Businesses are under threat from many directions, both externally and internally. Directors can be held personally liable for their acts or omissions in managing the business; HM Revenue and Customs can increase their tax take if VAT and PAYE are not paid or not paid on time; and there are pitfalls arising for the unwary where proper tax planning and filing is not undertaken. However, one of the biggest threats facing a business is where a key person dies or becomes disabled – where that person becomes a cost and drain on the business, as opposed to generating profits.
There is also the situation where shareholders are unprotected should one of them die, and their shares pass to third parties (including family) who have no interest in the business.
For both the key person and the shareholder, they and the business can be protected through taking out life assurance. However, there are tax implications for this form of business protection that should be planned for.
Keyperson policies
These policies are owned by the company and taken out on the life of the key person. If the policy is a term policy for five years or less with reasonable premiums, the premiums should be allowable for tax purposes. However, the policy proceeds will be taxable in the company. The policy proceeds are not only diminished through taxation, but are also trapped in the company. A ‘whole of life policy’ will not have allowable premiums, and any gain will also be taxable.
Shareholder policies
Policies may be taken out by shareholders on each other’s lives to pay the survivors in the event of death of one of them, paying the proceeds in trust to the survivors. The policy proceeds are tax-free and the premiums are not allowable as deductions to them personally. Often the business pays the premiums, which are added back and treated as a taxable benefit-in-kind for the individual. However, the survivors have some flexibility on policy proceeds depending on the agreements underlying the purchase of the deceased’s shares. Any surplus after share purchase is for their own use.
Business agreements
There are two main business agreements. The first is a ‘buy and sell’ agreement, where shares must be purchased from the deceased’s representatives on death, and (as treated as a pre-sale of shares) will be subject to inheritance tax (IHT) at 40%.
By contrast, a double or cross-option agreement means that shares are only purchased when one of the parties exercises the option to purchase or to sell. If neither does, then shares pass by will or intestacy. This arrangement is normally treated as free of IHT.
Saving tax and creating flexibility
Most business owners would prefer flexibility on how and when funds arise in the business. The ideal situation would be not to have policy proceeds taxable in the business, to have the use of whole of life or longer term policies, and to avoid IHT where possible; also to have fewer policies and fewer costs.
A possible solution is a combination agreement, which is a double option agreement incorporating keyperson policy proceeds. The shareholders affect the life assurance, increasing their sum assured to cover the amount required by the business for the loss of the key person. If there are three shareholders, then only three polices are required, as opposed to six if keyperson cover was incorporated. On the death of the individual, the policy proceeds provide sufficient funds to buy the deceased’s shares, and also the survivors to fund the company through their directors’ loan accounts, which they can have repaid to them, tax free.
Practical Tip:
Examine current arrangements to save IHT and company taxation on policy proceeds if possible; check agreements to ensure no IHT is payable. Update or check policies to create tax efficiency. Seek expert professional advice whenever necessary, based on your particular circumstances.
