There are various forms of protection available to businesses in case they lose a key person, and these have different tax implications.
A director’s priorities are likely to be two-fold: to cover their personal income needs in the event of being unable to work, and to fairly compensate both their family and the remaining shareholders in the event of their death.
Key person assurance is widely used to cover the costs incurred by a company where a key person is unable to work.
Corporation tax relief
Corporation tax relief for premiums paid by the business is normally allowed, provided the so-called ‘Anderson rules’ apply. See Box One.
Typically, if the premiums attracted corporation tax relief, then any policy proceeds would be taxable as a trading receipt. Most companies would prefer to gain tax relief on premiums (a certainty) rather than on any policy payout (a, hopefully remote, possibility). There are several scenarios where corporation tax relief will not be available. See Box Two.
Share protection
On the death of a shareholder, typically the remaining shareholders would want to retain control of the company while the deceased’s family would prefer the cash value of the shares. In the absence of share protection arrangements, shares may pass to the deceased shareholder’s family by will or intestacy.
The family may not have the desire or ability to be involved in the company, and profits would likely suffer as a result.
The family may wish to sell the shares, but they are likely to be illiquid or of little interest to those not already involved in the company. The remaining shareholders may lack sufficient cash to purchase the shares from the deceased shareholder’s family.
Whole of life policies can solve these various issues. A policy can be used to direct the shares to the remaining shareholders and provide the family with a cash lump sum.
The company cannot obtain tax relief on whole of life premiums because the policy is for the benefit of the individuals and their families, rather than for the purposes of ongoing trade. Therefore, the directors will pay the premiums themselves out of their taxed income. The policy proceeds are then usually paid tax-free to the nominated beneficiaries.
A company’s articles of association may restrict how shares can be transferred in the event of a shareholder’s death, so legal and tax advice is imperative.
Business relief
Partnership holdings and shareholdings in unlisted incorporated trading companies generally qualify for 100 per cent BR. However, a binding requirement for a deceased shareholder’s shares to be sold is a contract. This will result in loss of BR as at the date of death, because at that point the asset will effectively be in the form of cash rather than shares.
Cross-option agreements are often used to circumvent this issue. If one party exercises their option to buy/sell, the other party is obliged to comply. These arrangements are not binding contracts for sale which means BR is still available.
For example, the family initially receives the shares and the remaining shareholders receive the life policy proceeds. The family can exercise their option to sell to the remaining shareholders, who must purchase the shares.
Alternatively, the remaining shareholders may exercise their options to purchase the shares, and the family must sell to them. Cross-options will generally have an expiry date to provide greater certainty to the parties involved. See Graphic One.
Own life
Each shareholder takes out a policy on their own life and places it in trust. Where the shareholding is left to the family, the other shareholders are the beneficiaries of the policy proceeds. Where the shareholding is left directly to the other shareholders, the family are the beneficiaries.
The end result in both situations is that the remaining shareholders are in receipt of the deceased’s shareholding and the family receives a cash lump sum broadly equivalent to the value of the shares. Only one policy is required per director, making this arrangement relatively straightforward to administer, particularly if shareholders or shareholdings change.
Life of another
Each shareholder takes out a policy on the life of each of the other shareholders. This results in numerous policies, which may be costly and administratively inefficient, particularly where there are numerous shareholders and/or they change over time.
For example, where there are four directors, each must take out three separate policies, totalling 12 policies in all. This arrangement is therefore more suitable where there are a small number of shareholders who are well established and unlikely to leave the company.
Ill health cover
Income protection and critical illness cover can protect against loss of earnings due to ill health, while the policyholder is of working age.
Income protection can pay instalments until the policyholder is able to return to work. Critical illness cover provides a lump sum in the event of a diagnosis of certain conditions.
A single option allowing the policyholder to sell their shares to the remaining shareholders is preferable. A cross-option may force the policyholder to sell their shares, even if they feel they may be able to return to work.
A forced sale may also leave the ill director liable to capital gains tax and brings cash into their estate that might have been fully relievable from inheritance tax under BR. Difficulties can arise where the ill person is not capable of making a decision.
The remaining shareholders may be left with a cash lump sum but no right to purchase the shares. It may be more appropriate for directors to arrange CIC for their personal needs and deal with the company shares under a separate company policy.
Split trusts
These policies cover both critical illness and death and can be whole of life or term assurance. Benefits are paid out on the first event: they are paid to the assured individual on serious illness, or to the beneficiaries on death.
A potential drawback is that where a CIC claim is made and death occurs shortly afterwards, the bulk of the policy benefits would fall into the life assured’s estate for IHT.
Victoria Harman is senior technical expert at Hargreaves Lansdown
