Cross Options

We regularly come across the misconception that when a shareholder dies, the surviving shareholders have an automatic right to purchase the deceased’s shares. Well drafted Articles of Association and/or Shareholders’ Agreement do not make it a binding obligation for the personal representatives to sell to surviving shareholders.

If a shareholder of shares in a trading company, which is unlisted or listed on the Alternative Investment Market, dies then, provided that s/he has held them for 2 years, the value for inheritance tax purposes is reduced by 100% to nil.

Example 1 – At the date of Fred’s death he owned 40% of the allotted share capital in ABC Limited being 4,000 shares of £1.00 each fully paid up. Each share has been valued at £80 per share. The value to be included in the inheritance tax form (IHT 400) would be £320,000. However, since Fred owned the shares for more than 2 years his personal representatives will claim Business Property Relief (BPR), which reduces the value to £0.00. HMRC raise an aspect enquiry on the value of the shares and it transpires that under the terms of a Shareholders’ Agreement on the death of any one of the them the shares had to be sold to the surviving shareholders so as to preclude the deceased’s family or beneficiaries from participating in ABC Limited. The result is that BPR is denied (under section 113 Inheritance Tax Act 1984). Fred’s estate, without the shares, already exceeds the nil-rate band and so tax at 40% becomes due, namely £128,000.

Ordinarily there is a option (rather than a obligation) to purchase the deceased’s shares, but in many cases even with such an option the shareholders cannot pay for the shares as they do not have adequate resources. Here the cross option comes into play.

Example 2 – Let’s take Fred again. His other shareholders are Toby and Gregory: each hold 30% of the allotted share capital. With the assistance of their accountant they determine that the company is worth £800,000. With the assistance of their IFA, Fred takes out a life assurance policy for £320,000 and writes it in trust for Toby and Gregory. Since it is written in trust the benefit of the life policy is excluded from an IHT charge on Fred’s death. Toby takes out a life assurance policy for £240,000 and writes it in trust for Fred and Gregory and Gregory does the same but his trust favours Fred and Toby. So they each have enough cash (from the life assurance to pay for the shares on anyone of the shareholders’ deaths).

Under the terms of a cross option, the surviving shareholders have the option within a short period after the death of anyone of them (usually 3 to 4 months) to buy the deceased’s shares from the personal representative. This is known as the call option. If the call option is not exercised then the personal representatives have the option to require the surviving shareholders to but the deceased’s shares within a further period (usually 1 to 2 months).

Example 3 – Let’s carry on with Fred’s estate. So let’s assume the Articles of Association give the surviving shareholders the option to buy Fred’s shares and the shareholders have implemented the life assurance and entered into a cross option agreement. Fred’s personal representatives will be able to claim BPR on the value of the shares and Toby and Gregory have the cash to buy Fred’s shares and if they do not then Fred’s presonal representatives have the choice of requiring Toby and Gregory to buy the shares or pass Fred’s shares to the beneficiaries named in Fred’s will.

Leave a Reply