It is vital for shareholders of small corporations to plan in advance what will happen to their shares in the event of an unexpected death. Often, this is done by including a “buy/sell agreement” within a unanimous shareholders’ agreement. These agreements have the dual benefit of ensuring a smooth transition of the business and providing an opportunity for some significant tax planning.
The following is a brief overview of some of the more common forms of buy/sell agreements and their associated tax consequences. To keep matters simple, assume that all situations involve one corporation and two individual shareholders.
Strategy #1: The Cross Purchase
Under this strategy, the surviving shareholder simply agrees to buy the deceased shareholder’s shares on his or her death. The purchase can be funded by life insurance owned either by the surviving shareholder or by the corporation. The surviving shareholder receives the life insurance proceeds tax-free (either directly or by means of a tax-tree capital dividend) and purchases the estate’s shares for fair market value. The deceased shareholder may realize a capital gain on death, but his or her estate does not incur a capital gain on the sale to the surviving shareholder.
Strategy #2: The 100% Capital Dividend (Pre-Stop-Loss)
With this strategy, the corporation redeems the shares of the deceased shareholder using life insurance proceeds, and designates the resulting deemed dividend as a capital dividend to the deceased’s estate. The capital dividend is received tax-free by the estate and reduces its proceeds of disposition on the redemption to nil. The nil proceeds result in a capital loss to the estate which can be carried back to the deceased shareholder’s terminal return and applied against the capital gain which arose on death. This results in tax-free dispositions by both the deceased shareholder and the estate.
Unfortunately, the stop-loss rules which came into effect in 1995 have limited the effectiveness of this strategy in most cases. However, it is still available in limited situations where certain grandfathering rules apply.
Strategy #3: The 100% Capital Dividend (Post-Stop-Loss)
This strategy is the same as above, except the stop-loss rules now provide that only 50% of the previously-available capital loss can be claimed by the estate. This reduces the capital loss which can be carried back to the deceased’s final year, meaning the capital gain that arose on the deceased shareholder’s death cannot be entirely eliminated. In spite of the application of the stop-loss rules, this strategy remains attractive in certain situations.
Strategy #4: The 50% Solution
The 50% solution operates similarly to the 100% capital dividend solution except the dividend paid to the deceased’s estate is half capital dividend, half taxable dividend. This arrangement stays onside the stop-loss rules and offers greater tax savings to the deceased’s estate than the cross purchase method.
While the tax savings to the deceased’s estate are not as great as under the 100% capital dividend solution (even after the stop-loss rules), the 50% solution is often preferred because it allows the surviving shareholder to access the portion of the capital dividend account that was not paid out to the deceased’s estate.
Strategy #5: The Spousal Roll & Redeem
This strategy is available where the deceased shareholder has a surviving spouse. On the deceased’s death, the surviving spouse receives the deceased’s shares on a rollover basis. The surviving spouse will then have a “put” option under the unanimous shareholders’ agreement to require the corporation to purchase the shares. Alternatively, the corporation may have a “call” option to redeem or purchase the shares.
On sale/redemption, the corporation declares a tax-free capital dividend to the surviving spouse, which reduces his or her proceeds of disposition to nil. This completely eliminates the capital gain which the spouse would have realized on a disposition. The stop-loss rules do not affect this strategy as no gain is recognized on the deceased’s death to which a loss needs to be applied.