Two friends have run the company together for twenty years, fifty-fifty. One of them dies unexpectedly. On top of the grief, the surviving partner is suddenly faced with questions they had never discussed: who is the new co-owner – the widow, the two children at university? Can the company be kept so that control stays in one pair of hands? And if the heirs would rather have money for the share, where is it to come from? As a broker, what I see is that more and more SMEs think through key-person risk – but almost no one thinks through the ownership and liquidity consequences of a co-owner's death. Yet the legal framework is clear, and the financial solution is not complicated either; it just has to be prepared in advance. This article puts the two steps side by side: the clause in the articles of association and the funding of the buy-out.
- A business share in a kft. (Hungarian limited liability company) can be inherited: under the Hungarian Civil Code (Ptk.), the heir can ask to be entered in the register of members, and unless the articles of association provide otherwise, the remaining members cannot prevent the heir – even a spouse who does not understand how the company works, or a minor child – from becoming a member with full rights.
- The Ptk. allows the articles of association to entitle designated persons to buy out the share within a short deadline, after which the right lapses, by paying the share's market value – but this clause helps only if it was written into the articles of association in advance and there is money to pay for it.
- The money for the buy-out is typically provided by term life insurance: a policy taken out by the members on each other's lives, or by the company, pays a sum sized to the market value on death; the allocation of roles (policyholder, insured person, beneficiary) determines where the money arrives and how it is taxed.
The business share can be inherited: who becomes the new member?
The business share in a limited liability company (kft.) is part of a person's assets and, as such, is inherited. Under the kft. chapter of the Hungarian Civil Code (Ptk. Section 3:170), on the death of a member the heir – upon proving their status as heir – can ask the managing director to enter them in the register of members. Two things follow from this in practice. The first is time: status as heir is typically proven by the probate order transferring the estate, and the probate procedure can take months; until then, there is no one behind the deceased's share who could exercise the membership rights. If the deceased held half or the majority of the shares, the members' meeting may, depending on the articles of association, be unable to form a quorum during this period, and if they were also the sole managing director, the company is left without anyone to represent it – the articles of association can deal with this situation in advance through a second managing director or a substitution rule. The other consequence concerns the person: if the articles of association say nothing, the heir's registration cannot be refused, and the remaining member ends up with a co-owner they did not choose, who may not understand the trade, or who might even sell the share to an outsider. Expelling a member from a kft. is possible only through the courts and for a serious reason – the fact that someone 'does not fit the company' is not such a reason. The article on the policyholder and the insured person covers the allocation of roles from the insurance side; here, it is the ownership side that needs putting in order.
The clause in the articles of association: the right to buy out the share
In the same section, the Ptk. allows the articles of association to entitle certain persons – typically the other members – to buy out (acquire) the inherited share. To do so, the entitled persons must make a declaration under the conditions set out in the articles of association, within the short deadline laid down in the Ptk., after which the right lapses – the rule gives thirty days from when the heir's request for registration takes effect – and must pay the heir the market value of the share; if this happens, the managing director may refuse to register the heir. Three things depend on this clause. First: it applies only if it is in the articles of association – it can hardly be added afterwards, once the death has occurred: a clause written in later cannot be applied to an inheritance that has already opened, and the amendment would also require the consent of the member concerned. Second: the market value can give rise to disputes, so it is worth fixing the valuation method in advance (for example, an independent auditor's valuation, or a formula based on the results of recent years) in the articles of association or in a separate agreement between the members. Third: thirty days is not enough for anyone to raise the price of a whole business share from a loan or from the company's reserves – and this leads on to insurance. Drafting the clause is a job for a lawyer, and it is also worth settling the members' agreement among themselves (who buys what, for how much and by what deadline) in writing. What the sale of a share or the transformation of the company does to existing insurance policies is discussed in the article on selling or transforming the company.
Where does the money come from? Funding the buy-out with insurance
The money for the buy-out should not be searched for after the death but built up in advance – and this is what term life insurance is for, which insurers also offer under names such as key-person, business-partner or partner insurance; the name varies from insurer to insurer, what matters is the allocation of roles. One arrangement is cross-insurance: each member takes out a policy on the life of the other, acting as both policyholder and beneficiary, so the death benefit arrives with them as a private individual, and from it they pay the heirs the market value. Since the policyholder and the insured person are not the same person here, the written consent of the insured member is required to conclude the contract (Ptk. Section 6:475) – this also applies to the company variant below. With more than two members, this means several policies, and the premiums differ depending on the members' age and health, which the members would do well to balance out among themselves. The other arrangement is for the company to be the policyholder and the beneficiary, with the member as the insured person – this is the logic of key-person insurance, described in the article on the managing director's absence. Here the money arrives at the company, and the company would buy its own business share; however, the Ptk. sets limits on this (a company may acquire its own share only from assets in excess of its share capital and only up to a certain extent), so this variant has to be thought through with a lawyer and an accountant before the roles in the policy are finalised. It is worth sizing the sum insured to the estimated market value and the ownership stake, and reviewing it every few years, because the value of the company changes. Alongside death, it is also worth covering permanent total incapacity for work or disability, if the articles of association also provide for a buy-out when a member drops out in this way – insurers offer this as supplementary cover, with conditions that vary from insurer to insurer. What insurance does not solve: designating the buyer and the seller, the price and the deadline – these are matters for the articles of association and the members' agreement; insurance only puts the money on the table when it is needed.
Tax and accounting – in outline
The taxation of the arrangement depends on the allocation of roles, and this needs to be clarified with the accountant or a tax adviser before the contract is signed. The treatment is different if the members pay the premium as private individuals, from their own already-taxed income, and different again if the company pays it for the benefit of a private individual beneficiary; it is different if the beneficiary is the company and the benefit becomes the company's income – in that case, if the company is entitled to the insurer's benefit without restriction, the premium does not create income for the insured member under Section 7(1a) of the Personal Income Tax Act (Szja tv.). The Personal Income Tax Act's rules on tax-exempt income typically treat the death benefit of term insurance as tax-free for a private individual beneficiary, but the tax consequences of the company paying the premium depend on who the insured person is and who the beneficiary is – this is not something to build on assumptions. How the accountant and the broker share this work is covered in a separate article.
What should you do now?
Take out the articles of association and check what they say about a member's death, the inheritance of the business share and the right to buy it out; if they say nothing, this is the first task, together with a lawyer. The members should record in writing who would buy the deceased's share, using what valuation method and by what deadline, and should provide for a second managing director or a substitution rule. Then size the term life insurance to the market value and the ownership stake, decide on the allocation of roles with the accountant involved, and check every year whether the sum is keeping pace with the value of the company. If you let me know, I set out the role-allocation variants and the insurers' offers in a comparable table, and I help where I can; amending the articles of association and the members' agreement is a job for a lawyer, and the tax treatment is a job for the accountant.
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Sources
- Hungarian Civil Code (Ptk., Act V of 2013) – inheritance of a kft. business share and succession (Section 3:170), acquisition of the company's own business share
- Personal Income Tax Act (Szja tv., Act CXVII of 1995) – tax treatment of term (risk) insurance, tax-exempt income (Annex 1)
- Bankmonitor – Life insurance: can a co-owner's death mean bankruptcy?
- Wolters Kluwer – How the heir to a business share becomes a member (BH2020. 19.)
