A shareholders' agreement is a contractual arrangement between the shareholders of the corporation and the corporation itself. The primary purpose of the agreement is deal with the many potential issues that may arise between shareholders/management and how they are to be settled. However, as with any agreement, not all contingencies can necessarily be contemplated, and this can lead to some uncertainty.
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:
- Establish the process for appointing the board of directors, which is responsible for oversight of the business operations.
- Set out a process for dealing with disputes between shareholders/management in relation to the administration of the corporation.
- Restrict the transfer of shares to outside parties without the consent of all shareholders.
- Determine the mechanism for 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 retirement, death or disability
- Establish the mechanics for the sale and purchase of shares in the event of the death or disability of a shareholder .
The shareholders’ agreement is one of the most important tools of the business succession plan.
Life Insurance funding of Buy-Sell provisions
With respect to the buy/sell provisions in the event of death, life insurance is typically the most effective way to fund the purchase and it is often required under the terms of the agreement.
If life insurance is to be used to fund a buy/sell provision within a shareholder agreement, it may be structured in the following ways:
- The corporation may be the owner and of the insurance. When a shareholder dies the company will receive the insurance proceeds and will buy the shares from the deceased shareholder's estate (known as a share redemption).
- Alternatively, the shareholders may personally be the owner and beneficiary of the life insurance on each other. Upon the death of a shareholder, the insurance received by the surviving shareholder(s) is used to purchase the shares from the deceased’s estate. This is known as a criss-cross arrangement.
Each buy-out structure results in different tax consequences to the estate and subsequent owner of the shares. Establishing the proper ownership of insurance from the outset will avoid the need to transfer ownership at a later point, which could trigger a taxable disposition of the policy. It is therefore important that the shareholders determine the structure best suited to them, as well as the amount of insurance required, while also anticipating future growth in share value and resulting tax consequences on death.