A Guide To Cross Option Agreements

A shareholder’s death can have a devastating impact on their fellow shareholders and company. When operating a business, it is important to prepare for unforeseen circumstances – including the death of a shareholder. A company can put measures in place to protect their business in the event of a death. One way to address this concern is through a cross option agreement.

What happens when a shareholder dies?

Unless the company’s articles of association or a shareholders’ agreement contain provisions dealing with the death of a shareholder, the shares held by the deceased will be inherited by the beneficiaries of their will (or under the intestacy rules if the shareholder did not leave a will). The beneficiaries, often a spouse or child of the deceased, may have little interest or may lack the experience required to take on the deceased’s responsibilities within the business. It may be the case that the remaining shareholders do not have the financial means to buy the deceased’s shares. This is where a cross option agreement, together with the appropriate insurance, is beneficial.

What is a cross option agreement?

A cross option agreement is a contract entered into by the shareholders of a company that outlines the options available to the deceased’s estate and the remaining shareholders if a shareholder dies. Under the cross option agreement, the remaining shareholders have the option to buy the deceased’s shares and the deceased’s estate has the option to sell the shares to the remaining shareholders.

How does a cross option agreement work?

The remaining shareholders will have the right to exercise their call option which forces the deceased’s estate to sell the shares to the remaining shareholders at a pre-agreed price.

If the remaining shareholders do not exercise their call option, the deceased’s estate will then have the right to exercise its put option which forces the remaining shareholders to buy the shares at a pre-agreed price.

Although usually the put and call options will likely result in the shares being sold by the deceased’s estate to the remaining shareholders, it is possible that neither the remaining shareholders nor the deceased’s estate exercise their respective options. In this case, the beneficiaries of the deceased’s estate will inherit the deceased’s shares in the company.

In some instances, a cross option agreement can be structured so that only the deceased’s estate will have a put option, although this will allow the deceased’s estate to retain the shares if they do not wish to exercise the put option.

How do the remaining shareholders fund the acquisition of the deceased’s shares?

It is important to consider how the remaining shareholders will fund the acquisition of the deceased’s shares. A cross option agreement can require the shareholders to take out insurance on their lives under a life assurance policy. The policy will be owned and the insurance premiums will be paid by the shareholder whose life is insured, but the policy will be written in trust for the other shareholders so that they will receive the proceeds of the policy on the death of the shareholder, which can then be used to fund the purchase of the deceased’s shares. The trustees of the policy should have the discretion to pay the insurance proceeds to any of the shareholders that enter into a contract to buy the deceased’s shares. This keeps the insurance proceeds outside of the deceased’s estate and ensures that the remaining shareholders will have the financial means to finance the purchase.

Cross option agreements and wills

In some cases, the deceased may have made a specific gift of the shares they held in the company to a beneficiary included in their will as well as having granted an option over the shares to the remaining shareholders under a cross option agreement. The effect of the gift depends on when the will was executed.

If the option was granted before the will was executed, the beneficiary under the will is entitled to the sale proceeds if the option is exercised.

If the option was granted after the will was executed, the specific gift fails and the deceased’s estate will be entitled to the proceeds if the option is exercised.

What are the tax implications?

Structured in this way, cross option agreements are not viewed as binding contracts for sale in HMRC’s view, and so business relief from inheritance tax is available on the exercise of either option. This is because the parties only have an option to buy/sell the shares rather than an obligation to do so. Shares in a private company benefit from 100% business relief from inheritance tax as long as the shares were held by the deceased for a period of at least two years before they are bought by the remaining shareholders. This eliminates the risk of inheritance tax charges that would otherwise have a negative impact on the shareholders and the company.

The use of a cross option agreement (instead of the company buying back and cancelling the shares) may also be beneficial to the remaining shareholders from a capital gains tax perspective. If the deceased’s shares are bought back and cancelled by the company, the value of the remaining shareholders’ existing shares will increase to reflect the reduced number of shares, but the acquisition cost of each share will remain the same. This would result in a higher chargeable gain on any future disposal of the shares by the remaining shareholders.

In addition, no income tax should be payable by the trustees or the beneficiaries of the insurance policy. Inheritance tax should also not be charged on the insurance policy as the proceeds are kept outside of the deceased’s estate.

It is worth noting that for investors to qualify for tax relief under the Enterprise Investment Scheme there must be no prearranged exit. Relief is not allowed on shares that are subject to put or call options if the options are granted within the period beginning two years before the shares are issued and ending three years after the shares are issued.

In most cases, on exercise of the option, stamp duty is payable on the stock transfer forms at a rate of 0.5% of the value of the amount paid for the transfer of the shares.

Overall, having a cross option agreement in place is usually a tax-efficient way to deal with the deceased’s shares as long as the agreement is structured properly.

How we can help

If you are interested in implementing a cross option agreement with the other shareholders of your company, we offer a no-cost, no-obligation 20-minute introductory call as a starting point. Please email wewillhelp@jonathanlea.net providing us with any relevant information ensuring that any call we have is as productive as possible. After this call, we can then email you a scope of work, fee estimate, and confirmation of any other points or information mentioned on the call.

This article is intended for general information only, applies to the law at the time of publication, is not specific to the facts of your case and is not intended to be a replacement for legal advice. It is recommended that specific professional advice is sought before relying on any of the information given. © Jonathan Lea Limited 2024.