Estate and corporate advisors often suggest to shareholders to enter into a shareholders’ agreement. The shareholders’ agreement is essentially a contract where the shareholders plan in advance for certain contingencies or future events for which they are in agreement as to the outcome.

Essentially, the shareholders’ agreement governs the shareholders’ relationship and the rules and procedures in case of a dispute or an event, notably, the transfer of shares on death of a shareholder.

Buy-Sell Agreement in a Shareholders’ Agreement Context

The buy-sell agreement is the provision in the shareholders’ agreement that deals with the transfer of shares. A well drafted shareholders’ agreement will address the death of a shareholder. The buy-sell agreement typically provides that the shares of the deceased shareholder are either to be sold to the remaining shareholders or be redeemed by the corporation.

The buy-sell agreement must be carefully drafted, at least, from a tax perspective. In the context of the death of the shareholder, estate advisors should review the shareholders’ agreement for potential unexpected tax implications. Indeed, if the deceased shareholder’s intention is for the shares to be transferred to the surviving spouse, or a spousal trust, on a tax-free rollover basis, the shares must vest indefeasibly in the spouse or spousal trust within 36 months of death. Vesting indefeasibly essentially means without any condition.

According to the Canada Revenue Agency (the “CRA“), for the vesting to be available, the buy-sell agreement must be optional. The CRA’s position is that if the buy-sell agreement is mandatory and binding on the estate, the vesting criterion is absent, the rollover is unavailable, and the capital gain on the shareholdings is triggered on the death of the shareholder.

In other words, if the buy-sell provision is mandatory on the death of a shareholder, resulting in the estate’s obligation to sell the shares to remaining shareholders or to the corporation, the shares will not vest indefeasibly in the estate. That is because the shares are transferred to the estate with the condition that the shares must be sold in accordance with the terms of the buy-sell agreement. As a result, the estate receives the shares at a tax cost equal to fair market value resulting in a capital gain on the shares.

An alternative outcome is if the shares are to be redeemed by the corporation, then a deemed dividend and a capital loss will result. The value of the deemed dividend is the difference between the fair market value of the shares and the paid-up capital of the shares; the dividend tax rate is higher than the capital gain tax rate so the redemption of shares can be more expensive to the estate. The capital loss is the difference between the paid-up capital and the adjusted cost base of the shares and can be carried back to the capital gain triggered on the death of the shareholder if the loss is triggered in the first taxation year of the graduated rate estate.

Other Buy-Sell Agreement

A buy-sell agreement is not limited to shareholders’ agreements. There are other instances, such as the family cottage, that may be subject to a buy-sell agreement and result in an adverse tax outcome.  Essentially, if the deceased has contracted a specific outcome before his death that is binding on the estate, the asset may be deemed not to have vest indefeasibly thus, preventing the spousal rollover resulting in a capital gain and taxes payable by the estate.

Conclusion

Estate advisors will want to review the shareholders’ agreement when discussing the clients’ estate plan.  There are many issues considered when the shareholders’ agreement is discussed and taxation at death is only one of those issues. The funding and structuring of the obligations in often drafted in a tax efficient manner, however, the spousal rollover for estate purposes may not have been the priority.