Partner/Shareholder Protection set-up

Principally there are two ways you might set up the plans for partnership or shareholder protection and this article looks at how to set up each.

Life of another arrangement

This is a simple arrangement, which is suitable for a few policyholders. Each business owner has a policy on their own life, taken out by the other owners. They do this by applying for insurance on each of the other owners, with the insurable interest being the interest in the business (see diagram below). It is appropriate when there are no more than three partners or shareholders.

Its advantages are that it is simple to set up, as no trusts are needed, and so no potential inheritance tax (IHT) charges associated with discretionary trusts. However, this method is less flexible should the company change in the future and more partners or shareholders need to be added.

How to set up life of another cover

For two owners:

  • each person takes out cover on the life of the other
  • the policies are not written in trust
  • cross-option agreement would typically be put in place.

For three owners:

  • each policy has two policyholders, with the third owner as the life assured
  • the policies are not written in trust
  • cross-option agreement would typically be put in place.

Following a valid claim, if the proceeds are not in fact used to purchase the shares, and the value was in the estate of the policyholder on their death, this would be subject to inheritance tax.

Writing the plan in trust

Each business owner takes out a policy on their own life and, at the same time, writes it under trust for the benefit of the other business owners. This method is suitable for a business of any size, with no limit on the numbers of partners/shareholders.

Generally a flexible or discretionary trust is used so the trustees have the power to alter the beneficiaries should the business change in the future. The trust may include the settlor as a potential beneficiary which may give rise to a liability to pre-owned asset tax (POAT) but gives the option to assign the policy back to the settlor when he or she retires from the business. If the settlor is excluded as a potential beneficiary of the trust, there is no potential for POAT, but the policy cannot be assigned back to the settlor at a later date. The settlor’s family members would not be beneficiaries, unless they are also partners or shareholders in the business.

Typically, all the people involved in the arrangement would be trustees, but should be set up with at least one other trustee to ensure prompt payment of the proceeds.

In conjunction with the trust, a legal agreement such as a cross option agreement would typically be put in place. If any of the business owners do not take out a policy, you should seek specific legal advice on this point on the implications.

Pre-owned asset tax

Before the 2005 Budget, business cover was not subject to the gift with reservation rules provided that the arrangement was commercial (ie did not have a gratuitous element). Now, following the introduction of pre-owned asset tax, there is a potential yearly liability to income tax.

This only applies if the settlor is included as a potential beneficiary of the trust and the tax is assessed yearly on the potential benefit, even if nothing is received. The potential is far lower for term assurance plans with no surrender value.

The tax due is assessed using an official rate of interest on the market value of the potential benefit. This may increase if the settlor is in poor health.

If the tax due is less than £5,000, no tax will be payable.

Trusts and inheritance tax

Since the 2006 Budget, discretionary trusts are potentially liable to IHT charges on entry, every ten years, and on exit. Partnership or shareholder cover will not be subject to an entry charge because it is generally a commercial arrangement and so no ‘gift’ is made.

You and your clients must select the most appropriate trust for their needs but generally a discretionary trust will be used because it has the flexibility to cope with changes in partners or shareholders, and in their relative shareholding.

How to set up partnership or shareholder cover written in trust

Each business owner should normally:

  • Complete a separate application form (all sections) and a separate direct debit instruction.
  • Complete a separate business assurance trust.
  • Complete a separate deed of appointment of more trustees (with the other partners or shareholders) if not already appointed in the trust deed.

Although we do not need to have these on record, to complete the arrangement the business owners should:

  • Get a professional valuation of the business.
  • Complete a double option agreement.
  • ‘Equalise’ the costs.

‘Equalising’ premiums

This does not mean that each participant pays the same premium level. Most partnerships will include partners of different ages and states of health, who need different levels of cover. If each person covered by the insurance were to pay their own premium, the oldest person is likely to pay the highest amount. However, because they are the most likely to die or get a critical illness first they are the least likely to benefit from the arrangement.

If the premiums are not ‘equalised’ between the partners, HMRC may not view it as a commercial arrangement and there may be an IHT liability. This is because without equalisation HMRC may consider the differences in premiums to have an element of ‘gift’ (transfers of value), and this could lead to a tax liability as the gifts favour the younger business owners or those with a smaller stake in the business.

There are some ways that may help to ensure your client is not liable to this tax:

  • Increase the business owner’s drawings to compensate for the inequality. However, there may be tax and national insurance implications in doing this.
  • ‘Equalise’ the premiums paid by the partners or shareholders. The principles are the same for both partnerships and limited companies.

The information provided in this article is not intended to offer advice.

It is based on Old Mutual Wealth's interpretation of the relevant law and is correct at the date shown on the title page. While we believe this interpretation to be correct, we cannot guarantee it. Old Mutual Wealth cannot accept any responsibility for any action taken or refrained from being taken as a result of the information contained in this article.

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