Buy Sell Agreement: What is it and How it Works

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Article Contents
Picture of By <span>Matthew Roberts</span>
By Matthew Roberts

Updated on May 29, 2024

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Picture of By <span>Matthew Roberts</span>
By Matthew Roberts

Updated May 29, 2024

Visit author page

5 minute read

Article Contents

Buy-sell agreements, a beacon of security, can help businesses stay afloat when multiple partners are involved and one passes away. They are essential to business continuity, providing a safety net and helping avoid personal conflicts.

Buy-Sell Agreements at a Glance:

  • Buy-sell agreements ensure a company survives unforeseen circumstances like death, critical illness, disability, retirement, or bankruptcy.
  • Companies can fund buy-sell agreements through a life insurance policy, disability insurance, bank loan, savings plan, or corporate buy-back.
  • Buy-sell agreements often have legal and tax implications. It’s best to get professional guidance from a corporate lawyer.

Learn how buy-sell arrangements work, who the beneficiaries are, and how to use them to mitigate losses.

What is a Buy-Sell Agreement?

A buy-sell agreement is a legally binding contract between business owners. This arrangement stipulates what will happen to a person’s share if they leave the company or pass away. It ensures smooth handovers, guarantees the company’s financial health, minimizes potential disputes, creates liquidity for illiquid shares, and reinforces business stability. 

There are three main types of buy-sell agreements.

Cross-Purchase Agreement

Cross-purchase agreements involve applying for life insurance policies for each shareholder. When a triggering event occurs, the remaining shareholders can use the death benefit to purchase the deceased or departing partner’s shares.

These arrangements highlight a shared responsibility among partners and seamlessly facilitate direct ownership transfer. However, it relies on the insurance payout to fund the buyout, which may only cover some costs.

Entity-Purchase Agreement

Corporations with entity-purchase agreements have life insurance policies for each shareholder. In a triggering event, the corporation receives the death benefit. 

This arrangement type can benefit corporations through tax deductions and centralized control but may impact the company’s cash flow.

Hybrid Agreement

As its title suggests, a hybrid agreement combines elements of cross-purchase and entity-purchase contracts. For example, individuals and corporations might simultaneously hold life insurance policies for each shareholder, allowing for greater flexibility and tax benefits. 

However, hybrid agreements are often highly complex and challenging to manage. To streamline a hybrid agreement, it’s best to seek professional guidance.

When choosing a buy-sell agreement structure, always consider your business situation, ownership structure, and overall financial goals.

How Buy-Sell Agreements Work in Canada

Buy-sell agreements in Canada function based on three components.

Triggering Events

Triggering events are occurrences that initiate the buy-sell process. Aside from death, these events might include the following:

  • Long-term disability
  • Critical illness preventing work
  • Retirement from business
  • Marital breakdown
  • Bankruptcy 
  • Intention to exit
  • Deadlock or dispute

Purchase Obligation

Next, businesses must determine who buys the shares. Contenders might include the remaining shareholders, a third party, or the corporation. 

Partners may determine the purchase price according to a pre-determined number or valuation formula. The latter provides a more flexible option, as the price may change depending on the company’s financial statements, appraisals, and industry benchmarks.

Companies can get assistance from The Canadian Institute of Chartered Accountants (CICA) to assist in business valuations.

Funding Options

Once the company makes its business valuation, it must determine how to secure the funds to buy the departing owner’s shares. Standard funding options include the following:

  • Life insurance policy death benefit
  • Disability insurance
  • Savings plan
  • Corporate buy-back

Facilitating buy-sell agreements typically involve lawyers who ensure the contract is executed accordingly. 

How Do Buy-sell Agreements Work

When Do You Need a Buy-Sell Agreement?

Buy-sell agreements are imperative for business owners in the following situations.

If There Are Multiple Shareholders or Partners

Co-owning a business can get tricky if one partner plans to leave or can no longer contribute. Buy-sell agreements prevent the company from going into limbo by defining a clear succession plan.

If You Want Business Continuity

A shareholder’s death can suddenly and financially devastatingly end a business. Fortunately, buy-sell contracts ensure business continuity by enforcing smooth transitions and preventing disruptions.

To Minimize Disputes

Even if your business seems stable, you never know when you might encounter a dispute. Buy-sell agreements reduce potential disputes regarding the next steps or business valuations.

Who Needs a Buy-sell Agreement

Who Are the Beneficiaries of a Buy-Sell Agreement?

Buy-sell agreements might appoint several beneficiaries, including the following:

  • Individuals named in the person’s life/critical illness/disability insurance policy
  • Estate beneficiaries of the deceased owner
  • The corporation itself

If your business has multiple partners, it can be easier to name the corporation as the beneficiary, as it prevents conflict between shareholders.

Funding Buy-Sell Agreements

These are several options for funding buy-sell agreements. Here is a breakdown of the standard funding methods.

Life insurance is one of the most common methods for funding buy-sell agreements. When a shareholder takes out a life insurance policy, the remaining partners can use the death benefit to buy out their shares. 

This option is cost-effective and provides immediate cash upon a partner’s death. In some cases, the corporation may receive the death benefit tax-free. However, it’s important to note that life insurance in Canada is not tax-deductible.

Disability insurance functions almost identically to life insurance in that a corporation can use the insurance benefit to buy out shares. This option is highly flexible and provides immediate financial security. However, disability insurance premiums are typically higher than that of life insurance. 

Companies can get loans from traditional banks, credit unions, or alternative lenders to fund buy-back agreements. Getting a loan can preserve a business’s cash flow but will require debt management. In addition, taking on debt increases the company’s financial obligations. 

Depending on where a company borrows this money, it may also be subject to strict lending requirements and a lengthy application process. If considering a loan, partners should shop around by comparing interest rates, loan terms, and fees.   

Dedicated savings plans are a straightforward way to finance future buyouts. They give the company complete control over the funding source, which it can adjust according to its financial situation. Still, savings plans require extreme discipline to build a sufficient pool of funds.

A corporate buy-back allows corporations to use their existing financial resources to repurchase shares, allowing for a smooth transition without relying on external parties. Loans used for buy-backs are often tax-exempt or tax-deductible, allowing partners to maintain ownership structure.

However, buy-backs can cause financial strain, especially if the business’s cash flow is weak. Corporations will also take on additional debt and should only consider a buy-back if they have healthy cash reserves and a strong borrowing capacity.

Considerations for Drafting Buy-Sell Agreements in Canada

A well-crafted buy-sell agreement should help Canadian businesses navigate tax complexities. Here are a few considerations to remember when drafting your agreement.

Legal and Tax Implications

All buy-sell agreements must comply with corporate law and consider the tax implications imposed by the chosen funding method. For example, life insurance death benefits are typically tax-free, so the business may not receive as large a lump sum from a disability policy.

However, life insurance premiums are not usually deductible, so they may be best for corporations in lower tax brackets instead of individual shareholders, who may be in higher tax brackets.

The Canadian Revenue Agency (CRA) provides more information on the tax implications of buy-sell agreements.

Guidance from Lawyers

Hiring a lawyer to help draft a buy-sell agreement can ensure the contract is legally sound, protects all parties, and minimizes tax burdens.

Choosing the Right Insurance Plan

The nature of your business and its trajectory can dictate what type of life insurance you get in case of a buy-sell agreement. Term life insurance is typically more cost-effective and flexible, but it doesn’t have a cash value component. On the other hand, permanent life insurance provides a guaranteed death benefit with cash value accumulation. However, permanent life insurance has higher premiums and may involve additional fees.

Remember to compare quotes online when choosing the best term life insurance for your agreement.

Updating the Agreement

While buy-sell agreements are usually final and set in stone, they may occasionally change. Corporations must update their contracts in case of:

  • Change of ownership
  • Adjustments to the valuation formula
  • Change of funding mechanism
  • Change of legislation
  • Unforeseen circumstances like changes in disability definitions within insurance policies 

Key Advice from MyChoice

Buy-sell agreements play a critical role in keeping businesses afloat amidst unforeseen circumstances. They act as a roadmap for easy business transitions. Now that you know how they work, here are a few key tips from MyChoice to keep in mind:

  • Consult with a lawyer experienced in corporate law to ensure your buy-sell agreement is legal and tax-efficient.
  • Explore as many funding options as possible to determine which will offer the smoothest transition and keep your cash flow healthy.
  • When drafting your buy-sell agreement, outline triggering events thoroughly, determine purchase obligations, and develop a clear valuation method.
  • Maintain clear communication between all shareholders.

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