A Revitalized Look at Shareholder Agreements: Uncovering the Unintended Results

By Gary Clark

2006 CALU Annual Meeting, May 9, 2006

A Cut Above

Reviewing a client's or prospective client's shareholder agreement can create instant credibility for the advisor who is able to identify pitfalls and provide workable solutions that add value to the business succession plan

Insurance advisors are well positioned to help clients or potential clients plan for business succession. In order for an advisor to review a shareholder agreement, he or she should have an understanding of the tax implications of the various corporate structures and the role insurance can play in funding the agreement. The capital dividend account created by the corporate receipt of life insurance proceeds is frequently used under the terms of a buy/sell agreement and different strategies can be used to structure the purchase and sale of a deceased shareholder's shares.

From an insurance perspective, there are a number of issues in a shareholder agreement that could be problematic or uneconomical for the client and identifying those issues is key. When reviewing agreements, advisors will often discover that what will actually happen upon the death of a shareholder and what the client wants to happen are not the same.

Identifying the issues

There are three ways in which a shareholder agreement can be structured: a "cross purchase," an agreement between shareholders; a "corporate repurchase," an agreement between the shareholders and the corporation; and a "hybrid" agreement, a combination of both.

When working with business owners, advisors may find that there is either no agreement in place, an agreement has been drafted but unsigned, an agreement has been signed but isn't tax efficient, or it fails to reflect the client's current wishes. Agreements are often like wills: once signed, they are seldom revisited.

The following are examples of clauses commonly found in a shareholder agreement and their potential pitfalls. Understanding and identifying deficiencies in the agreement will allow you to make recommendations to the client that will ensure a problem-free succession plan in the event of a shareholder's death.

1. The agreement restricts the trading, assignment or hypothecation, etc., of shares of the company, but not of the holding companies owning the shares, if they exist.
   The agreement could be circumvented by selling the shares of the holding company. A shareholder could be allowed to transfer the ownership of shares to a holding company, provided he or she maintains voting control. Some agreements state that a transfer is acceptable as long as the principal shareholder maintains 50 per cent voting control. Fifty per cent ownership would not provide control. The agreement should bind the new holding company to the terms of the agreement.
2. Life insurance proceeds received by the corporation are not excluded in the valuation formula.
   Without specific reference to the exclusion of life insurance in the valuation formula outlined in the shareholder agreement, an executor could claim that the value of the company has increased by the amount of the life insurance received.
3. Shareholders can be associated if the agreement calls for an "option" to purchase shares on partial disability, receivership, shares attached under a matrimonial property settlement or retirement of a shareholder.
   This is a common clause that can eliminate the low corporate tax rate for the business where a shareholder owns shares of another active business. There is the presumption by the Canada Revenue Agency (CRA) that the "option" results in control, therefore associating the companies for tax purposes.
   An "option'' does not associate the companies upon death, permanent disability or bankruptcy.
4. A trustee is to be the owner and beneficiary of the life insurance to fund the agreement.
   The intention of this arrangement is to ensure the insurance funds will be applied for no other purpose than to purchase shares from the deceased shareholder. There is some question, however, as to whether the insurance, which is to be directed to the corporation by the trustee, will create a credit to the corporation's capital dividend account. The client's tax advisor should be consulted for an opinion.
5. 5 - A withdrawing shareholder is entitled to acquire the life insurance policy on his or her life before the buyout is complete.
   This is also a common clause that can create a problem for the purchaser. The purchase may be financed over time, however, the withdrawing party is entitled to acquire the ownership of the policy that was to fund the agreement. A better arrangement could be to state that the insurance can only be transferred once the shareholder (or the financing) has been paid in full.
   Another alternative could be to split the beneficiary designation as the debt is reduced and each party pay a proportionate cost of the insurance.
6. 6 - Upon a shortfall in the funding of the purchase of a deceased's shares (insufficient insurance), the estate must transfer the shares on an initial down payment with no recourse for default.
   The agreement should provide for the securitization of the unfunded debt or it will invoke penalties for a default in payment.
7. An unintended control position can result when there are unequal shareholdings and the agreement calls for a corporate repurchase or a pro-rata cross purchase.
   If shareholders own 40 per cent, 38 per cent and 22 per cent, for example, a change of control will result on the death of any shareholder. A different planning strategy may be required.
8. The purchase price between parties not dealing at arms' length fails to reflect fair market value (FMV).
   The deceased's estate could be taxed on the amount deemed to be fair market value by CRA. If the agreement is a cross purchase, the purchaser's cost base would not be increased to the value determined by CRA.

Agreements: optional versus binding

Some agreements state that a deceased's estate has an "option" to remain a shareholder or to sell within a specified number of days (60 to 90). This occurs when a shareholder would not want to deprive the heirs the opportunity to benefit from the future growth of a vibrant business. A problem can occur, however, in the funding of the agreement with life insurance. As the life insurance proceeds are received after death, it could be argued that the deceased's estate should participate in the increased value of the business related to the receipt of the insurance proceeds.

The decision by the estate to remain a shareholder and subsequently sell their interest when income falls short of expectations creates a problem for the purchaser(s). This is because the insurance proceeds may have been used to reduce corporate debt or fund expansion. This may increase the value of the business and leave no insurance funds available to complete the purchase.

A better solution might be to have a mandatory buy-out on death and allow the deceased's estate the right to buy back in within a three- to six-month period. However, once the heirs have received a significant amount of cash from the estate, they may not be motivated to buy back in.

Life insurance funding of agreements (ownership)

Many life insurance-funded agreements call for the corporation to be the owner and beneficiary of the insurance. There are certain difficulties in this ownership structure:

The cash values become an asset of the corporation, which can be attached by creditors. Cash values increase the value of the corporation for buy-sell purposes (and disappear off the balance sheet upon death).

Insurance proceeds received by the corporation could be greater than the value of the shares to be purchased, there by creating a windfall for the surviving shareholder(s).

The transfer of a policy on the life of a withdrawing share-holder could be a taxable disposition when the policy's cash value exceeds its cost base.

• A transfer of a policy on the life of a withdrawing shareholder could also be a taxable disposition when the life insured is uninsurable. The policy is deemed to be acquired at its FMV. What is FMV if the shareholder is uninsurable?

Alternative ownership

As an alternative to the corporation as owner and beneficiary arrangement, each shareholder could own the insurance on their own life through their holding company, naming the operating company beneficiary in an amount sufficient to fund the agreement (shared ownership or split dollar arrangement).

Cash values become an asset of the holding company (Holdco) and not the operating company (Opco), thereby removed one level from creditors. The cash value of insurance owned by Holdco will have no impact on the FMV of Opco. The cost can be the same to the Holdco as to Opco by the use of inter-corporate dividends. The holding company would need to own more than 10 per cent of Opco's shares for the dividend to be tax-free.

This arrangement enables the holding company to accrue tax-sheltered cash through a universal life policy and fund the agreement. The Holdco would be the beneficiary for insurance in excess of the purchase price (i.e., accumulation fund of the policy).

If the life insurance exceeds the value of the shareholder's interest, a split beneficiary designation between Opco and Holdco could assure the shareholder that the total amount of insurance would benefit his or her heirs. In addition, there would be no cost incurred by a withdrawing party wanting to acquire the policy on his own life as the policy has been owned by the Holdco.

Another significant advantage of this arrangement could be that the capital dividend account credit is not reduced by the policy's cost base, provided there are sufficient business reasons for the arrangement. CRA has indicated that the policy's adjusted cost base (ACB) belongs to the policyowner.

Purchasing shares

Small business gains exemption

Many agreements call for the corporate repurchase of shares without recognizing the availability of the $500,000 "small business gains exemption" (SBGE). The deceased could be bought out tax-free, to the extent of the SBGE, and provide the surviving shareholder(s) an increase in cost base (hybrid buy-sell). Many agreements fail to take advantage of this opportunity.

Funding shareholder loans

Often the agreement will ignore the funding of shareholder loans, as these funds are tax-paid. Shareholder loans normally arise when a company has bonused out earnings in excess of the low corporate tax rate and the funds are re-loaned back to the company to finance its operations.

Life insurance often provides the cash to complete the purchase of shares on the death of a shareholder. The shareholder's loan, however, is usually to be paid over time. Generally, these loans are not liquid and therefore have to be repaid out of "new" after-tax earnings.

If life insured, the corporation receives the liquidity it requires to repay the loan, which would increase the value of the company and create a capital dividend account credit for the benefit of the surviving shareholders. Alternatively, the funds could be paid out to the surviving shareholders by a tax-free dividend and re-loaned to the company and applied to repay the deceased's shareholder loan. The benefit of this arrangement is that the shares have not increased in value and new shareholder loans have been created for the surviving shareholders.

Valuation of shares

Many agreements state that the shareholders will determine the business value following each fiscal year end. This seldom occurs. The agreement will often say that if the shareholders have not established a value within 18 months, the company's accountants are to determine the value. If a triggering event has occurred, such as the death of a shareholder, the accounting advisors will have a conflict of interest as they would be acting on behalf of the company with whom they would have a continuing relationship and would not be acting for the deceased's estate.

An alternative might be to have each side select an accountant who will then select a third-party accountant. The decision of this accountant would then be binding. Some agreements call for a business valuator to be hired to do a complete valuation or for the parties to seek arbitration. Both strategies, however, may be expensive and unnecessary.

Grandfathered status of shares

Prior to April 26, 1995, a deceased shareholder could be bought out tax-free to the extent of the life insurance received by the corporation. The repurchase of shares is considered a deemed dividend and, by agreement, the dividend is to be elected out of the capital dividend account created by the receipt of insurance proceeds.

The stop loss rules limited the tax-free repurchase of shares to 50 per cent of the deemed dividend, making the remaining 50 per cent taxable. The Conference for Advanced Life Underwriting (CALU) negotiated the "grandfathering" of shares owned prior to the April 26 date. Shares were grandfathered on two basis: restricted and unrestricted.

On a restricted basis, shares are grandfathered if there was an agreement in place prior to April 27, 1995, which called for the repurchase of shares. Insurance can be added at any time, however, the agreement cannot be significantly altered. The shares cannot be changed and, if rolled into a holding company, the shares of the Holdco would not be grandfathered.

On an unrestricted basis, shares are grandfathered where a corporation was named beneficiary of a life insurance policy on or before April 26, 1995, and where a " main" purpose was to repurchase shares.

An agreement can be added or changed. Shares can be rolled into a holding company and retain status. The shares can also be reorganized. It is important to note that the insurance grandfathers the shares and not the insurance policies themselves. In each case, insurance may be added, increased, replaced or converted without jeopardizing the status of the shares.

Occasionally, lawyers unfamiliar with these rules draft agreements calling for the repurchase of shares, electing the deemed dividend out of the corporation's capital dividend account, with no knowledge of the grandfathered status of the shares. The repurchase of shares that do not qualify could waste 50 per cent of the capital dividend account and create tax in the estate.

If the deceased shareholder has a surviving spouse to whom the shares could be rolled, the purchase could still occur tax-free. The agreement would provide for the surviving spouse to "put" the shares to the company within 60 days, after which the company could "call" for the repurchase if the "put" had not been exercised. As the spouse's shares would be repurchased by a capital dividend, the repurchase would occur tax-free.

Every business succession plan is unique and reviewing a client or prospective client's shareholder agreement provides an opportunity to create value, gain trust and grow the relationship. The funding of the agreement with life insurance becomes simply part of the process, as it is the most reasonable, economical and logical way to provide cash when needed. Having a sound knowledge of agreements and being able to identify their deficiencies can build your credibility as an insurance advisor and give you the edge you need to stay ahead of the competition.

This article originally appeared in the July 2005 issue of FORUM magazine. Reprinted with permission from the Financial Advisors Association of Canada (Advocis).