Business Protection: 3 Steps to Effective Planning

Business owners will be familiar with the concept of business protection planning by way of death or critical illness insurance. This is crucial 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, unless correctly structured, 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 Relief, potentially creating an additional charge to tax on the deceased’s estate.

Imagine the fictional case of James and Paul, who have been in business together for a number of years and remain the key drivers of growth and value. Unfortunately, one morning Paul is killed on his way to work. This is of course devastating for Paul’s family, friends and for his business partner, James. From a business perspective James has lost a valuable partner, who contributed equally to the running of the business. It is doubtful whether James will be able to continue to generate the same level of turnover without Paul’s future input.

Under the terms of Paul’s will, his widow now owns the shares in her late husband’s company. However, Paul’s wife may lack 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.

James 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. James may, therefore, be faced with the prospect of setting up a new business on his own, leaving Paul’s widow with shares in a worthless company. Both parties are left in a worse position.

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

Had Paul and James undertaken business protection planning, they would have taken 3 steps for the benefit of both Paul’s family and the on-going business.  Firstly, insurance policies would have been taken out on their respective lives. Secondly, 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 Paul’s estate and being unavailable to James as was originally intended. Assuming Paul and James 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 Paul’s estate to James.

Assuming all three stages of the business protection planning had been completed, on Paul’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 Paul’s widow to James, but would be suitably drafted to avoid any loss of the valuable Inheritance Tax Business Relief on Paul’s shares. The business protection trust could pay out a lump sum to James, which he can use to purchase Paul’s shares. James is then free to continue to run the company on his own, or take on additional assistance if required and retain the profits. Paul’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 in such devastating circumstances.

If you would like to further discuss any of the information detailed above, please contact our Corporate & commercial team.