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Death, divorce and disability—the 3 Ds
Some ways to deal with them in shareholder agreements.
Death
Not a happy subject, but a good shareholder agreement takes this eventuality into account. If one of the owners passes away, he or she can leave their shares to anyone they want. You may not want their beneficiaries as partners. Your agreement can provide the surviving party(ies) a right, but not necessarily the obligation, to buy the shares.
On death you are deemed to have disposed of all of your assets at the then fair market value and guess what, there may be tax to pay. This deemed disposition at fair market value does not apply if the shares are willed to a spouse or a spousal trust. Proceeds received by the company on a life insurance policy in excess of the cost base of the policy (cash surrender value) go into the capital dividend account for income tax purposes and can be distributed tax free. There are a lot of different kinds of insurance products and a lot of factors to consider in making a decision. You need to think about how to finance these arrangements so you don't put the business through undue hardship or give up value.
Insurance is an option, but not the only one. The buyer can take back a note for some of the purchase price. There are actually financial intermediaries who will finance succession, a leveraged buy-out or a "Shotgun." There are even funds that specialize in this.
A refinancing may provide funds for retirement, planned succession, a staged buy-out or a flat out buy-out. The objective here is to come up with an affordable solution that provides money for the estate, to buy-out shares or pay off creditors (like taxes) so that you don't have to sell or liquidate the business.
"Say the words 'estate sale' and the fins that appear in the water are sharks, not dolphins," says Bob Holden, Enterprise Leader for Okanagan-South Thompson, British Columbia.
Disability
You want to define what constitutes "disability" and consider what you want to have happen in the event that one of you becomes disabled. You want a practical solution that won't make you 'insurance poor' and that provides needed cash to the disabled party. Some insurance products provide disability payments or you may be able to use the cash surrender value of a life insurance policy. Insurance proceeds as a result of disability are taxable if the premiums are paid by the employer.
"Disability is one of the most under-emphasized areas in shareholder agreements," says Holden. One way to deal with disability is to provide long-term disability insurance on a portion of the salary and have the surviving partner or the company acquire the shares for some up-front cash and a note secured by the assets of the business and bearing a commercial rate of interest and payable over 5 to 10 years. This provides for continuance of the business, income and security to the disabled party.
Divorce
Some shareholder agreements provide for a buy-out of shares that have been transferred to the ex-spouse of a partner as a result of family law legislation.
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