What happens to a company on the death or critical illness of one of the shareholders?
A cross-option agreement deals with what happens within a company upon the death or critical illness of one of the shareholders. There are potentially some undesirable outcomes for the unfortunate shareholder and also the company:
(a) the surviving shareholder(s) may wish to purchase the shares of the deceased shareholder but the next-of-kin or Personal Representatives of the deceased shareholder may not wish to sell the shares back;
(b) the widow/er of the deceased shareholder may wish to have involvement in the running of the business, which the surviving shareholder(s) may not appreciate;
(c) if the surviving shareholder(s) refuse to buy back the shares then the next-of-kin of the deceased shareholder may be left holding shares that are not capable of sale and no way of turning those shares into cash.
So what is the solution?
A cross-option agreement is a simple contract between shareholders in a company that gives the surviving shareholder(s) an option to buy back the shares of the unwell/deceased shareholder. It contains a corresponding option that gives the next-of-kin the ability to force the surviving shareholder(s) to buy back the shares and thus turn paper shares into real money. These corresponding or crossing ‘options’ give the document its name.
A secondary problem in this scenario is that the surviving shareholder(s) may not have access to sufficient funds to buy back the shares when called upon to do so. This can be planned for by each shareholder taking out insurance on the life of the other, or the company taking out insurance on the lives of the shareholders. This would usually be arranged by an Independent Financial Adviser.
Will any cross-option template do the job?
Unless the particular set-up of your business happens, by luck, to fit within the off-the-shelf cross option template then the agreement may not do the job that you are hoping it will. Getting the cross option document right is vitally important for taxation planning purposes. Important tax reliefs for both inheritance tax and capital gains tax can be lost if the documentation is not properly structured.
Business Property Relief is an extremely valuable relief from inheritance tax (IHT). Some types of ‘relevant business property’ (which can include shares in a private company) can qualify for 100% relief from BPR. However, Business Property Relief is subject to certain conditions. Failure to satisfy those conditions can result in business owners or shareholders inadvertently losing the benefit of Business Property Relief.
‘Binding contract’ trap
Business Property Relief will generally be lost if there is a ‘binding contract’ for sale of shares which is in effect prior to the time of their transfer (e.g. Business Property Relief is lost if a cross-option agreement prescribes that the shares of the deceased shareholder ‘must’ be bought back by the company upon death or critical illness, rather than there being an ‘option’ to do so).
What can be done?
Fortunately, cross option agreements can be structured in such a way that Business Property Relief remains available. For example, cross option agreements may include ‘crossing options’ which achieve the buy back of shares without it falling foul of the binding contract trap. The beneficial tax effect is that the deceased shareholder’s shares fall into his estate, but with the benefit of 100% Business Property Relief. HMRC accepts that these types of arrangement do not constitute binding contracts for sale, and therefore do not prevent the business interest qualifying for BPR.