A major consideration in structuring a Buy/Sell Agreement for dealing with the potential of the death of a shareholder is ensuring that the remaining shareholders have the financial means to pay for the purchase. The estate wants to be sure that the proper value of the business interest can be received in a timely fashion.
Whether the shareholder is departing voluntarily or because of death or disability will have a direct bearing on the options available.
Funding a Buy/Sell Agreement with Life Insurance
Life insurance taken out on the life of a shareholder/partner will provide a tax-free, lump sum payment to the beneficiary which can be used to purchase the business interest from the estate of the deceased. The structure of the insurance coverage will be dependent on whether the Entity or Criss-Cross approach is used.
Corporations and Funding Buy/Sell Agreements
Corporations and their shareholders have the choice of funding Buy/Sell agreements through the Entity or Cross Purchase or Entity approach.
Share Redemption (Entity) Approach
In this approach, the corporation as an entity will purchase the shares from the estate of a deceased shareholder. When there are numerous shareholders, this strategy is usually preferable to the Cross Purchase agreement since the corporation deals directly with the estate and each shareholder is not required to deal with the estate. The estate only has to deal with one party (the Corporation).
The taxation of the share redemption approach is very complex. Prior to 1995 the mechanism could be done on an essentially tax-free basis but since that time the tax rules have become more onerous and there will probably be some tax consequences. Careful planning with professional tax advice should be undertaken.
Cross Purchase Approach
In this approach the surviving shareholders agree to purchase the shares from the estate of a deceased shareholder. The insurance to fund a Buy/Sell agreement using the Cross Purchase approach can be structured two ways:
Each shareholder takes out insurance policies on each other shareholder and uses any death benefits to purchase shares directly from the estate of the deceased shareholder.
The Corporation takes out insurance policies on the lives of each shareholder and on a death of the shareholder, flows through death benefits to the surviving shareholders to use to purchase the shares from the estate of the deceased. There are several ways to do this and a careful analysis of the tax situation is required to determine the best course of action. Advantages to this approach are that the number of insurance policies required is kept to a minimum and the actual payment of the premiums can be tracked.
One advantage of the Cross Purchase approach is that if the shares qualify, the shareholder’s estate may be able to take advantage of the $750,000 capital gains exemption which can materially affect the amount of tax payable.
How can Buy/Sell Agreements for a Partnership be structured and funded?
There are two basic types of Buy/Sell Agreements for a partnership interest:
Cross Purchase Agreement
This approach involves an agreement between the departing or deceased partner and the remaining partners rather than with the Partnership. In this case all the partners agree to purchase the interest of the departing or deceased partner at an agreed value and the departing partner would obligate his or her estate to agree to the sale.
Yves, John, and Sarah were the three equal partners in YJS Partners, a metal fabricating firm. They had a Cross Purchase agreement in place whereby if a partner decided to sell their interest or died then the others would each purchase a 50% share for its appraised value from the departing partner or his or her estate. Yves was considering going out on his own and offered to sell his interest to the others for $200,000 or $100,000 each, its appraised value. John and Sarah then each purchased the interest for $100,000 each leaving them 50:50 partners.
The Entity Approach
With the entity approach, the partnership itself is obligated to purchase the Partnership interest from the estate of a deceased partner. This approach is not used much in Canada since there can be tax complications that can result in double taxation to the deceased partner and the surviving partners.