Business Protection: 3 Steps to Effective Planning

12 March, 2013
by: Cripps Pemberton Greenish

Business owners and their advisers will be familiar with the concept of business protection planning. This is critical when considering the impact that the death or serious illness of a business partner or shareholder might have on the continued success, profitability and long-term value of their business. However, in order to be fully effective, business protection planning is a three stage process necessitating the client’s financial and legal advisers to work together to produce the desired outcome.

The role of the financial adviser is to assess and put in place adequate business protection insurance. Insurance aims to provide the remaining business owners with tax efficient funding, which they can use to purchase the deceased business owner’s shares or partnership interests. However, in most cases, where insurance is taken out on the lives of the business owners, individual policies must then be assigned into a specialist business protection trust. This ensures that the proceeds of the policies remain outside the estates of the business owners and sums are freely available to the survivors, if and when needed. The third step is ensuring there is an appropriate partnership/shareholders agreement in place. This governs the tax efficient transfer of business interests to the surviving owners.

Unless all three steps are carried out there is a risk that the proceeds of insurance policies may fall into the wrong hands and may even be taxed as forming part of the deceased’s estate. In addition, unless an effective partnership/shareholders agreement is in place there may be insufficient rules to allow a transfer of the business. Worse still, in some cases rules may be in place which actually impact on the availability of Inheritance Tax Business Property Relief. This could potentially create an additional charge to tax on the deceased’s estate (of as much as 40%), on the value of their business interests.

Imagine the fictional case of Peter and John. They have been in business together for many years as directors and principle shareholders of a private limited company. Through their hard work, specialist skills and industry knowledge their business has grown steadily, employed more staff and produced healthy profits for them as the owners. Peter and John hope one day to be in a position to sell up and possibly even retire early.

Unfortunately, one morning Peter is killed on his way to work. This is of course devastating for Peter’s family, friends and for his business partner, John. From a business perspective John has lost a valuable partner, who contributed equally to the running of the business. It is doubtful whether John will be able to continue to generate the same level of turnover without Peter’s future input?

Peter’s family has lost a husband, father and the main bread-winner. Under the terms of Peter’s will, his widow now owns the shares in her late husband’s company, which may continue to provide her with some income. However, Peter’s wife lacks the knowledge and skills to simply step into her late husband’s shoes and, in any event, she must continue to care for the children.

John has not only lost his original business partner, but he now has a new business partner who is unable to contribute to the continued success of the business, but who will still be entitled to receive a share of the profits. John may, therefore, be faced with the prospect of setting up a new business on his own, leaving Peter’s widow with shares in a worthless company. Both parties are left in a worst position.

The situation would have been no better for Peter and John if, instead of dying, Peter had been left permanently disabled or diagnosed with a terminal illness. In that case, Peter would still be entitled to draw an income from the business, but again in the long-term John would have little motivation towards its continued success. Sadly, things might have been very different if only Peter and John had put in place an appropriate business protection strategy.

Had Peter and John undertaken business protection planning, insurance policies would have been taken out on their respective lives. The benefit of those policies should have been assigned into specialist business protection trusts. Failure to carry out this important second stage could see the policy proceeds falling into Peter’s estate and being unavailable to John as was originally intended. Assuming Peter and John did assign the policies into trust, the third step is ensuring there is an appropriate, tax efficient shareholders agreement in place, governing the transfer of shares from Peter’s estate to John.

Assuming all three stages of the business protection planning had been completed, on Peter’s death the business protection trust would have received a sum of money (tax free) equal to the value of his shares in the company. The shareholders agreement would govern the transfer of shares from Peter’s widow to John, but would be suitably drafted to avoid any loss of the valuable Inheritance Tax Business Property Relief on Peter’s shares. The business protection trust could pay out a lump sum to John, which he can use to purchase Peter’s shares. John is then free to continue to run the company on his own, or take on additional assistance if required and retain the profits. Peter’s widow has a cash fund, which she can now invest to produce an income for her family. A bit of forward planning, therefore, acts in the interests of both the business owners and their families.

With all the immediate everyday pressures involved in running a business it is hardly surprising that little attention is paid to what would happen if a partner or shareholder died or became seriously ill. Nevertheless, it is certainly in the interests of every partnership or private limited company to do so if they wish to ensure the long-term financial security, stability and continuity of their business. Where business owners undertake such planning it’s vital that financial and legal advisers work together to ensure all three steps in the planning process are completed.