Most people know that a will is an important piece to the estate planning jig-saw. As discussed in a previous article, a Buy/Sell Agreement is an important part to the larger Shareholders’ Agreement, which is also an important piece to the estate planning puzzle.
Buy Sell Agreement Between Business Partners
Let’s consider a company where there are 3 equal shareholders. It is currently valued at $1,000,000. The partners have agreed to details in a Buy/Sell Agreement whereby if a partner dies, each surviving partner must be offered the deceased partners shares, valued according to the formula stated in the Agreement. If a partner dies tomorrow, how will the surviving partners fund their purchase? Each partner would owe $166,667 to the deceased’s estate, assuming the Agreement requires the partners to maintain equal ownership. There are a number of methods by which the share transfer may be structured, which should be detailed in the Agreement and crafted in consultation with both the necessary legal and accounting professionals.
The most immediately effective and least expensive method of funding a Buy/Sell Agreement is with life insurance. A typical share purchase scenario will be discussed below, with the following assumptions:
1. the adjusted cost base of each partner’s block of shares is $1,000.
2. being a Canadian-controlled private corporation, the shares qualify for the enhanced capital gains exemption and no shareholder has taken advantage of the exemption.
3. the Agreement requires the purchase of life insurance in the amount of $333,333 on the life of each partner. The policies are owned and premiums paid by the company. The company is named the beneficiary of each policy. The adjusted cost base of each policy is nil.
Upon the death of shareholder A, shareholders B and C would purchase equal portions of all A’s shares, from his estate, with a promissory note (as stipulated in the Agreement).
Now that B and C own 100% of the company’s shares, a corporate dividend is paid to B and C from the life insurance proceeds. The dividend payment is tax free because it is paid out of the capital dividend account into which the insurance monies were paid. With each of B and C receiving $166,667 tax free, they then pay shareholder A’s estate and redeem their promissory notes.
Shareholder A is deemed to have sold his shares prior to death for $333,333. The capital gain is this amount less the $1,000 cost base. Half of the capital gain must be reported on his terminal tax return. However, this amount ($166,167) qualifies for the enhanced capital gains exemption and therefore is not subject to income tax.
Since shareholder A’s estate receives the shares at a cost base of $333,333, and the sale to B and C is at $333,333, there are no taxes payable by the estate.
Shareholders B and C each own shares valued at $500,000 with a cost base of $1,000 plus $166,667. This will be important for tax purposes on the future sale of any shares by B or C.
As mentioned earlier, it is very important to get knowledgeable advice regarding the structure of the Buy/Sell Agreement. There are several good methods of crafting the document based upon the specific situation. It is then important to involve a competent life insurance agent to provide the most appropriate life policies in order to fund the Agreement.
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