Planning for the death of a shareholder shouldn’t be considered morbid—it makes smart business sense.
And proper provisions in a shareholders’ agreement can help make the buy-out of the deceased’s shares tax effective; and lessen the tax burden on their family.
The purpose is to give the family a market for those shares and also permit the other surviving shareholders to carry on business without having the deceased’s family involved.
When a business owner dies, it’s often necessary to do some tax planning to avoid double taxation. This is where a shareholders’ agreement comes in handy, but take care to ensure the terms don’t limit or frustrate an appropriate tax plan.
It pays to know the rules. At death, Canada’s Income Tax Act deems a person has disposed of his or her capital property (including shares of a private corporation) at fair market value. But a person can transfer capital property to a spouse to defer the tax on capital gains until the sale of the property or upon the spouse’s death. This spousal transfer is often an essential element in a tax-efficient buyout of the deceased’s shares, and the details of a shareholders’ agreement should allow for this.
Who buys the shares?
If a buy-out occurs after a death, the shareholders’ agreement should identify who will purchase the shares from the deceased’s estate or surviving family members: the remaining individual shareholders or the corporation. Tax implications will dictate which choice is better.
If the remaining shareholders buy the shares, the tax result for the deceased and family is a capital gain equal to the difference between the purchase price and the tax cost of the shares. That gap can be very large, which means the remaining shareholders will buy additional shares at a tax cost equal to the amount paid for the shares.
Read: Avoid surprises
If the corporation buys the shares, the tax result for the family is a dividend equal to the difference between the purchase price and the tax paid-up capital of the shares (the value of the capital the owner has put into the business), which may or may not equal the tax cost of the shares. While dividends are generally taxed at a higher rate than capital gains, if the corporation has a positive balance in its capital dividend account, proper tax planning could reduce or even eliminate this rate.
In a common buy-out plan, the corporation buys life insurance for shareholders and uses the proceeds to buy back the shares. If the amount of life insurance (and resulting capital dividend account balance) is sufficient to cover the purchase price, or at least the deemed dividend that results, and the deceased shareholder transfers shares to a spouse, the taxes can be eliminated. So the spouse gets the purchase proceeds tax free.
Proceed with caution
The devil is in the details. Structuring a shareholders’ agreement is not easy. For instance, not everyone knows it’s more difficult to reduce or eliminate tax if shares are not transferred to the spouse or if the transfer is tainted under the tax rules. The specific terms of a shareholders’ agreement should be analyzed by a tax professional to avoid unintended—and costly—consequences.
This article was originally published on capitalmagazine.ca.