Cross-option Agreements and Business Property Relief

The death of a shareholder who is also a director can have a major impact on any business, particularly where the company has not made plans for such an event.  For owner/managers of small to medium-sized private companies, this is a particular concern, since the shareholder’s death can potentially give rise to a host of adverse consequences for the business.

Shareholders may also have concerns for the welfare of the beneficiaries in the event of death.  When a shareholder dies, his beneficiaries’ interests do not necessarily align with those of the other shareholders, especially where such beneficiaries lack any business experience. As the company is under no obligation to provide a deceased shareholder’s beneficiaries with benefits such as income or pensions, it is clear that such concerns are entirely legitimate.  Regardless of assurances a shareholder may give his fellow shareholder that he will make sure that his fellow shareholder’s wife and children are ‘looked after’ in the event of death, if the shareholders have not made formal provisions, the worst case scenario can, and sometimes does, happen.

In such circumstances, the question of whether the continuing shareholders have sufficient funds to buy the deceased’s shares becomes critical.  In many cases, a suitably-drafted cross-option agreement, backed by an appropriate term assurance policy is the solution.  This can be drafted on a stand-alone basis or can be included as a separate section in a shareholders’ agreement.

The fundamentals of a cross-option agreement are simple: each shareholder agrees that upon his death his fellow shareholders have the option to buy his shares (and, in some cases, those of his spouse), usually at market value (a so-called ‘call option’) and that his personal representatives (on death) have the option to sell his shares (and, in some cases, those of his spouse) to the continuing shareholders (a ‘put option’).

At the same time, each shareholder takes out a term assurance policy, under which any amount which becomes payable under the policy is held in trust by the continuing shareholders to pay for the deceased’s shares under the put and call options.

By structuring the transfer of shares in this way it is possible to ensure that the deceased’s shares qualify for business property relief (which, in valid circumstances, provides 100% relief from inheritance tax) whilst the proceeds of the insurance policy fall outside of the deceased’s estate and are not subject to inheritance tax.

It is essential that the person drafting the cross-option agreement appreciates the necessity to ensure that it does not fall foul of certain inheritance tax provisions, which could render the transfer of the shares ineligible for business property relief.   The key factor is that the ability for the continuing shareholders to buy the deceased’s shares and the ability for the deceased’s personal representatives to sell the shares must be drafted as a right, rather than an obligation.  If any of the parties is under an obligation to buy or sell the deceased’s shares, the transfer of the shares would effectively be subject to a binding contract for sale and, as such, for inheritance tax purposes would be treated as a transfer of cash and, consequently, business property relief would be lost.

A properly-drafted cross-option agreement with associated term policies not only ensures that a deceased shareholder’s beneficiaries can extract value from the company, but it does so in a way which is both tax-efficient and causes minimum disruption to the remaining shareholders.

The use of a cross-option can also be extended to partnerships.  Historically, some partnership agreements included provisions which required the continuing partners  to purchase a deceased partner’s share from his beneficiaries and required his beneficiaries to sell it to them.  Such provisions meant that upon death there was a binding contract for the sale of his partnership share and thus business property relief would not be applicable to the transfer.  Increasingly, solicitors are replacing such provisions with cross-options, which, in valid circumstances, allow the deceased partner’s beneficiaries to take full advantage of business property relief.

To contact Raworths, telephone 01423 566666 or visit our offices at Eton House, 89 Station Parade, Harrogate HG1 1HF. Alternatively, visit our website on www.raworths.co.uk or email Fionula.scanlan@raworths.co.uk