September/October
2004: by Jim Nellis
Benefits of buy-sell agreements
Small business plays a major role in the health
of our economy. In Canada, family-owned small businesses employ
approximately 4.75 million people, or about 50 per cent of working
Canadians.
Small businesses are often created when one
person or a group of people are inspired by a unique thought for
a product or service. During the chaos of the day-to-day operations
of running your business, during the complexities of meetings
with your banker, your financial advisor, your lawyer and accountant,
planning for the future is often overlooked.
Whether your business is one that goes public,
or is eventually sold to a private group inside or outside of
your business, you should not overlook the importance of a properly
drafted buy-sell agreement as a planning tool.
A buy-sell agreement is a legal document that
restricts the disposition of privately held business interests,
usually among existing owners, their families, or an employee
group. Partners in a partnership or shareholders of a corporation
usually execute a buy-sell agreement for one or all of the following
reasons:
- They want to protect the value of their business
interest for their heirs; or
- They want to protect the business from interference
from beneficiaries of the interest of a deceased partner or
shareholder; or
- They want to provide for orderly termination
of a relationship between the shareholders if there is a future
disagreement.
Generally speaking, there are basically two
types of buy-sell agreements: the cross purchase agreement and
the share redemption plan.
A cross purchase agreement is a buy-sell agreement
that is entered into between partners in a partnership, or among
shareholders in a corporation, obligating the surviving partners
to purchase the interest of the retiring or deceased partner or
shareholder. The agreement will specify a fixed price for the
purchase, or set out a formula that specifies how the price is
to be determined at retirement or the time of death of the partner
or shareholder.
In a share redemption plan the agreement is
between the corporation and the shareholders and states that the
corporation must purchase the interest of a retiring or deceased
shareholder at a fixed price or to be determined by an agreed-upon
formula included in the agreement.
A major consideration with both plans is how
to best finance the purchase price. There are a few different
options available. These include: borrowing funds; establishing
a sinking fund; or life and/or disability insurance proceeds.
Borrowing funds are sometimes difficult to obtain,
generally more expensive, and add risk to the current health of
the business.
Using a sinking fund involves establishing a
separate fund and contributing to it regularly in order to build
up a cash reserve. This is a slower process and one of the major
concerns with this strategy is that if one of the parties dies
shortly after the agreement is executed, the reserves in the fund
may not be suitable to buy out the interest of the deceased.
Because of the drawbacks associated with the
previous two options, most buy-sell agreements incorporate a life
insurance provision to ensure that sufficient funds are available
exactly when they are needed. These insured agreements usually
take one of two forms: cross insurance or corporate-owned insurance.
Beneficiaries of cross insurance are the other
shareholders. They use the proceeds they receive upon death to
purchase the shares of the deceased.
More frequently today corporate owned life insurance
is used to fund cross purchase and share redemption plans. When
used to fund a cross purchase agreement, the corporation becomes
the beneficiary and pays the premiums. Upon the death of a shareholder
the corporation receives the proceeds and the funds are then credited
to the corporation's capital dividend account. The remaining shareholders
then declare a dividend and the funds are used to retire a promissory
note held by the deceased's estate. This is efficient as the funds
flow out free of tax.
Tax considerations play a major role in planning
for shareholder agreements. The tax treatment of life insurance
payments, the availability of the $500,000 capital gains exemption,
the valuation of shares, and many other issues must be considered.
Clearly, shareholder agreements should always be drafted with
proper professional advice as to both legal and tax issues.
. . .
About the author
Jim Nellis, B.Comm, is a Financial Planning Advisor with Assante
Financial Management Ltd. He can be reached at 1-877-837-3377
or 306-665-3377, or Click
to email Jim Nellis.
Disclaimer
Please contact a professional advisor to discuss your particular
circumstances prior to acting on the information above. The opinions
expressed are those of the author and not necessarily those of
Assante Financial Management Ltd.
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