Buy-Sell Agreements

Buy-sell agreements provide for the transfer of the ownership of the business in different circumstances death, disability, retirement or disagreement. At death or disability, for example, the remaining owners may not want to be in business with the deceased owner’s heirs or the non-active disabled owner. As well, the heirs or disabled owner may prefer to receive the value of the deceased owner’s share of the business in cash. If an owner retires, an agreement paves the way for business as usual. If owners have a falling out, a buy/sell agreement will enable the business to continue or be “wound up” in an orderly fashion.

To illustrate how the cross-purchase method of the buy/sell agreement works, consider the following scenario:

  1. A and B are equal shareholders in a Canadian-controlled private corporation.
  2. The adjusted cost base (ACB) of each shareholder’s shares is $100.
  3. The shares in corporation have a fair market value of $400,000.
  4. A buy/sell agreement is in place between A and B which is fully funded by personally-owned insurance i.e. A owns an insurance policy on the life of B for $200,000 and B owns an insurance policy on the life of A for $200,000.

Upon the death of A, B is obligated, under the terms of the buy/sell agreement,to purchase the shares from the deceased’s estate, at the price agreed to in the buy/sell. Likewise, A’s estate is so obligated to sell the deceased’s shares to B.

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Tax Consequences

Tax Consequences to the Deceased Shareholder

Upon his/her death, A has a deemed disposition of shares in the corporation equal to the fair market value of $200,000. This deemed disposition will generate a capital gain of $199,900, equal to the FMV of the shares minus their adjusted cost base. One-half of this capital gain will be reported as income in A’s final tax return. (Some or all of this gain may be off-set by the life-time capital gain exemption allowed on the shares of a small business corporation).

Tax Consequences to the Deceased Shareholder’s Estate

A’s estate will acquire the shares from A with an adjusted cost base equal to the fair market value of the disposition, i.e. $200,000. When the estate sells the shares to B pursuant to the buy/sell agreement, a gain or loss will be realized by the estate depending upon whether the sale was less than or equal to the FMV of the shares. If the fair market value of the shares was greater than the $200,000 stipulated in the buy/sell agreement, a loss would be incurred by the estate on the subsequent sale to B. If this happened, the capital loss could be carried back to offset the deceased’s capital gain as reported in his/her final tax return. (subsection 164(6) of the Act).

Tax Consequences to the Surviving Shareholder

B will purchase A’s shares at the price agreed to in the buy/sell agreement ($200,000 ) from the insurance payout that B receives tax-free. The ACB of the acquired shares is averaged with the ACB of B’s original shares to determine the capital gain or loss realized when B eventually sells his shares.

Benefits of an insured Buy-Sell Agreement:

* The business’ working capital remains untouched.

* The owner’s business has a guaranteed market at a fair price.

* The deceased or disabled owner’s family is provided with cash.

* Employees, creditors, suppliers and customers are ensured that the death, disability or retirement of a business owner will not disrupt daily business operations.

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