Business Succession Planning
When disaster strikes…
If you are a business owner, business succession planning and insurance is important. It is simply the process of planning for what you want to happen if you (or your co-owner, if you have one) were to die or fall seriously ill.
If this happens family and business partners can be left in a complex situation. In some instances, the business ends up in the wrong hands, in others the business can fail. These issues apply to sole traders, partners and shareholders in limited companies, and all of this can be avoided with some sensible succession planning.
The legal position on the death of a business owner will depend on the type of business entity.
- A sole trader business automatically comes to an end. The business may still have a value – stock, buildings, or assets such as equipment and vehicles and goodwill, but the business itself will cease to exist legally.
- A partnership may come to an end if the partnership agreement does not set out that the business should continue.
- A limited company continues but the owner’s shares will pass to their beneficiaries through their estate in line with their will, or the intestacy rules if no will is in place.
When a sole trader dies their business dies with them, legally speaking. The business’s assets will form part of the sole owner’s estate and pass on to beneficiaries under the terms of their will. If the owner has not made a will, the intestacy rules apply; in effect, the state decides who the estate should pass to. If there is a spouse but no children, the situation may be reasonably straightforward, with the spouse inheriting everything. However, where there is no spouse, or there are children involved, things can become considerably more complicated.
If the estate is large enough, and is not left to a husband/wife or civil partner, inheritance tax (IHT) can be payable on all assets above the nil rate band (£325,000 standard amount in 2018/19), meaning that the government can become one of the largest beneficiaries of your estate. The good news is that most trading businesses are not subject to IHT – if you are unsure about yours you should take advice.
Several issues can arise:
- Paying the IHT bill if the business does not qualify for the normal 100% tax relief.
- Passing on the business – perhaps to an employee or to a family member.
- Paying the liabilities the business has incurred. These could include outstanding rent on premises, unpaid tax, an overdraft or business loan.
In each of these instances, the basic requirement is to create a capital sum, preferably outside the estate, to minimise IHT.
This could be achieved with the help of a suitable life insurance policy. Generally, we recommend that sole traders in this position take out life insurance policies on their own lives and put the policy into a trust that will receive the proceeds on their death and pay them out to the intended beneficiaries at the right time. It is often said that the benefits of a trust lie in insuring that the ‘right money’ ends up in the ‘right hands’, at the ‘right time’.
The exact solution depends on several factors, but here are a few examples:
A partnership is a business owned by at least two people. Unless there is some specific provision in the partnership agreement (and very many partnerships have no formal agreement), a partnership ceases when a partner dies. When that happens, the deceased partner’s estate becomes entitled to their share of the business.
This can mean a choice for the surviving partner or partners. They could:
- Pay the deceased partner’s estate a sum of money they all agree to be the value of the deceased partner’s share.
- Carry on in business together with the deceased partner’s husband/wife or other beneficiary – even if the new partner has little to contribute to the success of the business.
For example, John and Jane are in partnership and Jane dies. Jane’s sole beneficiary, her daughter Kylie, is keen for the business to continue, and so is John, who could not afford to buy out Kylie’s interest anyway. Unfortunately, Kylie is unable to play any active part in the business and John resents having to split the partnership’s income with a sleeping partner who contributes nothing other than capital to the business.
John and Jane could have done some succession planning along the following lines. Two main options are available to meet such needs, and are illustrated below. Other options are available, but they are generally not as attractive.
The result of both solutions is that the remaining partner continues to run the business and the deceased partner’s beneficiaries receive a fair price. Without these arrangements, the business could be in danger and the beneficiaries might receive little or nothing.
There may also be a need to insure the lives of all the partners to cover potential liabilities that might arise on their death – perhaps to pay off an overdraft or other creditors.
Companies continue after a shareholder’s death, but the basic succession issues are similar to those facing a partnership. The key is to ensure the shares end up with the surviving shareholders and the deceased shareholder’s family receives some money.
Generally, the deceased shareholder’s beneficiaries will want financial compensation in return for their shares, assuming they do not plan to continue in the business. There may also be the need to pay off creditors on an owner-director’s death and this should be dealt with separately.
If we return to the earlier example of Jane and John and assume that rather than being in partnership they were co-owners of a limited company, we can see the same issues apply. John would probably still want to be able to run the business without having to worry about Kylie being involved, and Kylie would want to be compensated for giving up the share of the business she inherited.
A double or cross option agreement is often used for company shareholder succession planning. If a shareholder dies, their beneficiaries can require the remaining shareholders to buy them out or the remaining shareholders can require the beneficiaries to sell their shares.
This means that John could insist that Kylie sells him the shares she inherited from Jane. It also means that Kylie could insist that John buys her shares. If neither of them exercises this option, however, the business continues to run with John and Kylie now being joint owners.
One advantage of double options is that they do not affect the entitlement to IHT business property relief. So the deceased person’s shares in a trading business can usually pass down to the beneficiaries free of IHT – unlike most other assets.
To provide the funds, each shareholder takes out an own life policy written under a special business trust to benefit the other shareholders.
Of course, it is not just the death of a business owner that can stop a business. If a business owner suffers a critical illness such as a heart attack or cancer, it may not be possible to continue in the business either temporarily or permanently. Good planning can ensure that, should this disaster strike, the needs of the sick business owner, their family, business partners and co-shareholders can all be protected.
Let’s consider a couple of examples to show how this might work:
In both of these situations, disaster could have been avoided. Had they taken expert advice before the event, arrangements could have been made, to ensure that both ended up with the outcome they desired. A suitable critical illness insurance policy would have been the best way to provide protection against the financial consequences of having a serious illness in both cases. These policies pay a cash lump sum on diagnosis of a specified critical illness or disability.
When using critical illness insurance in these contexts, the policies are normally written in trust for the other business owners, along with an agreement between the business owners about the circumstances in which the share in the business should be transferred. In this case a ‘single option’ agreement would allow the sick person the option of selling their shares to the others (who would have to buy) but would not allow the others to ‘force out’ the sick person.
How can we help?
When we advise clients about business insurance and succession planning, we start by finding out the most important issues in each specific case. Just as we saw above, this means understanding both the structure of your business and your aspirations. Once these have been identified and prioritised, we can then recommend a suitable way forward.
In doing so, we will advise on:
- The options available and their costs.
- Tax implications.
- Methods of valuing the business.
The death or critical illness of a business owner can lead to unexpected or undesirable consequences for those left behind. Taking the opportunity – well in advance of such an event happening – to plan for such a situation can help crystallise what you want to happen to your business after your death, and to identify how best to ensure that this will actually come about.
The Financial Conduct Authority does not regulate advice on trusts or tax advice.
This publication is for general information only and is not intended to be advice to any specific person. You are recommended to seek competent professional advice before taking or refraining from taking any action on the basis of the contents of this publication. The Financial Conduct Authority does not regulate tax advice, so it is outside the investment protection rules of the Financial Services and Markets Act and the Financial Services Compensation Scheme. This publication represents our understanding of law and HM Revenue & Customs practice as at 26 June 2018.