A shareholders' agreement is a contract between the shareholders of the corporation and the corporation itself. The primary purpose of the agreement is to try and deal with the many potential issues that may arise between shareholders and how they are to be settled. However, as with any agreement, this is not always a certainty.
The shareholders' agreement will typically include provisions relating to the management of the business and the transfer of shares in the event of death or other stipulated events. The provisions dealing with transfers of shares are commonly referred to as the “buy-sell” portion of the agreement.
Objectives of a Shareholders’ Agreement
Primary objectives of a shareholders' agreement are to:
- Minimize disputes over the administration of the corporation.
- Restrict the transfer of shares.
- Determine the mechanism of valuing shares which are being transferred or sold.
- Protect the interests of minority shareholders.
- Ensure an orderly transition in the withdrawal of a shareholder for any reason, including death or disability
- Create a way for the sale and purchase of shares in the event of the death or disability of a shareholder and a formula as to how the shares are to be valued at the time of such a purchase and sale.
- Protect remaining or surviving shareholders from the possibility of an outside party purchase.
A shareholders’ agreement may restrict the transfer of shares to third parties. It will usually provide buy-sell provisions in the event of death, disability, retirement, marriage breakdown, insolvency, dissension, third party offers, and so forth. The buy-sell provisions may include; direction as to how the purchase and sale will be structured and financed, valuation of the business interest, and how, when and to whom payments are to be made.
With respect to the buy/sell provisions in the event of death, life insurance is the most effective way to fund the purchase and it is often specifically called for in the agreement.
The shareholders’ agreement is one of the most important tools of the business succession plan.
Life Insurance funding of Buy-Sell provisions
If the life insurance is to be used to fund a buy/sell provision within a Shareholders Agreement, it may be structured in one of a couple of ways:
- The corporation may be the owner and of the insurance. At time of death the company will receive the insurance proceeds and it will buy the shares from the deceased shareholder's estate.
- Alternatively, the shareholders may personally be the owner and beneficiary of the life insurance on each other. This is known as a criss-cross arrangement.
Each different buy-out structure results in different tax consequences to the estate and subsequent owner of the shares. Proper ownership of the insurance from the outset will avoid the need to transfer ownership at a later point, which could trigger tax. It is therefore important that the shareholders determine the structure best suited to them, as well as the amount of insurance required, all while anticipating future growth in share value and tax consequences.