating to insurance-backed cross option arrangements would not typically address this situation, provision will often be made in a separate shareholders agreement and/or dovetailed articles of association for an outgoing owner manager to be required to offer up his shares for acquisition by or at the direction of the remaining shareholders.

If an owner manager leaves where a life insurance policy for him or her has been put in place to support cross option arrangements, that policy may simply lapse or, subject to taxation advice, it may be possible for the benefit of the policy to revert to the life assured.

What if a new significant owner manager shareholder joins the business?

While the company’s existing articles of association will automatically bind any new shareholder, a new owner manager shareholder will only be bound by any agreement if he or she specifically agrees to that and/or new agreements are put in place. All existing insurance-backed cross option arrangements should be reviewed at this point.

How are the insurance premiums paid?

The most straightforward way to pay the premiums may be for the company to pay them on behalf of each owner manager shareholder. This would be treated as a benefit in kind for tax purposes, but may provide greater certainty that insurance premiums will continue to be paid on a regular basis. Whether or not the company can obtain a corporation tax deduction is open to debate and further advice is recommended.

However, payment of premiums by the company can give rise to inheritance tax concerns, which can if necessary be addressed by the individual owner manager shareholders paying the insurance premiums themselves.

What about taxation implications?

Detailed tax advice is available from Stevens & Bolton, ensuring that these arrangements achieve maximum efficiency and do not trigger unwanted taxation liabilities. Particular areas for specialist advice include:

  • structuring payment of the insurance premiums;
  • optimising inheritance tax planning in relation to the trust arrangements and distribution of policy proceeds;
  • avoiding unwanted capital gains tax charges when the insurance policies are put in place;
  • if a specified fixed share value is used, rather than a floating fair value, further inheritance tax and tax points will need to be considered;
  • if the participants have significantly differing age profiles or any of them has significant health concerns, further capital gains tax points will need to be considered.

In the majority of cases any tax concerns can be addressed with specialist advice and careful drafting of the documents to implement these arrangements. Any likely challenges are typically identified at an early stage.

The information contained in this guide is intended to be a general introductory summary of the subject matters covered only. It does not purport to be exhaustive, or to provide legal advice, and should not be used as a substitute for such advice.

© Stevens & Bolton LLP June 2015

 

Contact our experts for further advice

Richard Baxter, Nick Acomb, Jenny Robertson, Matthew Carman, Bethany Sheen

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