Setting up your own business can give you the flexibility to manage your own hours and workload, without having to answer to anyone above you.

You can set up a business as a sole trader, as a partnership or as a limited company and depending on which route you take, what happens with the company in the case of death or critical illness varies.

Sarah Deaves, Lloyds Bank private banking director, says: “How the business is set up is key when determining the inheritance position and what happens in the event of death. If a business is set up as a sole trader, in effect there is no distinction between someone’s personal assets and their business – they are treated broadly speaking as one, for tax purposes.

“Partnerships or limited companies are separate legal entities so the terms and framework of the organisation drive the inheritance position, for example through partnership agreements or allocation of shares in a limited company.”

Peter Savage, chartered financial planner at Fairstone Financial Management, says in all cases, it’s extremely important the deceased has an up-to-date will otherwise their share/business assets would be distributed under the laws of intestacy, so an unmarried partner may not receive any share of the business.

Savage says: “If a sole trader dies and they do not have a will, their estate along with the business assets will be distributed under the laws of intestacy.

“Under a partnership with two or more partners, the partnership will cease on the death of a partner unless there is a partnership agreement in place stating other agreed provisions. The deceased partner’s estate will become entitled to their share of the business.

“A limited company will continue after the death of a shareholder. The shares in the business will pass to the estate of the deceased and will be distributed under the terms of their will.”

He explains that if a director of a limited company leaves the business to a spouse, the spouse may want the value of the shares or they may want to be involved in the business.

“The existing shareholders would prefer the shares rather than have the spouse sell them to a third party or have the spouse involved in a business that they cannot actively contribute to running. The ideal scenario is for the remaining shareholders to purchase the deceased shareholder’s shares from their beneficiary. However, they need capital to do this otherwise the deceased shareholder beneficiary is free to sell elsewhere or get involved with the business.”

When it comes to arranging the transfer of shares, Savage says one of the best ways is via a cross-option agreement, including the following:

• The shareholders of the business have an option to buy the shares from the estate of a deceased shareholder, and the estate has an option to sell the shares
• Should either side wish to exercise their option, the other must comply
• The agreement would specify a timescale for the options to be exercised, normally within three to six months of death.

He says the main advantage of this type of arrangement is that it retains inheritance tax business property relief, as well as achieving the desired result for both parties. Savage also suggests each shareholding director/partner takes out a life policy on his/her own life for the amount of the shareholding and places it in trust for the benefit of the other shareholders/partners.

A trust would ensure that the proceeds would pass to the appropriate people. It can stop other people having access to the funds and it can help ensure the proceeds are available quickly, therefore not requiring probate, plus the proceeds are received tax free.

Deaves adds that expert advice in this area is crucial. She says: “Certain reliefs may also be available to offset tax on death, but these are subject to complex rules so expert advice is crucial. Plans can be put in place to deal with death (or critical illness) which can help the business to continue to operate and pay any asset share to a spouse outside the business but as most family businesses have unique circumstances it’s important to get expert guidance.”

Protection in the event of critical illness

Death isn’t the only factor that can impact a business – critical illness in the form of a heart attack or cancer can also be a problem.

Savage says: “All business owners must consider what happens if they are unable to work due to illness or disability and how this will affect the business and their beneficiaries. They need to consider how the business will be dealt with on their death and how their beneficiaries will benefit or be compensated.”

He says a suitable critical illness insurance policy is probably the best way to provide protection, though a single option agreement may be more appropriate in this instance:

• The shareholder would be able to leave the business if they became seriously ill
• It would give the disabled/ill individual the option to require their co-owners to purchase the disabled/ill shareholder’s share in the business
• The co-owners have no option to force the sale of the disabled/ill shareholder’s share in the business.

Recent Lloyds Private Bank research revealed that wealthier families (those with £250,000 in investable assets) set aside three quarters of their financial assets as an inheritance to go to the next generation. One way to pass on wealth include handing over a share of the family business.

Deaves says passing on family wealth through a business can be an effective way of planning for the future. “But it’s not always workable if say, a family member doesn’t want to work for the business. It also comes with additional risks if it’s the only asset in the family, so future-proofed planning can help mitigate those risks,” she says.

She adds: “It’s really important to take the right steps and professional advice for setting up the best ownership structure, gaining a good understanding of ongoing taxation treatment, considering the impact of ill health or death for key people/owners, and understanding how passing on assets could be treated for inheritance purposes.”