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Insuring Trevor to pay Paul

In this series of articles, I have been examining the process by which a limited company might be assessed for the possible need for a share purchase arrangement, that is, a strategy by which a deceased shareholder&#39s shares pass to the desired beneficiaries with appropriate payment.

In the last article, having identified the need for such an arrangement for a mythical company – Owl Sewerage Services – we moved on to the valuation of shareholdings and considered the need, or otherwise, for each shareholder to be included in a share purchase strategy.

In this latter respect, we particularly noted the possibility that, for some shareholders, the beneficiary of their shares under their will (or under intestacy if basic estate planning has not been undertaken) is the person to whom all parties wish the shares to pass in the longer term. This contrasts with the probably more usual situation where the beneficiary is likely to seek to liquidate his or her inheritance of those shares.

We have been using an example involving shareholders Joanne (30 per cent), Trevor (40 per cent), Lynne (15 per cent) and Paul (15 per cent), noting that Lynne and Paul are content for their shares to pass to each other on death. Their fellow shareholders are happy with this situation, too. This means that their advisers need not consider their holdings for inclusion in a share purchase arrangement. Financial consideration need only be given, therefore, to the situation on the death of one or more of the other two shareholders, with the following summary of needs calculated at the end of the last article (see table on the right).

This table shows the potential financing needed by each shareholder to enable him or her to buy out the shares of one or more deceased fellow shareholder (either Trevor or Joanne). In Lynne and Paul&#39s case, it could be argued that the initial need is not as great as £164,000, which would only be needed if both Trevor and Joanne were to die before them. Perhaps, this line of argument continues, provision of only £100,000 would suffice, being enough to buy the shares in the event of the death of either of those two, subsequent to which further planning should be undertaken. This argument has merit in many circumstances but, for the purposes of this illustration, let us assume that Lynne and Paul agree that the higher figure should be provided for.

The next obvious task is to establish whether each shareholder has these sums of money available or can easily make them available from their existing resources. Here, I am discounting the possibility of the company buying a deceased&#39s shares, which I will consider in a later article. If so, then the financing of the share purchase strategy has already been taken care of for that person although the legal and valuation aspects must still be covered.

In most cases, I am informed by fellow practitioners in this field, either the individuals do not have ready access to the required amounts of money or choose not to rely on their existing resources (being earmarked for other financial purposes, usually) and seek further provision.

Moving on with this example, we will assume that all four shareholders require further information about how this money can be provided.

Almost invariably, the most appropriate and convenient solution, as all financial advisers are fully aware (although they should not assume that this will be immediately obvious to clients) is to effect life insurance policies on each relevant shareholder, with the benefits payable to the remaining shareholders, geared to the amounts each would have to pay for their share of the deceased&#39s holding. Note the words relevant shareholder as, in our example, there is no need to effect policies on the lives of Lynne and Paul.

This link to the possible or probable need or desire for life insurance policies – which is by no means the end of the planning process for share purchase strategies, as we note in later articles – leads us on to issues which are, in my experience, not invariably well dealt with in financial services training or text books:

•What sums assured are required? (Quite straightforward.)

•What type of life insurance policies might be appropriate? (Less straightforward.)

•How should the life insurance policies be effected? (Much less straightforward.)

•Who pays the premiums? (Potentially highly contentious and mathematically complex.)

As regards the sums assured, these can be calculated as in the table shown earlier in this series of articles, which indicates that £400,000 of cover is required on the death of Trevor and £300,000 cover is required on the death of Joanne. These sums could be provided under one policy, with benefits being distributed appropriately to the surviving shareholders, or under separate policies for each shareholder, as we will discuss when we look at the appropriate methods of effecting policies. This is as far as we need to go for now.

Less straightforward is the identification of the type of policies which should be used. Fundamentally, the choice will be between term insurance and whole of life. The latter, of course, is the most comprehensive policy but term insurance could be deemed appropriate not only on the grounds of lower cost but also by setting the term of the policy to coincide with, say, each shareholder&#39s planned retirement date (perhaps only appropriate when we are talking about shareholders who are actively involved in the management of the business, however). The latter argument presupposes that provision has been made for the transfer of shares at a holder&#39s planned retirement date – a dangerous and often incorrect presumption.

It is my strong belief that advisers should not have a favoured type of policy to be used in all circumstances. Rather, very important consideration must now be given to the interaction of the needs of each shareholder, either on death or on an earlier transfer of shares, if this is required. This latter aspect is crucial to the planning process but, for relative brevity of this series of articles, I will assume that the shareholders in Owl Sewerage Services, our example company, require provision for the transfer of shares only on one of their deaths. I would suggest that whole-of-life policies might be most appropriate.

Even if this suggestion is accepted, consideration has to be given to the type of whole-of-life policy, noting that the value of the company – and hence the value of the respective shareholdings – is almost certain to change in future.

The potential for a reduction in the value of the company is easily dealt with by almost every provider and policy but the (surely greater for this type of client?) likelihood of an increase in value can only properly be accommodated by consideration of some form of guaranteed increasability provision, however modest this may be.

Even endowment policies could come into the equation, offering buyout finance on death or at a fixed earlier date, but I really do not want to get into that argument (is there one?) at this stage.

You would not expect me to start to discuss the choice of life policy in these articles (FPC level stuff, mostly) so I will move on to more specialist and contentious stuff. How should the policy be effected?

The choices, in a nutshell, include whether the policy should be written on an own-life basis in trust or assigned or on the life of another. But, of course, that core choice is just the start of it. We will develop this discussion in the next article, which then leads us to the legal and accounting issues to properly conclude the initial strategy. Not as simple as we were led to believe in our induction training, eh?

Keith Popplewell is managing director of Professional Briefing


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