Small companies make up a large part of the private sector in the UK. Indeed, SMEs employed 15.6m people in 2015: 60 per cent of the private sector workforce. What is more, the combined annual turnover of SMEs was £1.8trn, accounting for 47 per cent of all turnover in the private sector.
Although the majority of businesses in the SME bracket are sole traders, 2015 government statistics estimate there are around 1.6 million small companies and over 400,000 partnerships.
So a large chunk of the economy is made of businesses of modest scale and many of these will be owned and managed by a small group of shareholders – in many cases the original founders. This presents a financial planning opportunity.
Business owners will often focus on investing everything they can in the future growth of the firm, and newly launched companies and those with ambitious growth plans can quickly consume capital. Discussing the added expense of insurance premiums may be a tough sell. But there are good reasons for business owners to think about cover.
If a partner or shareholder in a business dies, their share of the company will typically pass to their family. This can cause a problem. While the partner will surely know the business inside out, it does not automatically follow that their family will share the same interest. This can present an issue for remaining owners that want to continue to build the company but must do so with an unsuitable shareholder intact.
Similarly, if one partner becomes ill, the firm risks losing the intellectual capital they bring to the table, their business relationships, contacts and so on. This could be costly for the firm and can have an adverse affect on relationships between owners.
This risk can be managed through effective protection arrangements utilising trusts. The basic principle is that each business owner should take out cover, with the policy held in trust for the benefit of those remaining. If required, the sum assured can then be used by the remaining business owners to purchase the shares of the policy holder.
However, there are a number of different technicalities that need to be considered when putting in place this kind of arrangement.
It is very likely business owners will find the cost of cover varies due to age, health and other demographic differences among partners and the share of the business they own. This can be a sticking point since those with higher premiums are less likely to benefit. It is worth noting HM Revenue & Customs may deem the arrangement as a gift since it effectively amounts to a net transfer of value from older shareholders or those with a larger stake to their junior business partners.
In some cases, business owners may choose to equalise the premium costs between them, effectively pooling the cost of insuring each business owner. If they are equalised, HMRC will view this as a commercial arrangement, thereby taking inheritance tax considerations out of the equation.
It is also important to consider the legalities and contracts concerning the sale and purchase of the shares of the exiting business owner. A binding buy and sell agreement can be put in place, which sets out agreed terms on which other business owners must buy and the family must sell.
However, the share of the business could lose business property relief as a result. This is because BPR is not applicable where a binding sale agreement exists: a stipulation HMRC has in place as an anti-avoidance measure.
An alternative is a cross option agreement. These vary in form but the relevant point is that they do not constitute a mandatory binding agreement over the sale and purchase of the company. A sale need not take place if all parties agree not to go ahead with it and invoking an agreement for the sale of the business is an option to be taken out by one party to the agreement.
Where a critical illness policy is concerned, for example, a “single option” agreement is normally deployed. In this case the owner who falls ill can ask the others to buy their share, at which point they are compelled to do so, using the proceeds from the policy to complete the transaction. However, the option belongs to the policyholder, so other business owners cannot enforce a sale.
This gives business partners the re-assurance they can realise some value for their share of the business if they have to leave due to illness. And because the agreement is structured as an optional arrangement, BPR is not lost as in the case of a binding agreement.
The services of a solicitor will likely be required to draw up the relevant contracts. There are a variety of options available, such as a “double option” whereby the remaining business owners and the family of the former business owner have the option sale/purchase, but the transaction agreement is not binding if both parties agree not to go ahead.
Despite the complexities, it is an important subject for business owners to consider. The death or illness of one partner can have a dramatic impact on a firm but it can be even more damaging if there is no suitable contingency plan in place.
Paul Roberts is head of protection at Old Mutual Wealth