Obligations, Remedies, Liquidity are powerful words. A shareholders’ agreement is a contractual undertaking under which each shareholder and the corporation assume certain rights and obligations. Yet, when we think about these words in the context of a shareholders’ agreement, there are a number of questions that are brought to mind.

Why do parties not have a shareholders’ agreement for their business?

“Everything is fine. We have known each other for years. There is no need for an agreement.”

“If we write it down then it is written in stone and we cannot change it.”

“I am not going to spend $X on legal fees. That costs money.”

“I am too busy to look at this right now. Catch me after the busy season…”

“We are brothers. We are family.”

“It is a complicated process.”

Truthfully, this is not an exercise to be taken lightly. It can be a complicated process to draft the shareholders’ agreement to reflect the different parties’ intentions. So, who should be involved in this process? You need professionals that understand both the legal and tax aspects working closely together. Secondly, and just as important, is the ability of the professionals to explain to the shareholders the tax and practical implications. Parties will need to rely on professionals experienced in this area that can address a number of factors, such as:

-Are the shares owned personally or through a holding company?

-Are there multiple shareholders and are there significant age discrepancies?

-What is the value of the business and what is the relative shareholdings of each party?

-Are these arms length parties, related, or associated for tax purposes?

-Will the individuals have the ability to claim the capital gains exemption?

-Will there be the option to have the sale proceeds be paid over a number of years?

So, why should parties care if they don’t have a shareholders’ agreement?

You could say it will not change anything. You could have the belief that if one of the parties passed away that the family of the deceased and the remaining shareholder(s) will work out a harmonious result where both parties are satisfied. It can happen. However, there is no certainty in this.

If there is a shareholders’ agreement in place, it will contain provisions that will apply in the event of a shareholder’s death. These important buy-sell provisions help ensure an orderly transition of the deceased shareholders’ shares. It will outline how the purchase on death will be structured. 

The objective is to minimize shareholder disputes by having an action plan to follow upon death, or other events, such as:

-Disability

-Marriage breakdown

-Financial Difficulty (Insolvency, Bankruptcy)

-Retirement

Buy-sell provisions provide obligations, enforceability and remedies under these events. There is now certainty.

If a buy-out is to occur after a death of a shareholder, the shareholders’ agreement would identify who will purchase the shares from the deceased’s estate or surviving family members.

No matter who is identified to purchase the shares (the remaining shareholder or the corporation), funding the purchase price can be a challenge when it comes to liquidity. Think of the size this can be. Are we talking about a purchase price of $1 million or $2 million or $10 million or $20 million?

Options can include:

-Using personal savings (self funding)

-Borrowing funds (a loan)

-Pre-funding with life insurance

-Selling assets

-Paying the Estate on an installment basis (internal financing)

Many of these options can certainly have unintended tax, risk, and practical consequences. For example, if the purchaser is the surviving shareholder and corporate assets are to be extracted to fund the purchase price, additional tax will arise, unless the corporation has a sufficient balance in its capital dividend account (CDA).

CDA is defined in subsection 89(1) of the Income Tax Act (ITA). It is a notional tax account that tracks various tax-free amounts accumulated by a private corporation. Such accumulated amounts may be distributed to the corporation’s Canadian-resident shareholders free of income tax (tax-free).

Many shareholders are unaware that pre-funded corporate owned life insurance proceeds less adjusted cost basis triggers the CDA and provides an opportunity to distribute their value out of the corporation on their death to the surviving shareholder(s) or family members tax-free. It provides immediate liquidity on death --- a tax-efficient remedy, for both parties.

Next steps

1. Review your existing shareholders’ agreements.

2. If you don’t have one, then is it because of one the reasons identified earlier. Start the process.

3. Ensure there are provisions in the agreement that address various events that can impair your business.

4. Analyze how the shareholders’ agreement will be funded.

5. Ensure there is a liquidity mechanism and structure in place that reduces the financial risk for both parties.

Jos Herman, BComm, CPA, CA, CFP, CLU, TEP

Executive Advisor 

Wealth & Estate Planner

This material is for information purposes only and should not be construed as legal or tax advice. Every effort has been made to ensure its accuracy, but errors and omissions are possible. All comments related to taxation are general in nature and based on current Canadian tax legislation for Canadian residents, which is subject to change.