For advisers only. Not for use with customers Friends Life Protect+ Business Protection Technical Guide

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1 For advisers only. Not for use with customers Friends Life Protect+ Business Protection Technical Guide

2 Contents Introduction 03 Key Person Protection 04 What is Key Person Protection? 04 Identifying the need for Key Person Protection 04 The consequences of losing a Key Person 04 How we can help 05 Calculating the level of cover required 05 Tax implications 07 Key Person Loan Protection 08 What is Key Person Loan Protection? 08 How we can help 08 Calculating the level of cover required 08 Tax implications 08 Shareholder Protection 09 What is Shareholder Protection? 09 Identifying the need for Shareholder Protection 09 The consequences of losing a shareholder 09 How we can help 09 Calculating the level of cover required 10 Developing a Business Protection Plan for shareholders 11 Tax implications 14 Partnership Protection 15 What is Partnership Protection? 15 The consequences of losing a partner 15 How we can help 16 Calculating the level of cover required 16 Developing a Business Protection Plan for partners 17 Business Protection Plan Documentation 18 Tax implications 20 Alternative solutions 22 Further information 23 Contact us 23 02

3 Introduction In the modern world, Business Protection is playing an increasingly important role. Business Protection is key to the management of risk within a business. It is important that businesses identify their risks and put potential solutions in place. Business Protection can be a cost effective and tax efficient way to help businesses safeguard their future. Friends Life Protect+ provides a range of covers to meet specific business needs. We can tailor life and/or critical illness covers to ensure benefits provide the right solution at the right time. We will help you develop business plans that deliver risk-mitigating solutions for Key Persons, shareholders and partners. We recognise that the complexities of Business Protection can be difficult to understand. It can also be a time consuming product to arrange. Therefore, we have developed this guide to simplify many of the practical aspects of the sales process by helping you strengthen your knowledge and understanding of Business Protection and the Friends Life Protect+ plan. The information within this guide reflects our interpretation of legislation and HM Revenue & Customs (HMRC) practice at the time of publication. The law relating to taxation is subject to change and individual circumstances and, whilst we have taken every care in writing this guide, we cannot accept responsibility for any subsequent changes. The Friends Life Protect+ plan is available to anyone aged from 18 to 59 who lives in the UK or Channel Isles. For the purposes of Friends Life Individual Protection policies the Channel Isles means, Guernsey and Jersey only. Certain covers are affected if a policyholder becomes resident outside of England, Scotland, Wales or Northern Ireland. 03

4 Key Person Protection What is Key Person Protection? Businesses know their long-term success or failure will substantially depend upon the ability and value of their employees. They will frequently protect their buildings and equipment. It s easy to calculate the financial implications and potential loss of profits from the damage or loss of these assets. But they will often overlook or ignore protecting the value of their employees. Loss of employees needs to be assessed and an appropriate Business Protection solution selected. Our Key Person Protection allows a business to protect itself against the financial loss it may suffer from losing a Key employee due to death, critical illness, or disability. Identifying the need for Key Person Protection Key persons are those within a business who are vital to the business s profitability and continued financial success. There may be more than one Key Person within any one business. Some examples of Key Persons are: the founder of a business who gives it impetus and prestige Loss of profits Loss of profits should be a major concern of any business. A business s profits can be affected in the short term by situations such as an immediate loss of sales. But other situations may be more damaging to the business in the medium to long term. And the death of a Key Person is not the only situation that can affect profits. A Key Person suffering from a heart attack or disablement may result in a long recuperation period or perhaps never returning to work again. The business may not consider the what if scenarios of losing a Key Person. These can include: delay in completion of existing contracts (financial penalties) interruption or loss of future sales loss of confidence by banks, existing or new suppliers loss of competitive edge afforded by innovative or design expertise special projects delayed or not completed increased pressure on the remaining workforce to meet deadlines impact on staff morale, possibly causing some staff to leave potential for further recruitment costs, head hunting fees, or training costs for a replacement. a specialist such as a scientist or engineer whose knowledge and expertise is vital to the business s success a top sales person who has key business contacts and relationships a member of Senior Management The consequences of losing a Key Person Losing a Key Person can have a damaging affect on a business, such as loss of profits. 04

5 How we can help Our Key Person Protection allows a business to take out a life of another policy on a key employee. In the event of their death, we will pay life cover benefits directly to the business. The business can then use the benefits to fulfil their financial needs while recruiting a replacement or undergoing reorganisation. In the event of a critical illness, where the Key Person subsequently returns to work, the business can use critical illness cover benefits to pay for a temporary replacement or cover a profit shortfall. Calculating the level of cover required Having established a need to protect a business against the loss of a Key Person, you will need to work out how much cover the business requires. There are no definitive rules for calculating the amount of cover, but the calculations outlined in this section will help you work out the amount of cover your clients need to apply for. You will need to decide which calculation is most appropriate for your clients needs. If the calculations do not result in the level of cover you may have been expecting, it is possible to apply for a higher level of cover. This depends on the type of business and you should consult our underwriters on how to do this. Salary multiple calculation An approach often used to calculate an amount of cover is to base the figure on what the Key Person is paid. This approach is very straightforward and suitable where the business s main concern would be the replacement costs of recruitment or training. Salary calculation To calculate, take the Key Person s total remuneration and multiply by up to ten. Definition: total remuneration is the gross salary including the value of all benefits The number you multiply the Key Person s salary by depends on how great the loss of the Key Person would be. Our underwriters are on hand to help with this decision. The amount of cover needs to be established and justified for financial underwriting purposes and you will need to demonstrate how the figure has been decided. Our underwriting team are on hand to provide assistance and support in calculating levels of cover. For details of how to get in touch, please read the Contact us section on page 23. Loss of Profit Calculation This calculation allows you to assess the potential loss of profits due to the death or serious illness of a Key Person. Gross profit To calculate, take the average gross profit for the last three years and multiply by two. Definition: Gross profit is revenue from sales less the cost of sales. Net profit To calculate, take the average net profit for the last three years and multiply by five. Definition: Net profit is Gross profit less salaries, administration and/or production costs, any other overheads and interest payments. Net profit is the total amount before tax deductions. 05

6 Recovery Period Calculation Another approach to calculating the amount of cover is to estimate how long it will take the business to recover from the loss of a Key Person. For example: if the Key Person s total remuneration is 50,000, the business s total salary bill is 4 million, the business has a gross profit of 10 million and the estimated recovery period is 4 years, the sum assured is calculated as follows: 50,000 4 million X 10 million X 4 years = 500,000 There is potential for a greater protection need where the business is yet to make a profit or is in a period where the business is suffering financial losses. For example, the business may have employed the Key Person to improve their financial position. In such circumstances, you can use the business turnover instead of Gross profit within the calculation. Definition: Total salary bill is the amount entered in the business accounts for the gross salary and benefits of all employees Definition: Turnover is the amount of business transacted over a period of time. 06

7 Tax implications HMRC consider the tax treatment of each Key Person policy on a case-by-case basis. It has not clarified the Corporation Tax situation because there is no direct legislation on the subject of Key Person Protection. Therefore, we recommend that businesses should always consult their local Inspector of Taxes. Experience shows that simply asking the local Inspector of Taxes for a decision is unlikely to bring a definitive response. We recommend that the business writes to their local Inspector of Taxes to detail how they expect the premiums and benefits to be treated for tax purposes. Attempting to establish the tax position in advance should help in avoiding any future dispute regarding the tax treatment of the cover. Tax implications on Key Person Protection The rules often referred to by the local Inspector of Taxes are commonly known as the Anderson Rules. They state that premiums for Key Person Protection may be eligible for tax relief if: the sole relationship is that of employer and employee; the insurance is intended to meet loss of profit resulting from the loss of services of the employee; and it is an annual or short term insurance. Therefore, if the business meets the above criteria, their local Inspector of Taxes may approve relief on the premiums as allowable deductions from profits for corporation tax purposes. When premiums for Key Person Protection have qualified for this tax relief, the amount of cover will be taxable and will be treated as a trading receipt. This means any benefits paid to the business may be taxed, depending upon that business s profitability. The reverse of this is also generally true, but should not be assumed. If tax relief is not claimed on premiums, the benefits paid to the business may still be taxed on the basis that relief could have been claimed on the premiums. The business should always consult their local Inspector of Taxes. Tax implications on Key Person Protection for a shareholding director It is possible for a shareholding director to be protected by Key Person Protection. The business should explain this to their local Inspector of Taxes, detail the percentage of shares held and indicate the holdings of other family shareholders. In this instance, tax relief on premiums is unlikely as the local Inspector of Taxes may decide that any benefits paid will be largely for the benefit of the shareholding director, especially if they own significant shareholdings in the business (a holding of over 5%). It is also important to note that any cover benefits paid to the business will boost the value of the business s shares. This could increase the value of the deceased Key Person s estate if they were a shareholder. An example of where a local Inspector of Taxes will not normally approve relief is on life and/or critical illness covers lasting longer than five years. A local Inspector of Taxes may approve relief on a short term critical illness cover. 07

8 Key Person Loan Protection What is Key Person Loan Protection? Most types of business borrow money at some point to assist in their growth and development. The cost of these loans is usually covered by the business s income. But this income can be affected by the loss of a Key Person or someone who has acted as a guarantor for the loan. As with Key Person Protection, these consequences can be significant. Unpaid loans can result in a loss of confidence by banks or other moneylenders. This can have a devastating effect on the business s ability to grow or even survive. Our Key Person Loan Protection allows a business to put in place an appropriate solution that will provide funds to repay any borrowing. How we can help Our Key Person Loan Protection can be arranged to provide payment in the event of death, critical illness, or both. Calculating the level of cover required In order to be able to protect the value of any loan, the business will need to demonstrate how a financial loss could be incurred in the event of the loss of a Key Person. This will typically be that the bank demands immediate repayment of the loan. For business loans that are secured on the lives of key individuals, the cover will be determined by: the amount and term of the loan; and the number of key individuals upon which the loan has been secured. Tax implications Where a policy is effected as collateral security for a loan, premiums paid will not be treated as a deductible expense from profits for corporation tax purposes. They will be regarded as part of the cost of raising capital. Benefits will be treated as a capital receipt and not taxed. The business will need life cover on their key individuals to provide security for outstanding loans with the capital sum outstanding being used to determine the amount of cover. The types of loan that may exist: Commercial loans Personal guarantees. Consideration will need to be made as to whether critical illness cover should also be included and/or whether level or decreasing cover is most appropriate. 08

9 Shareholder Protection What is Shareholder Protection? A business comprised of major shareholders will be aware that the long-term success of the business will depend on their contribution. The loss of a shareholding director due to death, serious illness or permanent disablement can have a serious impact, both on the future of a business itself and on their family. Our Shareholder Protection allows a business to protect itself against the financial loss it may suffer from losing a major shareholder due to these events. Identifying the need for Shareholder Protection Primarily, this protection is designed to cover the shareholding director of private limited companies. The liability of these shareholders, the owners, is limited to the value of their unpaid share capital in the business and any personal guarantees. We can also protect major shareholders of public limited companies with this cover. The consequences of losing a shareholder Shareholders may have important voting rights, which directly affect the running of the business. Losing a shareholder would normally result in these rights passing to the deceased shareholder s beneficiaries, such as their family. This can affect the business in two ways: After inheriting voting rights, the beneficiaries have the right to a say in the running of the business. But they may not have the necessary skills and experience to take on such a role. Furthermore, they may not share the aspirations and objectives the surviving shareholders have for the business. How we can help Our Shareholder Protection provides a solution to support a business where, in the event of death, serious illness or permanent disablement, the surviving shareholders can purchase the available shareholdings allowing the business to continue without further disruption. It is important to ensure sufficient funds are available to allow this purchase to take place. To do this each shareholding director will take out a policy on their own life for an amount that reflects the value of their individual holdings. We can help your clients by tailoring life and/or critical illness covers that provide: cover against the loss of a major shareholder funds to purchase shares from a deceased shareholder s estate legal agreements that protect the business tax efficiency The cover will be written under a special form of business trust so that any proceeds payable will be paid to the surviving shareholders. You can find a business trust form on our website - The business shareholders should also set up an agreement that details how shares will be treated in the event of death or critical illness. These agreements are called cross option agreements, which are explained further on page 18. It is important to note that all businesses are governed by two documents, The Memorandum of Association and The Articles of Association. If you are unsure of the purpose of these two documents, you can find more details in the Further information section on page 23. The deceased s beneficiaries may prefer to receive the value of the shares in cash. The surviving shareholders may wish to purchase these shares but may not have sufficient capital available. Without the necessary capital an outside third party, potential hostile bidder, or even a competitor could purchase the shares. 09

10 Calculating the level of cover required Having established a need to protect a business against the loss of a major shareholder, you will need to work out the value of the business and how much cover is needed. Most business owners will have a clear understanding of the value of their business, but the calculation outlined in this section will help you work out the amount of cover your clients need to apply for. The amount of cover needs to be established and justified for financial underwriting purposes and you will need to demonstrate how the figure has been decided. Our underwriting team is on hand to provide assistance and support in calculating levels of cover. You can find their phone number in the Contact us section on the back page. Net assets Net assets shown on a business s balance sheet may not be a helpful guide to the valuation of shares. However, whichever method you use to produce a valuation, it is essential to keep in mind the net asset position. It is also necessary, where possible, to replace the asset values shown in the balance sheet with their open market value. Net asset value + (multiple of net profit) Type of business Established company Growing company Manufacturer multiply by 3 multiply by 5 Service multiply by 5 multiply by 7 When valuing a business, it is important to refer to the business s Articles of Association and check for any restrictions on the transfer of shares, as this will affect their value. Many Articles simply allow directors the discretion to refuse registration of the transfer to any person for any reason. Larger businesses may have more complicated restrictions. The valuation methods could range from allowing the business auditors or valuation expert to fix the price to putting a fixed price on any transfer, for example 1 per share. 10

11 Developing a Business Protection Plan for shareholders For the benefit of their co-shareholders, each shareholder takes out an own life policy with a sum assured under trust that reflects the value of their shares. The shareholders should also set up an agreement that details how shares will be treated in the event of death or critical illness. If one of the shareholders dies or suffers a critical illness, the claim proceeds will provide the other shareholders with funds to purchase the available shares either: from their personal representatives following the death; or directly from the shareholder following critical illness. For example Shareholding Directors A Company Ltd Jones Evans Brown 200,000 in Trust for Evans and Brown 100,000 in Trust for Jones and Brown 100,000 in Trust for Jones and Evans On the death/critical illness of Jones Jones dies/becomes critically ill Shares Jones family/jones Shares Cash Evans and Brown Policy 200, ,000 policy proceeds On receipt of the proceeds of the sale, the deceased s personal representatives will be able to distribute the proceeds in accordance with the deceased s will, or where a will does not exist, under the rules of intestacy. In a private limited company, the shareholders are often the directors running the business. It is important to ensure the Business Protection Plan complies with the Articles of Association. 11

12 Business Protection Plan Documentation The documentation supporting the Shareholder Protection arrangement is vital. Under the own life in business trust approach each shareholder takes out own life cover equal to the value of their shareholding the beneficiaries, appointed in our business trust, are the other shareholders (the shareholders could also be the trustees) an arrangement is set up for the business that allows each shareholder to enter into an agreement that enables the purchase of a deceased or critically ill shareholder s equity this is known as cross option agreements and can be single option to cover a critical illness or double option to cover death further explanation is set out below the proceeds of the sale are paid by the trustees to the critically ill shareholder or the deceased shareholder s estate in exchange for the shares held the purchased shares are divided between the surviving shareholders. It is vital that all trust documentation is completed and received by us prior to the cover commencing. Cross option agreements Cross option agreements are the most widely accepted method of integrating share purchase into Articles of Association, and are vital to facilitate the exchange of the plan proceeds and the business shares, and are drafted to be used in conjunction with our business trust. taken. Whilst binding on the participants to enforce the agreement, the flexibility / option preserves valuable taxation benefits (Business Property Relief). The timescale in which the options may be exercised is specified in the agreement. During the specified timescale, the executors/ beneficiaries of the deceased shareholder cannot sell the interest to any other party. Death If a shareholder dies then the option to buy/sell the shares and other assets is available. The agreement works by creating a sell option and a buy option: The sell option requires the deceased shareholder s personal representatives to sell the available shares to the surviving shareholders. The buy option requires the surviving shareholders to buy the available shares from the deceased s personal representatives in the event of a death. This is known as a double option agreement. If either party chooses to exercise their option, the other must comply. Equally, it is possible neither party will exercise their option and for the beneficiaries to become shareholders in the business. A draft double cross option agreement is available on our website This document does not offer a single (sell) cross option for standalone critical illness cover or the critical illness element of life and critical illness cover. See the next section for more information. Whilst a legal document, it is important that the cross option agreement is flexible in allowing an option that preserves a degree of choice as opposed to being an obligation that forces action to be 12

13 Critical illness If a partner or shareholder becomes critically ill, they have the option to retain or sell the shares/assets. This is known as a single option agreement. In the event of a critical illness, the critically ill shareholder can exercise their sell option but cannot be forced to sell by the other shareholders. This means that the shareholder suffering the critical illness can continue working and not be forced out of the business against their will. In this instance, the shareholders/trustees can retain the claim proceeds (until an appropriate time) if the insured shareholder decides not to sell their shares. A draft double and single cross option agreement is held on our website - this document incorporates both a double option agreement for death benefit and a single critical illness sell option. Shareholding directors joining the business Any new shareholding directors should enter into the Shareholder Protection plan. We recommend that the protection and trusts should be set up in a similar way to the existing shareholders arrangements. An updated Cross Option Agreement will be required. We also think that the introduction of a new shareholding director is the ideal opportunity for existing directors to review their arrangements. They can, where appropriate: make any necessary adjustments to covers; make sure trusts are up to date and complete; and make sure option agreements are up to date and complete. Shareholding directors leaving the business If a shareholding director leaves the business, the protection will no longer be needed for its original purpose. Under the terms of our Business Trust, the Trustee(s) would then automatically hold any life cover the leaving director has for the leaving director s own benefit. Company Share Buyback You should also be aware of the other solutions available. Accountants will often favour a Company Share Buyback arrangement. This means on the death or serious illness of one of the shareholders, the business will repurchase the available shares. For this arrangement, you first need to make sure the business s Articles of Association caters for the business to buy back shares from the shareholders. If appropriate, the business can then insure shareholders for the value of their shareholding. The business, as the policy owner, will make the cover payments and receive the benefits on a death or critical illness claim. When the business buys the deceased s shares, they must then cancel the shares. This in turn will proportionately increase the value of the shares held by the remaining shareholders. A trust document will not be required, but the arrangement will require a Cross Option Agreement to preserve Business Property Relief. This process is complicated in terms of tax and company law so should not be attempted without advice from either the business s auditors, tax advisers or corporate lawyers. 13

14 Tax implications Pre-Owned Asset Tax (POAT) was introduced under Schedule 15 of the Finance Act 2004 and implemented in A charge to POAT could arise where the shareholder or partner leave the business other than as a result of death. Our Business Trust could be subject to an annual charge to POAT based on the market value, because the Settlor is included as a potential beneficiary. The reason for such inclusion is to allow a shareholder who leaves and/or no longer has a financial interest in a business to continue with their plan for the purpose of personal cover. As Friends Life Protect+ is a term assurance plan, it is only in very limited circumstances that it would acquire a market value. Therefore it is unlikely that a POAT charge would apply. Tax implications for the business Corporation Tax on cover payments If the business pays for the cover on behalf of the shareholder, it can deduct the expense for Corporation Tax purposes because it is effectively fulfilling the shareholder s responsibility to pay. The business will also incur a liability to National Insurance Contributions paid on behalf of the shareholding director, but this will also be a deductible expense. Tax implications for the individual Income Tax on cover payments If the business pays for the cover on behalf of the shareholder, the director shareholder will be liable to pay Income Tax and National Insurance on the value of the premiums paid by the company. The company will be liable to pay National Insurance on the benefit of paying the insurance for the employee. When individuals pay their own premiums, the payment should be from their net (after tax and National Insurance) salary. Capital Gains Tax on claim benefits There is normally no Capital Gains Tax payable on the claim benefits of a life and/or critical illness cover. However, on death there could be a liability on the beneficiaries of the deceased s estate on the increase in value of the shares between death and sale. A Capital Gains Tax liability may arise in the event of the sale of a director s shares due to critical illness. Inheritance Tax on claim benefits The claim benefits of the cover when effected as part of a commercial arrangement written under a suitable trust will normally be payable to the Trustees free from Inheritance Tax, and will not form part of the deceased s estate. The estate of the deceased shareholder includes the shares and not cash, thus preserving (where appropriate) Business Property Relief on the value of the shareholding. The trust is treated as relevant property for Inheritance Tax purposes. At each 10 year anniversary of the trust there could be an Inheritance Tax liability based on the value of the property that is held in the trust. The value of the property would be, in the case of life and/or critical illness cover under Friends Life Protect+ plans, the market value of the cover. If a charge does arise, this charge (the effective rate ) will not exceed 6% of the value of the trust property. When any property leaves the trust it could be subject to a proportionate charge based on an appropriate fraction of the effective rate. Again, the charge will not exceed 6% (this is due to the proportionate charge being based on the previous anniversary charge). If the business is a family business, Inheritance Tax and Business Property Relief are unlikely to be affected as long as the arrangement is solely to protect the business and is arranged to protect only those with direct shareholdings. Inheritance Tax on cover payments Premiums paid to a trust policy are normally considered gifts for Inheritance Tax purposes (and potentially chargeable to Inheritance Tax subject to any available exemptions). However, where there is a reciprocal commercial arrangement requiring all shareholder directors to enter into such a protection agreement HMRC may accept the premiums are not gifts. It is recommended that HMRC agreement to the position is sought in advance. Income Tax on claim benefits There is no liability to Income Tax on the payment of claim benefits under life and/or critical illness cover. 14

15 Partnership Protection What is Partnership Protection? A business comprised of partners will be aware that the long-term success of the business depends on their contribution. The death, serious illness or permanent disablement of a partner can have a serious impact, both on the future of a business itself and on their family. To preserve the continuity of the business it is vital that the remaining partners are fully prepared for such an eventuality. Our Partnership Protection allows a business to protect itself against the financial loss it may suffer from losing a partner due to these events. A partnership is defined as the relationship which exists between persons carrying on a business in common with a view to profit. Ideally, all partnerships should have a written agreement known as a Partnership Agreement, that would normally include the following: name of business place of business transactions date partnership comes into effect partners responsibilities and duties share of profits arrangements on resignation of a partner arrangements on retirement of a partner arrangements on death of a partner dissolution of the partnership. The consequences of losing a partner A partnership in England and Wales does not have its own legal identity, meaning individual partners may be personally responsible for their business s risks. Losing one partner due to death or serious illness could result in other partners losing both their share in the business assets and part or all of their private assets as well. Partnerships with agreements Most remaining partners in this situation will want to buy the missing partner s share to keep control of the business. They may already have some form of agreement in place to allow the business to carry on after the loss of a partner. But they may not have access to funds to allow this to happen. Realistically, few partners will have the funds available and some will turn to their bankers, but: they may have existing loans that rule out further advances; or the bank s uncertainty over the future stability of the partnership may mean that banks will be less likely to make a further loan. Please note that a Scottish partnership does have its own separate legal identity, as do Limited Liability Partnerships in England and Wales. Partnerships without agreements Without an agreement, the death of a partner automatically dissolves the partnership. The estate of the deceased partner becomes entitled to the value of the deceased partner s interest in the business. For the remaining partner(s) this means either: selling the business to pay off the estate; selling assets to pay off the estate and then setting up business as a Sole Trader or starting a new partnership with someone else; or coming to an arrangement with the estate to, for example, set up a new partnership with the late partner s widow(er)/civil partner. For the deceased partner s widow(er)/civil partner this might mean an inadequate price to compensate for the late spouse/civil partner s business interest or being forced into the business against his/her will. 15

16 How we can help Our Partnership Protection provides a solution to support a business where, in the event of the death, serious illness or permanent disablement, the surviving partners can purchase the available share allowing the business to continue without further disruption. This will in turn provide the deceased partner s beneficiaries with a willing buyer and capital instead of an interest in a business. We can help your clients by tailoring life and/or critical illness covers that provide: cover against the loss of a partner funds to allow the partnership to continue trading legal agreements that protect the business tax efficiency. This cover can be written on each partner s life for an amount that reflects the value of his or her individual interest in the business. The cover will be written under our business trust so that any proceeds payable will be paid to the surviving partners. Where appropriate, provision could also be made to cover a partner in the event of a serious illness or disablement. Average partnership profits The value of the partnership can be calculated as a multiple of the average of the last given number of years profits. Value of goodwill The partners should agree, after taking professional advice, on a method to value the goodwill of the business. Net assets Net assets are not always a helpful guide to the business s value, but they should be taken into account. The value of any business can fluctuate so we recommend that the Partnership Protection arrangement is regularly reviewed and updated. The amount of cover needs to be established and justified for financial underwriting purposes and you will need to demonstrate how the figure has been decided. Our Underwriting team is on hand to provide assistance and support in calculating levels of cover. Calculating the level of cover required Having established a need to protect a business against the loss of a partner they must agree upon the value of the business. Partners will often have an idea as to the value of the partnership. However, difficulty often arises from the fact that much of a partnership s value is in the form of goodwill. This section outlines the things you need to consider to work out the amount of cover your clients need to apply for. 16

17 Developing a Business Protection Plan for partners When developing Business Protection Plans for partners, the most widely used solution is Individual Purchase. Individual Purchase For the benefit of their co-partners, each partner takes out an own life policy with a sum assured that reflects the value of their share of the business. Partners should also set up an agreement that details how shares will be treated in the event of death or critical illness. If one of the partners dies or suffers a critical illness, cover proceeds would provide the other partners with funds to purchase the available share of the business. For example Partnership Protection Sample Partnership Jones Smith Davis 50,000 in Trust for Smith and Davis 25,000 in Trust for Jones and Davis 25,000 in Trust for Jones and Smith On the death/critical illness of Jones Jones dies/becomes critically ill Partnership Interest Jones family/jones Partnership Interest Cash Smith and Davis Policy 50,000 50,000 policy proceeds 17

18 Business Protection Plan Documentation The documentation supporting the Partnership Protection arrangement is vital. Under the individual purchase approach each partner takes out own life cover equal to the value of their share of the business the beneficiaries, appointed in our business trust, are the other partners (the partners could also be the trustees) an arrangement is set up for the business that allows each partner to enter into an agreement that enables the purchase of a deceased or critically ill partner s share of the business this is known as a cross option agreement and can be single option to cover a critical illness or double option to cover death further explanation is set out below the proceeds of the sale are paid by the trustees to the critically ill partner or the deceased partner s estate in exchange for the shares held the share of the business is divided between the surviving partners. It is vital that all trust documentation is completed and received by us prior to the cover commencing. Cross option agreements Cross option agreements are the most widely accepted method of integrating partnership protection into partnership agreements, and are vital to facilitate the exchange of the plan proceeds and the business share, and are drafted to be used in conjunction with our business trust. Whilst a legal document, it is important that the cross option agreement is flexible in allowing an option that preserves a degree of choice as opposed to being an obligation that forces action to be taken. Whilst binding on the participants to enforce the agreement, the flexibility/option preserves valuable taxation benefits (Business Property Relief, see page 21). Death If a partner dies then the option to buy/sell their share of the business and other assets is available. The agreement works by creating a sell option and a buy option: The sell option requires the deceased partner s personal representatives to sell the available share to the surviving partners. The buy option requires the surviving partners to buy the available business share from the deceased s personal representatives in the event of a death. This is known as a double option agreement. If either party chooses to exercise their option, the other must comply. Equally, it is possible neither party will exercise their option and for the beneficiaries to become partners in the business. A draft double cross option agreement is held on our website This document does not offer a single (sell) option for standalone critical illness cover or the critical illness element of life and critical illness cover (see next section). Critical illness If a partner becomes critically ill, they have the option to retain or sell their business share/assets. This is known as a single option agreement. In the event of critical illness, the critically ill partner can exercise their sell option but cannot be forced to sell by the other partners. This means that the partner suffering the critical illness can continue working and not be forced out of the business against their will. In this instance, the partners/trustees can retain the claim proceeds (until an appropriate time) if the insured partner decides not to sell their shares. A draft double and single cross option agreement is held on our website - this document incorporates both a double option agreement for death benefit and a single critical illness sell option. The timescale in which the options may be exercised is specified in the agreement. During the specified timescale, the executors/ beneficiaries of the deceased shareholder cannot sell the interest to any other party. 18

19 Automatic Accrual Another solution for Partnership Protection is Automatic Accrual. This approach requires each partner to take out cover that equates to their own share of the business, which is then supported by an automatic accrual arrangement written by the partnership s legal advisers. On a partner s death, automatic accrual allows their interest (or more commonly the value of the goodwill) to pass directly to the remaining partners. Instead of a share in the business, the deceased s family will receive the death benefit from Life Cover set up by the deceased partner on their own life. The life cover should be put in an appropriate trust for the partner s beneficiaries. This may help to avoid the delays often encountered when obtaining probate, and avoid the sum assured being included as an asset within their estate, possibly giving rise to an Inheritance Tax charge. Guidance should be sought on both the trust documentation and cross option agreement. For example Partnership Protection Sample Partnership Jones Smith Davis 50,000 under Trust for Jones family 25,000 under Trust for Smith s family 25,000 under Trust for Davis s family On the death of Jones Jones dies Policy for 50,000 Trust for the benefit of Jones family Jones interest in the Partnership (Goodwill) Smith and Davis Where an automatic accrual arrangement is in existence, it will often be beneficial to consider appropriate life assurance for co-partners. This would provide the necessary funds to repay any balance on partnership loan accounts outstanding on a partner s death. 19

20 Partners joining the business All new partners joining the business should enter into the Partnership Protection arrangement. We recommend that the protection and trusts should be set up in a similar way to the existing partners arrangements. An updated cross option agreement will be required. We also think that the introduction of a new partner is the ideal opportunity for existing partners to review their arrangements. They can, where appropriate: make any necessary adjustments to covers; make sure trusts are up to date and complete; and make sure option agreements are up to date and complete. Partners leaving the business If a partner leaves the business, the policy will no longer be needed for its original purpose. Under the terms of our Business Trust, the Trustee(s) would then automatically hold any life cover the leaving partner has for the leaving partner s own benefit. Limited Liability Partnerships A Limited Liability Partnership (LLP) in England and Wales does have its own legal identity and can own assets in its own right. The Limited Liability Partnerships Act 2000 now permits the formation of LLPs which limit the liability of partnerships under the following conditions: the firm must be registered as an LLP and must comply with a disclosure regime; a LLP is treated as a corporate body, that is, is a distinct legal person with full legal capacity; the liability of members is limited to their actual and pledged contributions; financial statements must be disclosed in the same manner as for limited companies; similar rules to those applying to company directors relating to wrongful trading etc., apply to members. A full description and the taxation implications are beyond the scope of this guide but if you require further information, you should contact your Friends Life Individual Protection Account Manager. Tax implications Pre-Owned Asset Tax (POAT) was introduced under Schedule 15 of the Finance Act 2004 and implemented in A charge to POAT could arise where the partner leaves the business other than as a result of death. Our Business Trust could be subject to an annual charge to POAT based on the market value, because the Settlor is included as a potential beneficiary. The reason for such inclusion is to allow a partner who leaves and/or no longer has a financial interest in a business to continue with their plan for the purpose of personal cover. As Friends Life Protect+ is a term assurance plan, it is only in limited circumstances that it would acquire a market value. Therefore it is unlikely that a POAT charge would apply. 20

21 Tax implications for the business Income Tax on cover payments If the individual partner pays the premiums, this will come from their taxed income. In the event of the partnership paying the premiums they will be taxed as partnership drawings, unless the premiums are deducted from the partner s capital, current or loan accounts (that is, an account where tax has already been settled). Tax implications for the individual Income Tax on claim benefits There is no liability to Income Tax on the payment of claim benefits under life and/or critical illness cover. Inheritance Tax on cover payments Premiums paid to a trust policy are normally considered gifts for Inheritance Tax purposes (and potentially chargeable to Inheritance Tax subject to any available exemptions). However, where there is a reciprocal commercial arrangement requiring all partners to enter into such a protection agreement HMRC may accept the premiums are not gifts. It is recommended that HMRC agreement to the position is sought in advance. As the trust is treated as relevant property for Inheritance Tax purposes, at each 10 year anniversary of the trust there could be a charge to Inheritance Tax based on the value of the property then held in the trust. The value of the property would be, in the case of a term assurance cover under a Friends Life Protect+ plan, the market value of the cover. If a charge does arise, this charge (the effective rate ) will not exceed 6% of the value of the trust property. When any property leaves the trust, it could be subject to a proportionate charge based on an appropriate fraction of the effective rate. Again, the charge will not exceed 6% (this is due to the proportionate charge being based on the previous anniversary charge). Automatic Accrual of Partnership Goodwill The deceased partner s interest in the firm passes to the surviving partners automatically. That share of the firm will normally qualify for Business Property Relief, which is currently 100% for a partner s interest in their firm. Capital Gains Tax on claim benefits There is normally no Capital Gains Tax on the payment of the proceeds of a life and/or critical illness policy. However, on death there could be a liability on the beneficiaries of the deceased s estate on the increase in value of the partner s interest between death and sale. A Capital Gains Tax liability may arise in the event of the sale of a partner s interest due to critical illness. Inheritance Tax on claim benefits The proceeds of the life and/ or critical illness policy when effected as part of a commercial arrangement and written under a suitable trust will normally be payable to the Trustees free from Inheritance Tax, and will not form part of the deceased s estate. The estate of the deceased partner includes the share of the business and not cash, therefore preserving (where appropriate) Business Property Relief on the value of the share. 21

22 Alternative solutions There are alternative ways you can arrange Partnership and Shareholder Protection: Binding arrangements (Buy and Sell agreement) Life of another arrangements Absolute Trust Joint life first death policies. While some of these alternatives may have cost advantages, they may have major disadvantages in the longer term. Binding arrangements (Buy and Sell agreement) With this method, the partners enter into an agreement whereby on retirement or death, the retiring partner or their estate will sell their share to the remaining partners who, in turn, will buy. The partners will purchase the share in the proportion in which the remaining share in the business is held. The major disadvantage of the Buy and Sell method is the loss of Business Property Relief so, when a partner dies, their share of the business may be liable to Inheritance Tax. Life of another arrangements Life of another, as a way of writing the life policies, has its limitations in that it is inflexible when the business dissolves or when new shareholding directors/partners join. Absolute Trust An Absolute Trust is similarly inflexible for businesses where new members join or existing ones leave. Joint life first death policies If there are only two participants, a joint life policy can be written. Again, there is no flexibility when someone joins or leaves, and if one dies, the survivor may no longer have any life cover. 22

23 Further information Articles of Association The Articles of Association are the regulations governing the relationships between the shareholders and directors of the company, and are a requirement for the establishment of a company under the law of the United Kingdom. Together with the Memorandum of Association, they form the constitution of a company. Articles of Association typically cover the issuing of shares, the different voting and dividend rights attached to different classes of share, restrictions on the transfer of shares, the rules of board meetings and shareholder meetings, and other similar issues. Contact us For more information about Business Protection, please contact your Friends Life Individual Protection Account Manager or call us on Calls may be recorded and may be monitored. Our dedicated protection website also contains useful information about selling Business Protection please visit - You can also contact our Underwriting team on Memorandum of Association The Memorandum of Association is the document that governs the relationship between the company and the outside world. It is one of the documents required to incorporate a company in the United Kingdom. The Memorandum of Association is designed to communicate to the public the state of affairs of the company and its purpose of being and operating. This aids various stakeholders of the company (creditors, suppliers, shareholders, etc.) to evaluate the extent of their risk and also possibilities of the company to overcome them at a future date. 23

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