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Proportional representation

This article concludes my short series discussing key issues within director sharepurchase arrangements by first considering who should pay the premiums under associated life policies and then summarising some of the key stages in establishing the arrangement.

I will start by reminding readers of the example company I have used in this series, Totley Printing. Table 1 assumes it is valued at £1m and illustrates the value of shares which would pass to surviving shareholders on the death of one of them.

For example, Jeremy’s holding is valued at £500,000, as he is the 50 per cent shareholder. If he were to die and the agreement was for the deceased’s shares to pass to the survivors in proportion to their respective holdings, his shares would pass £300,000 to Marie, £150,000 to Claire and £50,000 to John.

This method of distribution, which is typical of most agreements, although other strategies can be adopted according to the desires of the shareholders, ensures the respective shareholding strengths of the survivors remain the same as before a participant’s death.

For the purposes of this illustration, I will assume that the shares of a deceased shareholder will pass to the survivors only on payment to the deceased’s beneficiaries of money equal to the value of those shares. I will further assume (perhaps wrongly in companies of this relatively small size) that the money to buy out a deceased’s shares must be funded by life insurance policies.

If the policies selected for Totley Printing are for a term of years to each participant’s 60th birthday, the premiums are as shown in Table 2.

Here is where the maths can become very complex. Take, for example, the life insurance policy on Jeremy. Premiums for this policy are the highest of the four policies, due partly to Jeremy being one of the older participants but mostly because he is the biggest shareholder, owning 50 per cent of the company. Would it be fair to expect Jeremy to meet the entire cost of the premiums for his policy when his estate will not be the direct beneficiary of the death benefits? In fact, would it be fair to expect Jeremy to meet even part of the cost of the premiums?

Arguably not. I think there would be a general appreciation of the suggestion that Marie, Claire and John should meet the cost of the premiums for Jeremy’s policy, probably in proportion to their respective shares of the death benefits. This would mean the division of Jeremy’s premiums as shown in Table 3.

The same exercise would then have to be performed in respect of the policies on the other shareholders. For example, the premiums for John’s policy are also relatively high due to his age. However, noting the small size of John’s holding, it would surely be unfair for him to meet the cost of his own premiums, which should be the respon?sibility of the other shareholders.

Table 4, which summarises the position for all four shareholders, is admittedly complex although I would suggest this is necessary under this method of dividing responsibility for the premiums.

In summary, under the whole share-purchase arrangement, Jeremy must pay premiums totalling £85 a month, Marie £96 a month, Claire £52.50 a month and John just £13.50 a month.

There is no hard and fast rule as to the division of premium payments between the participants, the eventual solution being the one most acceptable to the them.

We have so far discussed the proportions in which each participant should be responsible for the premiums but who should make the payments? Should it be the individuals from their own resources or could it be the company? The decision should be taken as a combination of taxation and convenience factors.

In the case of Totley Printing, it would be administratively impossible for each director to pay directly to the insurance company a share of the premiums in the insurance policies of each of their fellow participants in the share-purchase arrangement.

It is often more convenient for all the premiums to be paid by the company. These premiums must then usually be charged to each participant according to their agreed contributions unless it has been decided that the total cost should be divided equally. This may be effected by an equivalent reduction in the salaries or drawings of each participant.

Tax considerations must be borne in mind and I would suggest the involvement of the company accountant should be extended to this area of advice.

In closing, I would like to recount a story I mentioned in an earlier article about the days of my own induction training regarding director share-purchase arrangements. The limit of my training was to bring the potential problem of the death of a shareholder to the company’s attention, agree with the participants a notional valuation of the company and then sign up the life insurance policies.

Thankfully, I completed only a handful of cases before I left that employer. When I learned more from my next employer, I considered it my duty to go back and rebroke the original advice. Then I learned yet more from a subsequent employer and rebroked again out of duty to the clients. A while later, term insurance premiums fell and so further rebroking saved the companies money.

A little knowledge may be dangerous but can be highly profitable when just a little more knowledge is acquired.

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