A buy-sell agreement can help a business plan for an owner’s death, disability, dispute or exit.
In this article, we talk about buy-sell agreements, agreements among business owners that establish in advance how one can leave a company if there’s a dispute, someone becomes disabled, or someone dies.
This article uses CRA’s capital-dividend folio, CRA’s guidance on insurance expenses, the federal life-insurance guide, and CBV Institute’s valuation guidance.
What Is a Buy-Sell Agreement and How Does It Work?
An insurance policy isn’t the same as an agreement to purchase shares or business interests, and that is where a buy-sell agreement comes in.
This agreement, whether a legal contract or a provision in a shareholder or partnership agreement, lays out what happens to a business owner’s shares in the event of certain occurrences. It also details whether buying out an owner is optional or required, who can or must purchase the owner’s business interest, how the purchase price will be determined, when funds are payable, and what happens if insurance and/or cash aren’t sufficient.
Unlike a buy-sell agreement, an insurance policy provides funds when certain criteria and events occur. Whereas a buy-sell agreement outlines what happens to business ownership, an insurance policy names a policy owner, an insured person and a policy beneficiary.
The Main Buy-Sell Structures
| Structure | Share buyer | Typical insurance arrangement | Planning issue |
|---|---|---|---|
| Cross-purchase | Remaining owner or owners | Each owner may own the policy on the other owner. | Policy count grows as owners are added. The purchase changes the buyers’ share cost. |
| Entity purchase or redemption | Corporation | Corporations may own policies. Corporations may receive proceeds. | Each option needs legal and tax analysis. For a redemption, consider its tax treatment, the capital dividend account and the estate tax result. |
| Hybrid | Corporation or owners, depending on the event or election | Multiple methods can be used in combination. Ownership and proceeds can be coordinated across those methods. | More flexibility means more paperwork and more complicated tax issues. |
Choosing a structure based on which has the fewest insurance policies, or one described as tax-free, is a recipe for disappointment. Each structure can lead to very different results depending on the chain of share ownership, corporate law, the tax position of shareholders, and many other factors. It also depends on the numbers: paid-up capital, share cost, capital dividend account balance, etc.
Triggering Events Need Their Own Definitions
| Trigger | Clause to define | Funding question |
|---|---|---|
| Death | Define proof of death, closing time, estate obligations and simultaneous death. | Consider the policy owner, beneficiary, amount, and claims process. |
| Long-term disability | Define occupation, total or partial disability, waiting periods, recurrence and medical evidence. | Decide if payout will be a lump sum or instalments and define the triggering events. Definitions may depend on the disability buyout insurance policy. |
| Critical illness | Define which diagnosis or functional event would trigger the sale, if any. | Critical-illness proceeds are not always equal to the value of the person’s shares. Receipt of proceeds may not mean there will be a mandatory buyout. |
| Retirement or voluntary exit | Define notice, permitted dates, non-competes and buyer options. | Funding may come from savings, instalments, financing or company cash. |
| Marriage breakdown, insolvency or creditor action | Transfer restrictions, family-law interaction and forced-sale process | Insurance coverage may not respond to these events. |
| Deadlock, misconduct or termination | Define notice, cure, valuation, permitted discounts and dispute provisions. | Funding usually comes from cash, debt or a third-party sale rather than life insurance. |
Don’t assume disability insurance works the same way as life insurance. Disability buyout policies have their own definitions, waiting periods, benefit limits, and payment forms. Make sure the agreement uses terminology compatible with the disability insurance policy or provides a way to reconcile any differences.
Buyer, Seller and Insurance Beneficiary Are Not the Same Role
| Role | What the agreement or policy must show |
|---|---|
| Selling owner or estate | The transaction will specify what equity, shares or interest is being sold, who is buying it and who is getting paid. |
| Purchaser | In some circumstances, the owner, corporation or third party has the right, or is required, to make a purchase. |
| Policy owner | Specific contractual rights control who has the right to control the policy, who is responsible for paying the premium, and who is allowed to change the policy. |
| Life insured | Whose death triggers the policy benefit |
| Policy beneficiary | Insurance proceeds under a policy are payable to the policy beneficiary and may be different from buyer or seller. |
| Capital-dividend recipient | Which shareholder may receive a capital dividend where a private corporation has properly made a capital dividend election? |
Using the term beneficiary for everyone obscures what’s happening.
In an entity purchase, the corporation may receive the insurance proceeds.
The corporation may buy the deceased owner’s shares from the estate.
The corporation may be the policy beneficiary.
How to Set and Update the Purchase Price
Purchase price can be a predetermined amount, a formula based on business performance, a third-party valuation by a qualified independent professional, such as a Chartered Business Valuator (CBV), or a combination of these methods.
Examples are provided for explanatory purposes and to illustrate potential shortfall of funding; they are not necessarily representative of appropriate valuation methodologies.
| Illustrative fact | At last review | At trigger |
|---|---|---|
| Total equity value | $1,800,000 | $2,070,000 after a 15% increase |
| Three equal one-third interests | $600,000 each | $690,000 each |
| Insurance on the affected owner | $500,000 | $500,000 |
| Funding shortfall before fees and tax | $100,000 | $190,000 |
The agreement should specify how excess proceeds will be handled and how a shortfall, if one occurs, will be handled: paid at closing; covered by a secured promissory note from the buyer; financed through borrowing; the transaction reduced with the seller’s consent; or handled another way.
Funding Buy-Sell Agreements
| Funding method | Best matched to | Main limitation to plan for |
|---|---|---|
| Life insurance | Death of an insured owner | Underwriting, premiums, ownership, beneficiary, lapse risk and changing business value. |
| Disability buyout insurance | A defined long-term disability | Waiting period, definition, maximum benefit and payment schedule. |
| Critical-illness insurance | A covered diagnosis, if included in the agreement | A covered diagnosis does not necessarily mean the owner cannot work or must leave the business. |
| Cash reserve | A permitted trigger | Available funds may be insufficient or needed to run the business. |
| Bank loan or promissory note | Financed closing | Approvals, interest, security, cash flow and default. |
| Hybrid funding | Insurance, cash and debt | The agreement must set the priority of insurance proceeds, cash and debt. |
Read More: See How Corporate-Owned Life Insurance Works
Canadian Tax Limits That Need Professional Review
- Receipt of life-insurance proceeds by a beneficiary is not like a tax-free sale of shares.
- Proceeds of life insurance: Private companies are allowed to increase their capital dividend account (CDA) balance with the net proceeds of life insurance. CRA commonly considers net proceeds to be the death proceeds less the ACB (adjusted cost base) of the policy immediately before death, but other statutory adjustments may apply. Life-insurance proceeds may be paid as a capital dividend if the company has a CDA balance and makes a valid election. An election for more than the CDA balance has tax implications.
- Insurance premiums: With few exceptions, insurance premiums are not deductible. One narrow exception allows a deduction for premiums only when a qualifying insurance policy has been required and assigned to a restricted financial institution, subject to restrictions, as security for a loan.
- Borrowing and interest deductions: Borrowing to finance a buyout does not automatically make the interest deductible. Rules apply to allow or deny interest deductions based on use of the proceeds.
These and other rules can significantly affect the amount ultimately received by the estate, the corporation and/or the remaining owners after taxes. It is wise to have your buy-sell agreement reviewed by your business lawyer and CPA before you sign it and before you amend it.
Read More: Read the Canadian Guide to Life Insurance Tax Deductions