What to Look for in Shareholders' Agreements

HUB often receives inquiries about shareholder agreements, and how an insurance professional can analyze them for the purpose of making funding recommendations. Understanding the key elements of an agreement will enable advisors to work with other professionals in a way that facilitates positive outcomes for clients. We are pleased that Glenn Stephens, LL.B, TEP, FEA, Independent Consultant, has prepared for us the following blog on this topic. Glenn has lectured and written extensively on the subjects of estate planning, taxation, and life insurance. He is also the author of the book "Estate Planning with Life Insurance", the eighth edition which was published by Wolters Kluwer CCH in 2021.

INTERESTED IN JOINING THE #1 INDEPENDENT MGA IN CANADA? CLICK HERE TO REACH OUT TO US!

What to Look for in Shareholders' Agreements

Shareholders’ agreements are often deficient in how they deal with the purchase and sale of shares on a shareholder’s death or disability. This creates opportunities for knowledgeable insurance advisors who are comfortable reviewing agreements. The more effort you put into reading and understanding these agreements, the more you will be seen as a resource to clients and their other professional advisors, who may not necessarily be well-informed on insurance planning strategies.

The following are some key areas to look out for:

Structure of the Buyout on Death

A shareholders’ agreement will typically provide that, on a shareholder’s death, his or her shares will either be redeemed by the corporation or purchased by the surviving shareholder(s). There are many potential buyout structures and no single approach that works in all cases. In this regard, the involvement of the client's tax advisor is of course critical, but an insurance advisor can nonetheless assist in the analysis of the agreement by getting answers to the following questions:

• Does the agreement refer to the use of life insurance as a funding vehicle?

Most agreements will anticipate the use of insurance, but a surprising number are either underfunded or lack any funding at all. In that case, there is an opportunity for the insurance advisor to show the clients that, in most cases, life insurance is the most cost-effective and tax-effective funding alternative.

• Does the agreement refer to the capital dividend account (“CDA”) and how it is to be used in the buyout?

This is a fundamental part of tax planning when corporate-owned life insurance is used as a funding vehicle and should be specifically addressed in the agreement.

• Is the buyout on death mandatory or optional?

In most cases, it is recommended that a buyout on death be mandatory, so that all parties know exactly what will happen if a shareholder dies. This is especially true where insurance proceeds will be available.

Ownership of Insurance

Most agreements will provide for the corporation, which is typically an operating company (“Opco”), to be the owner and beneficiary of the insurance. While this is common, it is in fact something to be avoided if possible.

Having Opco owns the insurance increases the likelihood of having to transfer ownership of the policies in the future. For example, it is common for an individual to sell his or her Opco shares at the time of retirement. If the selling shareholder wants to obtain the policy for personal planning needs, the tax cost of transferring the policy can be prohibitive.

In cases where Opco shares are owned by an individual’s holding company (“Holdco”), it is often advisable for the Holdco to own the policy on the life of its shareholder, with Opco named as a beneficiary for as long as the shareholders’ agreement is in place. If Holdco sells its Opco shares at a later date, it will not be necessary to change ownership of the policy. A change in beneficiary is all that will be needed.

If the corporate structure or other factors require the policies to be owned by Opco, the agreement should usually provide that any shareholder selling shares during their lifetime has the option to purchase the policy on his or her life, perhaps for the greater of the policy’s cash surrender value and $1.00. Great care must be taken in this regard, as the applicable tax rules are complex.

Disability Buyouts

Shareholders’ agreements will often contemplate the purchase and sale of shares on disability. The following are some drafting/planning points regarding disability buyouts:

• Most disability buyouts are unfunded which means, in many cases, that the buyout should not be mandatory, but should be optional on the part of the non-disabled shareholder(s). This allows the prospective purchasers to determine whether or not the necessary financing can be obtained.
• A buyout should normally take place only when an active shareholder becomes disabled. The definition of disability in the agreement should refer to both mental and physical disability and should relate specifically to how the condition affects the individual’s ability to work.
• The agreement should provide for a reasonable waiting period, such as 365 days so that the extent of the shareholder’s disability can be properly assessed. This also allows time for the purchasers to arrange financing, if need be.
• As is the case with a buyout on death, the disabled party’s shares may be purchased by either the corporation or the other shareholder(s). However, even where the agreement is funded, the corporation will not be entitled to a CDA credit on the receipt of disability insurance proceeds. This means that a redemption of shares would create a deemed, taxable dividend in the shareholder’s hands, which is taxed at a much higher rate than capital gains (even with the recent increase in the capital gains inclusion rate). A purchase by the non-disabled shareholder(s) would allow for capital gains treatment, including potential access to the lifetime capital gains exemption. Unlike a corporate redemption, it would also give the other shareholders an increase in the adjusted cost base of their shares.

Share Valuation

In most cases, the price established for shares bought and sold on death or disability should be fair market value, although this can admittedly be difficult to determine in the case of a private corporation. Valuation is a key piece of information for the insurance advisor since this will help determine the amount of insurance that is required.

Agreements will sometimes provide for shareholders to meet annually and agree upon the value of their shares. Typically, it is expected that the yearly updated value will be added to a schedule attached to the agreement. This may make sense in theory, but in practice, most shareholders do not have the time or the inclination to perform this function.

In other cases, the agreement provides a formula for calculating fair market value. This can provide an objective method of determining value, although there is a risk that the formula will not remain current and therefore not provide an accurate measurement when the time comes.

In many cases, the preferred route will simply be to have the parties agree on a purchase price when a shareholder dies. In the event the parties are unable to agree, the agreement can provide for the appointment of an independent evaluator.

Whatever valuation method is used, the agreement should in most cases state clearly that the value of the shares will not include any amount in respect of the insurance proceeds that have been paid to the corporation on the shareholder’s death. Insurance is simply a funding vehicle and generally not part of long-term corporate value.