Firstly, what is shareholder protection insurance?
Shareholder protection insurance is a type of business insurance that can be purchased by shareholders or a company for the protection of its shareholders. It can taken out to pay in the event of death or with critical illness included. If a shareholder falls ill or passes away, the policy ensures that the remaining shareholders are paid a sum of money to then purchase the shares from the deceased estate. It is essential to a business as it means that the remaining shareholders can still own a percentage of the company, whilst the agreement put into place (the cross option agreement) ensures that the deceased shareholder’s family receive a sum of money to the value of the shares. This split allows the business to continue to function, whilst making sure that the family of the deceased aren’t forgotten about.
How can it be taken out?
Three key ways that shareholder protection insurance can be acquired.
Firstly, the company can purchase the shares. Paying the premiums and owning the policy, this way of acquiring the insurance requires a lot of consideration and professional advice. Often, people enter into shareholder agreements without fully understanding them. This understanding is crucial, as you need to know what taxes can be applicable, the value of the shares and have a trust agreement put into place if something happens to one of the shareholders.
The second way to acquire shareholder protection insurance is through a ‘Life of Another’ policy. This type of policy is most commonly found in a business which is owned by two shareholders. Each a beneficiary to the other, the premiums of the policy are paid by each of the shareholders individually. This has the benefit of exempting them from tax if they need to claim.
And thirdly, an ‘Own Life’ policy. This will be held under the trust of the business. This policy will have each of the shareholders purchasing their own individual policy, that they will place the benefits under the trust of the business. If a shareholder then passes, their shares will be shared between the existing shareholders after being purchased by them.
What is a cross option agreement?
A cross option agreement (also often referred to as a double option agreement) is an agreement that can be included with shareholder protection insurance, which ensures that if a shareholder becomes ill or passes away, the sale of their share runs smoothly. It can be entered into by all of the shareholders within the team and each of the shareholders will decide their Relevant Proportion of the shares. The shares can be valued in three ways (which are explored below) and the cross option agreement will be drafted carefully so that no unexpected tax charges occur after the death of the shareholder.
A cross option agreement is an essential clause within a shareholder agreement as it will protect the shares if any unforeseen circumstances occur. If there is a fatality or an illness contracted by a shareholder, without it, it could result in major disruptions within the business – for example, through either losing control of the company to a third party as the shares are sold externally or the equity being passed on to their family estate, leaving the family to decide what to do with all of the existing shares.
The cross option agreement guarantees that if one of these circumstances did occur, there would be one or more shareholders that are willing to buy the shares. A fair way of conducting business, it gives the remaining shareholders the chance to buy the owner’s/other shareholder’s interest in the business whilst granting the deceased’s beneficiaries the opportunity to sell it to them. Click here to download a Cross Option Agreement template.
Put simply, the Agreed Value is the amount that is agreed to be paid for the shares or interest in the company by the shareholders. An important part of the cross option agreement, if it is within a year of the death it is classified as Fair Value and within three years it is called Specified Value.
When a shareholder passes, the surviving shareholders will have to produce a written notice to the deceased shareholder’s representatives within three months of the death in order to purchase the shares for the Agreed Value which was set previously. Each of the remaining shareholders will have to pay their relevant proportion of the share (if there is more than one shareholder remaining) before gaining access to their agreed proportion.
Upon the death of any of the shareholders within the company, the deceased Shareholder’s representatives will request a written notice from the surviving shareholders within six months after the death of the shareholder. The shares will then be put up for sale for the Agreed Value and with the agreed terms set before the death occurred. If a shareholder becomes terminally ill, an Agreed Value of the shares can also be set in which the shareholders can purchase.
Who should enter into a cross option agreement?
Cross option agreements will usually be entered into by companies which are owner-managed. Providing the existing shareholders with a peace of mind if a disruption occurs, it carries many benefits that will help the business to continue to operate. A safety net, the cross option agreement should reflect the appropriate share valuation of the company itself and should be structured carefully. When you are filling out a cross option agreement template, ensure that you inquire about what the tax implications will be and make sure that you have considered what the company’s articles of associations are in case of a fatality. A cross option agreement shouldn’t be taken lightly, therefore, it’s important that the shareholders thoroughly read through it before it is signed.
What is the process?
magnifying glass with the word shares
Before the shareholder agreement is put into place, as mentioned above, each shareholder should take out life insurance or critical illness policy. It is written in a fully comprehensive trust document, which will be returned to the shareholders if an unexpected death or illness occurs. The value at which the life insurance or critical illness policy is should reflect what the value of each of the shareholder’s interest is in the business.
As mentioned above, when you have a shareholder agreement in place, when the business owner or another shareholder within the business passes, the surviving owners can purchase the shares. This process will run smoothly as the purchase price of the shares is funded by the life insurance policy that was taken out. It can also be held by a trust, in which the shareholders are beneficiaries.
If the shareholders do not have the funds available to purchase the shares, the immediate thought if they do not have a shareholder agreement, is to turn to a bank for a loan. This is an unlikely method of payment as they will not trust the stability of the business if an unforeseen circumstance such as death occurs.
If the owner passes, the agreement gives their personal representatives the opportunity to sell the shares of the business within six months of the passing. If the insurance that is taken out is less than what the Agreed Value was, it can be paid back in equal installments to the insurer. If it is more, the surviving shareholders can either pay over the excess money to the deceased shareholder’s personal representatives or retain the excess.
Cross option agreements and terminal illness/critical illness
Similarly to the above and mentioned in the put option, if an owner is diagnosed with a terminal illness, they can sell their share of the
business to the other shareholders. This can’t be actioned the other way around, however, as the owner needs to be in control and willing to sell. This is the same process as if the owner contracted a critical illness – six months after the proceeds, not when they were diagnosed, the shares can be sold. One thing to consider with critical illness cover however, is that when the valid critical illness claim has been paid, there will be no further benefits. The remaining shareholders will have to cooperate together if this occurs and will have to inform the insurers who will settle the claim.
Disadvantages of cross option agreements
Although there are many benefits of cross option agreements, it’s important to think about the disadvantages too. Shareholder agreements aren’t a binding contract for sale. If the share agreement has a buy and sell agreement included, Business Property Relief that the share of the business qualified under might be lost.
Even though it gives the surviving shareholders a chance to purchase the shares and the personal representatives of the deceased owner to sell them, the process will only begin once one or the other action their move.
How to value the share of the business
There are three methods that the shareholders can use to determine the value of the shares. Firstly, they could discover what the open market value of the company is. Perhaps the fairest and honest way of determining the value, it doesn’t however, consider if the amount it is worth is the same as what the shareholders would pay for it. The share will, therefore, have to be bought at open market value, which could cause several issues – such as the existing shareholders believing that they aren’t worth that amount or that they can’t afford it. This could slow down the process of sale and delay the purchase.
Secondly, determine what the fixed value is. If the shareholders adopt this method, they can make sure that the suitable amount of life cover can be purchased and the price that the shares will be sold for/bought for is accurate.
Thirdly, use a fair market value method. This will be worked out by a third party, professional valuer that’s usually a practising accountant who is part of the Association of Certified Accountants or the Institute of Chartered Accountants. The fair value of the share is worked out by determining what the market value is of the company at the time of the shareholder’s death. If the shareholders can’t decide on a valuer within 2 weeks of the passing of the shareholder, they are requested to inform the Secretary of the Institute of Chartered Accountants who will then appoint an appropriate valuer.
Shareholder agreement and tax
There are three types of tax that should be considered when shareholders want to fill out an agreement. These are inheritance tax, capital gains tax and income tax. If the shares have 100% business property relief, the estate will not be charged inheritance tax fees on the share value. Cross options can be specifically drafted in order to guarantee this.
Secondly, capital gains tax There are a few things to consider with this type of tax when you take out shareholder insurance. If the value of the shares rise in the period between the owner’s death and when they are being sold, a liability might arise which affects the beneficiaries or the owner’s estate. Generally, however, when the shares are being transferred there will be no capital gains tax implications.
Finally, income tax This form of tax is generally thought to be negligible if the value of the life policy in question rises and falls. This type of tax can come into action if the owner leaves the business.
What can Key Finance Limited do for you?
My Key Finance Limited is here to help! Offering shareholder protection insurance that is affordable from an array of top UK brands you are guaranteed to find the right insurance for you. Ensure peace of mind with our cross option agreements and give your fellow shareholders as well as your loved ones the support they require.
With a qualified and experienced team, we have helped 1000’s of companies across the UK. Want to find out more? Call us today and we can take you through the process and give you a quote for shareholder protection insurance.
Jody is the Managing Director and founder of My Key Finance Ltd. He has over 16 years experience as a protection adviser and is an authority within the UK business protection market. Jody has written articles for Business Matters Business Directory, and been featured in Forbes. As editor and Author of our blog Jody is hoping to educate and advise people with more in depth details and information on the various subject relating to the protection market.