Why would I want to protect myself and other directors?

The potential problems that might arise can depend on the business type, the size of the business share, and the procedures laid down in the articles of association or the membership or partnership agreement if there is one.

For example, if one of the owners of a limited company becomes critically ill or dies:

They or their family might want to sell their share of the business. They could sell it to a competitor or some other unsuitable buyer. If the owner was a majority shareholder then control of the business has been lost

If the outgoing owner had at least 75% of the shares then they could also force the outright sale or winding up of the business.

Perhaps the owner's family may wish to become involved in the business, which may be at best disruptive or at worst unacceptable to the other owners. A majority shareholding allows the new owner to appoint themselves as a director and remove other directors, gaining day-to-day control of the business.

The other owners may have to use funds they intended for other purposes to buy the share of the owner who has died or fallen ill.

How to Calculate the value of a Company

In valuing a company, always refer to the company's articles of association to see what, if any, restrictions there are on the transfer of shares and if there's a valuation clause included. The number of conditions relating to the transfer of the shares will affect their value. Many articles simply allow the directors the discretion to refuse to register the transfer to any person for any reason. Larger companies may have more complicated restrictions. The valuation methods could range from allowing the company's auditors or an expert valuer to fix the price or putting a fixed price on any transfer, for example £1 per share.

However, there are 3 commonly used methods. These are:

1. Dividend yield - By applying the level of yield a buyer might require from their investment to the actual dividend produced, we could find the capitalised value or the price per share they might be willing to pay.
2. Capitalised Earnings - In this method a price/earnings (p/e) ratio is used to capitalise a company's earnings after the deduction of corporation tax to determine the value of shares.
3. Net Assets - Net assets shown on a company's balance sheet are not necessarily a helpful guide to the valuation of shares as they're valued on the 'historic cost' of their purchase, and then down-valued each year in line with the depreciation method adopted by the accountants. This could result in a property with a market value of, say, £1 million being valued in the books at less than £200,000 if it was purchased some time ago.

How to Calculate the value of a Partnerships and LLP's

Partnerships and LLPs are particularly difficult types of businesses to value as much of a partnership's or LLP's value is often in the form of goodwill.

Commonly used methods include:

• Average partnership or membership profits - The value of the partnership or LLP can be expressed as a multiple of the average of the last given number of years profits.
• Value goodwill - An agreement can be made among the partners or members after taking professional advice on a method to value the goodwill of the firm.
• Net assets - As with companies, the net assets are not always a helpful guide to the firm's value, but they should be taken into account.
• Sole trader - A sole trader has 2 options: to sell their business as a going concern, in which case there will be a market value, or to wind up their business realising the value of assets less debts. As a sole trader's protection will be set up on an individual basis, an exact valuation is not vital. But the cover needs to be enough to provide for their family and pay all the business debts.

Individual purchase - Companies, LLPs & Partnerships

The first solution is for each owner to take out a protection plan on their own life for the value of their share of the business. This plan is written under business trust for their co-owners. All owners enter into an appropriate agreement. If one of the owners suffers a critical illness or dies, the others would receive the funds to purchase the share of the owner who has died or fallen ill.

The deceased's personal representatives would distribute the proceeds in accordance with their will or the rules of intestacy.

Alternatively, if there are only 2 or 3 owners it's possible for each owner to take out a life-of-another plan on the lives of each of the other owners. If one of the owners dies or suffers a critical illness, the plan would pay out directly to the other owners, which means they'd have the money to buy their share.

Company Purchase - Companies Only

The second solution is for the company to buy the shares of the shareholder who has died or fallen ill. The result of the share buyback is that the shares are cancelled and revert to unissued share capital. The actual number of shares of the remaining shareholders remains the same, but the proportion of the issued share capital that each shareholding represents increases.

Company share purchase must be permitted by the articles of association, and is subject to a number of conditions. The most important of these are outlined below. Please see the Companies Act 2006 Part 18 for full details.

The general rule is that any purchase of a company's own shares must be made out of the distributable profits of the company or out of the proceeds of a fresh issue of shares made for the purpose of the purchase.

Subject to stringent requirements a repurchase of shares out of capital reserves may be allowed. Such a capital payment may only be made after all distributable profits have been exhausted and is made by reference to 'relevant accounts'. The directors must also make a statement and the auditors will be required to report to the directors whether they feel a purchase out of capital is acceptable given the financial position of the company.

The company and each shareholder individually enter into an appropriate agreement that would provide for the purchase of the shareholder's shares on death or critical illness. At the same time the company takes out Life or Critical Illness Cover on the shareholder, the sum assured of which would pay for the share purchase.

The cross option agreement - An appropriate agreement is required between the shareholder and the company for the disposal of shares on death or critical illness of the shareholder. Separate cross option agreements may be required for each shareholder.

The company's legal adviser draws up a cross option agreement. The agreement works by creating a 'sell' option for the shareholder in the event of their death and/or critical illness and a 'buy' option for the company in the event of death only. The exercise of the sell option will require the company to buy the shares. The buy option will require the deceased shareholder's personal representatives to sell their shareholding to the company.

The Cross Option Agreement

An appropriate agreement is needed between the shareholders for the disposal of shares on death or critical illness. It mustn't be a binding agreement for sale otherwise business property relief from inheritance tax wo't be available. You can find more information on business property relief in the taxation section.

The business's legal adviser should draw up the cross option agreement to make sure it doesn't conflict with the articles of association or an existing partnership or membership agreement. The agreement works by creating a 'sell' option for each owner in the event of their death and/or critical illness and a 'buy' option for the co-owners in the event of death only. The exercise of the sell option will mean the surviving owners must buy the share of the owner who has died or fallen ill; the buy option will require the deceased owner's personal representatives to sell their share to the surviving co-owners.

If the arrangement is to include options on critical illness, your clients need to consider whether they only want an owner who suffers a critical illness to have a single option allowing them to sell, or if they also want the other owners to have an option to buy.

If they choose a single option on critical illness, the owner who suffers a critical illness can't be forced out of the business against their will. This gives that owner the opportunity to continue in the business if they recover and are able to return to work. But it also means that if they're unable to return, the remaining owners have no right to buy their share of the business. This could mean that the sick person is still entitled to their share of any profit even though they're no longer contributing to the business.

Alternatively, your client could choose to include a double option in the event of a critical illness. However, this would operate differently to the cross option on death. In the event of an owner suffering a critical illness, they have an immediate option to sell. If they exercise that option the other owners must buy that share of the business. But the other owners wouldn't be able to force the sick owner out immediately. Instead, they would have an option to buy only if the sick owner doesn't return to their normal duties within a specified period, usually 12 months. This gives the sick owner the opportunity to return to the business if they're able, and the other owners the security of being able to remove an owner who is no longer able to contribute.

Equalisation of Premiums

Where each of the shareholders, members or partners has set up trust plans for share purchase, it's possible to make an equitable arrangement to even out any differences between the premiums each is paying.

The partners, members or shareholders may agree to equalise costs according to the potential benefit each may receive. Equalisation removes the inequality of an older or more significant shareholder, member or partner paying more for cover than younger or more minor shareholders, members or partners, while gaining less benefit.

Equalisation brings about a fair distribution of costs. And in addition, where there are significant differences in the costs and benefits there's a danger that HM Revenue and Customs might view this inequality as conveying a 'gift' from one partner or member to another. If so, the arrangement may not be considered commercial and the premiums and policy proceeds would go back into the estate for inheritance tax purposes. This danger is particularly acute in family companies, especially in generational arrangements such as parent and child where HM Revenue and Customs will be more likely to assume there's an intention to gift.

Take Our Advice

Companies

The taxation implications for a company depend on the solution, the type of plan chosen, the reason for the cover and the relationship between the key person and the company. However, HM Revenue and Customs will treat each case on its own merits and may take a different approach to that outlined below. Contact the firm's local inspector of taxes to find out the approach they will take. You can find a draft letter to HM Revenue and Customs.

Life of Another

There are 4 tests to see if a premium is a tax-deductible expense for the company.

These are:

• The purpose of the plan is to solely protect against loss of profit.
• The sole relationship should be employer/employee (although very small shareholdings - e.g. under employee share schemes - are likely to be ignored)
• The plan must be a short-term assurance, which is normally understood to mean a non-convertible term insurance plan no more than 5 years.
• If the plan fails any of these tests the premium is unlikely to be tax deductible. For example, a plan taken out to provide security for a loan wouldn't meet the requirement to protect solely against loss of profit. So, premiums are not normally allowable for corporation tax relief and the sum assured is not normally regarded as a trading receipt.

Take Our Advice

With years of experience there's nothing we don't know about business protection, talk to us and we can give you sound advice on what type of cover is best for your business and how much.

Simply call 0800 583 7288 or submit an enquiry