Like most entrepreneurs you probably appreciate the importance of having a will to deal with the tax consequences of your death. But are you aware of the role that your shareholders’ agreement can play in your estate planning?
Normally a shareholders’ agreement is negotiated at a time when all of the parties are getting along and are healthy. The primary purpose of such an agreement is to define the relationships among the parties and to deal with the possibility that these relationships may sour or that the parties may change due to disability or death. If not structured properly, survivorship arrangements in shareholders’ agreements can have unintended and significant tax consequences.
In general, Canada’s Income Tax Act deems an individual to have, immediately before death, disposed of all of his or her capital property, including shares of a private corporation, at fair market value (FMV). The deceased individual will realize a capital gain on the deemed disposition to the extent the FMV of the capital property exceeds the tax cost, and 50% of such gain might be subject to tax depending on the availability of a capital gain exemption for qualifying small business shares. The deceased’s estate is deemed to acquire the shares at FMV, which becomes the new adjusted cost base of the shares.
Commonly, shareholders’ agreements are structured so that the corporation is required to purchase the deceased’s shares, and the estate is then deemed to receive a dividend. Without getting bogged down in the details, it may be possible for the estate to realize a capital loss with such an arrangement, and for that capital loss to be carried back to the terminal year of the deceased to offset capital gains realized by the deceased in the terminal year. Before
April 27, 1995 it was possible to wipe out any tax being paid by the deceased and the estate with respect to the shares in this way.
Today, dividend stop loss rules will result in the denial of part of the capital loss that an individual or an estate would otherwise realize on a disposition of shares by a portion of the capital dividends received on the shares. There are a few exceptions to the newer rules, as wells as grandfathering provisions that can apply in certain circumstances.
If not structured properly, survivorship arrangements in shareholders’ agreements can have unintended and significant tax consequences.
Where exceptions and grandfathering do not apply it may be more beneficial for the estate to sell the shares to the surviving shareholder(s), rather than for the corporation to purchase
the deceased shares for cancellation. Drafting flexibility into the shareholders’ agreement in order to allow for either a purchase for cancellation or a purchase by the surviving shareholder(s) is helpful since at the time the agreement is drafted, it would be impossible to foresee which course of action would be most beneficial at the time the purchase is exercised.
The preceding touches on only a small fraction of the tax considerations for shareholders’ agreements. Give us a call to see how these planning techniques as well as put/call options or estate rollover provisions in your shareholders’ agreement can be used to further reduce the taxes payable by your estate.