Business Owners: Shareholders Agreement
Whether it’s a family owned business or one owned by unrelated individuals, for private companies with multiple shareholders, a shareholders’ agreement can be an important tool for maintaining a healthy relationship between the owners.
A shareholders’ agreement outlines individuals’ expectations, serves to minimize the potential for conflict and provides a mechanism to resolve disputes. Generally, it covers any or all of the following three areas:
Ownership – This can be one of the most important provisions of an agreement, especially if you don’t want to end up in business with your business partner’s spouse or kids. An agreement may restrict shareholders from encumbering or transferring shares without the consent of other shareholders and outline the procedures that must be followed on a third-party sale or a buyout of existing shareholders. The agreement may also discuss the procedures to follow upon the death, bankruptcy, disability, inactivity/retirement or marital breakdown of a shareholder.
Management – Particular business decisions such as the purchase or sale of certain assets or hiring/firing of key employees could be required to have unanimous or majority shareholder approval. Employment terms for the shareholders may also be documented, as well as restrictions imposed on their business activities outside of the company.
Financing – An agreement may address the method and terms by which the company can obtain additional funds and also how the retained earnings of the company will be used in situations such as repaying loans or declaring dividends.
Prior to implementing any shareholders’ agreement, we recommend consulting with a legal and tax advisor.
Revisiting the Buy-Sell Agreement
Buy-sell agreements on death, whether stand-alone or as part of a shareholders’ agreement, are used to ensure a successful transition of the company. Here are some considerations when preparing/reviewing an agreement:
Funding the Buy-Sell — The effectiveness of the buy-sell provisions oftentimes depends on the ability of the surviving shareholder(s) or the company to fund the transaction. If funds are not readily available, the company may need to sell assets or obtain external financing, which may negatively impact operations.
If the company has accumulated cash to fund the buy-sell, this surplus may be viewed as a passive asset that results in the shares of the company not qualifying for the lifetime capital gains exemption, foregoing tax savings.
Tax Implications — Tax implications will depend on whether the buy-sell agreement requires the purchase of shares by a surviving shareholder or a share redemption/purchase for cancellation by the company. A share purchase may give rise to capital gains in the hands of the selling shareholder or his/her estate, while a share purchase by the corporation (known as a purchase for cancellation) may result in a deemed dividend.
Capital gains are generally subject to a lower rate of tax than dividend income (except in Alberta and the Yukon for eligible dividends). The difference between these two approaches can be further magnified if the capital gains exemption is available.
However, if life insurance is used to fund the purchase obligations under the agreement, all or a portion of the proceeds may be received as a tax-free dividend through use of the company’s capital dividend account (CDA).
Hybrid buy-sell provisions that allow for a share purchase and/or redemption/purchase for cancellation can provide greater flexibility for tax planning purposes.
Capital Dividend Account — If corporate insurance exists, the buy-sell terms must specify that the company treats dividends paid to the deceased shareholder, to the extent of the insurance proceeds, as tax-free capital dividends. Otherwise, case law provides that surviving shareholders could make the dividends to the deceased’s estate taxable and retain the CDA for their own future benefit.