The importance of a properly drafted shareholders’ agreement in the context of a business owner’s estate plan is often overlooked. Having a will, or multiple wills, to control what happens to the estate is important; but if a business owner is not the sole shareholder of a business, the rights and obligations of the various shareholders need to be taken into account. If there is a shareholders’ agreement in place, the will must conform to the shareholders’ agreement; and if a shareholders’ agreement is not in place, it would be prudent to prepare one as part of one’s overall estate plan.[1]

There are many benefits to having a shareholders’ agreement. It generally includes provisions for the management and control of a company, financing required for its operations, and the transfer or sale of shares.

In the context of one’s estate planning, the following are important issues to consider when reviewing an existing shareholders’ agreement or drafting one for the first time:

1. Who are the “permitted transferees”?

Who is allowed to receive shares, whether by transfer or sale, is often not fully thought-out. Typical permitted transfers include transfers to holding companies or trusts “controlled” by the shareholder. A shareholder wishing to sell his or her shares to someone other than a permitted transferee normally has to offer the shares to the remaining shareholders on a pro rata basis or there is a mandatory buy-out provision. But what happens on the death of a shareholder? Sometimes death is an ‘event of default’ triggering the sale provisions but, often, it is not even provided for in the shareholders’ agreement; or the agreement is ambiguously drafted without factoring in trust and estate law principles.

The complexities that arise when transfers on death are not properly provided for were highlighted in an Ontario case many years ago.[2] The case involved a deceased shareholder who left his shares in the family business to his sister. The deceased was a signatory to a shareholders’ agreement which provided that any shareholder wishing to sell his or her shares, must first offer the shares to the company and then to the other shareholders on a pro rata basis. On appeal, the Court found that this gift did not fail, as the testator was legally permitted to dispose of his assets as he wished. However, the Court also found that the estate trustee was bound by the terms of the shareholder’s agreement in that he could not transfer the actual shares to the deceased’s sister and must hold the shares in trust for her. While holding the shares in trust for her, the estate trustee was to exercise related voting rights for her benefit, until such time as the remaining parties to the shareholders’ agreement would permit the shares to be transferred. The problem with this outcome is that it could keep the estate from being wound-up for a long time.

This uncertainty, and costly litigation, could have been avoided with a properly thought-out estate plan that took into account the limitations of the shareholders’ agreement. In addition, discussions regarding the shareholders’ estate planning should have been considered when drafting the shareholders’ agreement.

To avoid the above scenario, shareholders should discuss the transfers that would be permitted if a shareholder dies. If a spouse is not permitted to receive share, can a spousal trust hold the shares? In the context of a family business, are transfers to the next generation permitted and if so, at what age? Are any of these persons allowed to hold voting shares or should a freeze be implemented to entitle beneficiaries solely to fixed-value, non-voting shares?

In addition, the needs of potential beneficiaries must be balanced with the needs of the company and the remaining shareholders. A transfer of shares to the beneficiaries of an estate may be necessary if there is a liquidity issue with the company or the other shareholders, and the shares cannot be redeemed or purchased for cancellation by the company or purchased by the other shareholders. Alternatively, if a shareholders’ agreement provides that the purchase of the shares by the company or by the other shareholders can be satisfied by a promissory note paid over the course of several years, will this leave dependant beneficiaries with sufficient income for the years the promissory note is not paid? In addition, a testator may wish to have beneficiaries benefit from regular dividends as direct shareholders or as beneficiaries under a trust that is a shareholder of the company. In such scenarios, if dividends are declared at the discretion of the board of directors, consideration should be given to the regularity of dividends and to the composition of the board of directors after the death of a shareholder. It may be prudent to ensure that the executor or trustee will have a seat on the board of directors.

In addition to the foregoing, when drafting a shareholders’ agreement where a trust is a shareholder or is a permitted transferee, care should be given to ensure that the permitted transferee language also permits the beneficiaries of the trust to receive the shares on a distribution from a trust.

While transfers not in accordance with a shareholders’ agreement may be permitted with the consent of the other shareholders, if that consent is not obtained, it can disrupt one’s estate planning and lead to unintended consequences.

2. Mandatory Buy-out

Where a shareholders’ agreement provides for a mandatory buy-out on death, a tax issue often missed is that the buy-out means that the deceased shareholder would not be able to take advantage of a the spousal rollover offered under s. 70(6) of the Income Tax Act (“ITA”). If there is an outright distribution of the shares to a spouse or the shares are transferred to a qualifying spousal trust, then the deemed disposition on the death of the shareholder under s. 70(5)(a) of the ITA would not apply. The spousal rollover would defer the income tax liability on the accrued gains of the shares until the spouse’s death or until the spouse disposes of the shares. This unintended consequence often leads to litigation because the shareholders’ estate planning and tax liability on death factors in a spousal rollover that is subsequently not allowed under the shareholders’ agreement.

3. Capital Dividend Account

Provisions regarding the capital dividend account (“CDA”) are often missed in both shareholders’ agreements and wills. The CDA generally includes the following: (i) the non-taxable portion of capital gains realized from the disposition of capital property (reduced by one-half of any capital losses); (ii) capital dividends received from other private Canadian corporations; and (iii) the proceeds from life insurance policies. Capital dividends, which are generally received as tax-free to Canadian residents, are paid from the CDA.

Including provisions regarding the CDA achieves a couple of objectives. First, it ensures that the funds are used as intended. For example, if the CDA is comprised of life insurance proceeds which are, in turn, to be used to pay any income tax liability of a particular shareholder as a consequence of the deemed disposition of the shares on death, then the capital dividend must be paid on those particular shares, as intended, and not to other shareholders. Alternatively, the life insurance proceeds may be for the remaining shareholders to purchase the shares of the deceased shareholder, and care should be taken to ensure the capital dividend is declared solely on the shares held by the remaining shareholders. In either case, proper drafting will avoid unintended results.

Second, provisions regarding the CDA can ensure that the funds are used in the most tax efficient manner. For instance, charitable giving of corporately held life insurance can sometimes include gifting shares of private companies that are subsequently to be redeemed by the board of directors of the company. This redemption results in a deemed dividend. In the circumstances, the deemed dividend should not be declared as a capital dividend despite the intention of the testator to have the life insurance proceeds gifted to charity. Proper planning would ensure that the tax-free nature of the capital dividend is not “wasted” with a tax-exempt charitable institution.

In addition to considering the tax efficiency of charitable giving, thought should be given to who may be entitled to receive a capital dividend. Notwithstanding the general tax-free nature of a capital dividend, any dividends paid to a non-resident from the CDA will, nonetheless, be subject to withholding taxes. If there are non-resident shareholders, it would be prudent to have different classes of shares issued to the resident and non-resident shareholders, and where there is an estate or a trust, inter vivos or testamentary, proper planning is needed to ensure that dividends paid from the CDA are not distributed to a Canadian-resident beneficiary.[3] Furthermore, where a capital dividend is received by an estate or trust and not distributed as income in that year, but rather added to the capital of the estate or trust, any subsequent distributions of capital, where the source of the distribution is traced to a capital dividend paid to the estate or trust in a previous year, will also be subject to withholding tax if distributed to a non-resident.[4] While there are efficient tax planning opportunities, like the CDA, there are factors that if not considered, can result in foregoing those tax efficiencies.

A proper estate plan must consider, among other aspects, tax-saving measures, the contractual limitations of shareholders’ agreements, and the needs of beneficiaries, such that all the pieces fit together in one cohesive, well thought-out estate plan.