What are cross option agreements?
Many companies have a few shareholders and those shareholders are also directors, who are intimately involved in the running of such a company. Typically, it will be undesirable for the shares of a deceased shareholder in such a company to be transferred under the provisions of a will to their family members, or indeed any other third parties. A transferee may be inexperienced in business and have no desire to become involved in the company.
Therefore, to avoid a new, unknown shareholder being introduced in to their midst on the death of an existing shareholder, the shareholders of a private company may all choose to enter into a cross-option agreement. The purpose of the agreement is to provide a mechanism for the transfer of the legal and beneficial ownership of each shareholder’s shares in these circumstances. It ensures that fellow shareholders have the opportunity to purchase those shares before they are transferred to third parties. Each shareholding will be subject to a call option and a put option:
1. A call option, being a right (but not an obligation) of the remaining shareholders to purchase the deceased shareholder’s shares from his personal representatives, and
2. A put option, being a right (but not an obligation) of the deceased shareholder’s personal representatives to require the remaining shareholders to purchase the deceased shareholder’s shares
It is important to ensure that the options are drafted as rights rather than obligations in order to avoid the transfer of shares on the death of the deceased shareholder being deemed to be subject to a binding contract for sale. If the transfer is deemed to be subject to a binding contract for sale, it will be treated as being a transfer of cash for inheritance tax purposes, which means that business property relief (BPR) for inheritance tax will be unavailable. BPR is a very valuable inheritance relief for private company owners as it provides 100% relief from inheritance tax where all the qualifying conditions are met.
Under this agreement, the purchase of the deceased shareholder’s shares will be financed by funds from an insurance policy covering the life of the deceased shareholder. Such a policy should be entered into by each shareholder and written under trust, with their fellow shareholders as beneficiaries. It is important that the life insurance policy is written under trust as this ensures that the proceeds of the policy will fall outside of the deceased shareholder’s estate and will not be subject to inheritance tax.