Since structuring buy-sell arrangements can be very flexible, and provide unique benefits and challenges to both the buyer and seller, it’s necessary to have a global scope of the needs of each party. Let’s see how our sample clients, Bradley Armbruster and Franklin Jones, structured their buy-sell. Keep in mind that I will be oversimplifying some of the numbers to create a clean example. Most actual cases will have different wrinkles, which may not result in such a straightforward situation.

Upon questioning, Franklin and Bradley said they both decided they wanted a relatively simple structure for their buy-sell for now, and wanted each party to be responsible for any taxes owing upon disposal of their shares. They also wanted tax-efficient payment of premiums, preferably with after-tax corporate dollars. Remember that we assumed that their business was worth $6 million, and they each owned 50% of it, with no holding companies involved. We also assumed that the adjusted cost base of each of the shareholder’s shares of the company is $1.5 million. Currently, Franklin is a 40-year-old non-smoker with no health issues, and Bradley is a healthy 50-year-old non-smoker.

Their advisor suggested that they consider using the Promissory Note method of buy-sell funding. Franklin and Bradley would be able to pay for their premiums with after-tax (non-deductible) corporate dollars, and could be covered for $3 million each, for about $670 per month, with a renewable and convertible 10-year term product (with rates increasing each 10-year period).

If they want to lock in their rates for the rest of their lives with a permanent plan, they could access a wide range of Term-to-100 plans, universal life or whole life plans, which would allow them to guarantee insurance costs for the rest of their lives, or even pay up their policies in a short time frame. For simplicity’s sake, we will concentrate on the term coverage mentioned above. The coverage is owned by the corporation, the premiums are paid by the corporation, and the beneficiary is the corporation.

We will assume that, in five years, Bradley dies an untimely death, and the company is still worth $6 million. There was still a good decade or more of accomplishments Bradley wanted to focus on. His business partners and family must now focus on ensuring that his family and business legacies continue to thrive. The buy-sell trigger inside their shareholders’ agreement is exercised, and the result is a transaction where Franklin takes over ownership of the business.

Based on the advice of their advisor and tax accountant, Franklin and Bradley had both agreed to structure the buyout in a way that would afford the utilization of the $750,000 capital gains exemption. Capital gains are calculated based on proceeds of disposition of an asset less the taxpayer’s adjusted cost base (ACB).

Since the 2007 federal budget, individuals are able to exempt $750,000 of value of a Qualified Small Business Corporation. There are a number of tests in order to qualify, (an accountant is best to advise whether your client’s business qualifies) but essentially the business must be a Canadian Controlled Private Corporation of which all or substantially all of the assets (i.e. 90%) are used in an active business carried on in Canada. (There are other tests as well, but that could be an entire article unto itself.) We are assuming the shares of Jones Manufacturing do in fact qualify for this exemption, and that the exemption will be used to minimize tax.

Upon Bradley’s death and after satisfaction of any proof-of-death requirements to the insurer, the death benefit will be paid to the company tax-free. With a simple, mandatory buy-sell agreement, Franklin would purchase Bradley’s shares from his estate with a promissory note as payment. Now that Franklin owns 100% of the company, he declares a tax-free capital dividend of $3 million, funded by the insurance proceeds, and pays off the promissory note. (The adjusted cost basis of this particular term policy in year five was $0, thus a full capital dividend credit was available). Bradley’s taxable capital gain on the sale would be $1.5 million, against which he would claim the capital gains exemption, leaving a taxable capital gain of $750,000.

You might be wondering if there is a way to multiply use of the capital gains exemption by involving Bradley’s wife. The answer is yes, but it’s complicated. To access the surviving spouse’s capital gains exemption, the remaining shares would need to pass to the surviving spouse and “vest indefeasibly.” This means that she owns the shares and is not required to sell them. So, a mandatory buy-sell agreement between Bradley and Franklin would not allow for this to occur.

If the agreement was not mandatory, it would allow for the shares to pass to the surviving spouse first (on a rollover basis) and then be purchased by Franklin. But this could present a big problem! Franklin doesn’t want to take the chance that Bradley’s wife would not agree to sell.

An alternative would have been to have a put-call option in the shareholders’ agreement that would have provided Franklin with the option to call in the shares from the spouse or provide the spouse with the option to put the shares to Franklin for purchase. This could be used in combination with the promissory note method, to enable Bradley’s estate to claim the capital gains exemption in respect of a sale of some of the shares to Franklin. And Bradley’s spouse would have the ability to claim the capital gains exemption in respect of the remaining shares on her sale of shares to Franklin. Franklin would purchase each set of shares with a promissory note and use the life insurance proceeds via the capital dividend account to repay the promissory notes.

This method must be specifically contemplated in the shareholders’ agreement. That is, you can’t just try this method after the fact with a mandatory buy-sell agreement.

In this example, it was possible for Bradley’s family to essentially avoid tax on disposition of their shares (there may be some impact due to AMT — Alternative Minimum Tax — but for simplicity’s sake, we are not discussing that in this short article). By using his capital gains exemption, rolling some shares to his wife, and using hers, Bradley’s family effectively extracted the value of their company upon his death with little to no tax cost.

The benefit to Franklin is that by buying the shares of Jones Manufacturing via a promissory note, he receives an increase in the ACB of his shares. If the company were to have purchased the shares from Bradley’s estate and cancelled them, increasing Franklin’s net value, Franklin would not have received an ACB increase.

From a tax perspective, both parties derived favourable tax consequences by engaging in more complex planning. During such a difficult time as an untimely death, planning that brings about tax-effective results to all parties is ideal to avoid any other emotionally charged situations.

Read part 1 and part 2 of Chris’s articles on buy-sell transactions.

Chris Paterson is vice-president of sales, living benefits, at Manulife Financial and has over 13 years of experience marketing various insurance products.