Multiple shareholder and their spouses: tax efficient estate planning
By ATB Wealth 20 March 2023 7 min read
You’ve put a lot of work into growing your business from start to success. Owning and operating a thriving business requires significant ongoing attention as you address day to day concerns. For this reason, daily operational demands often get prioritized over business succession planning. In fact, a 2016 survey of Alberta business owners found that 91% believe succession planning is important, yet only 21% have formal plans in place.
Developing a succession plan now will help to ensure that it’s there when you need it most, and that the long-term plans for your assets are clearly established. One aspect of your business succession plan to consider is the transfer of business ownership, and the value of shares, upon the death of a shareholder.
What if no succession planning has been done?
When two or more individuals own a business together, what would happen to the company if one of the owners were to pass away? In a situation with limited prior planning, the deceased’s spouse would typically be the beneficiary of the estate, which means he or she would inherit whatever ownership their deceased spouse had in the business, making the spouse a shareholder along with the other owners. This is likely not ideal because, whether or not they get along, it’s fair to assume that neither the surviving spouse nor the remaining business owner(s) intended to be in business with each other.
Roll and redeem strategy presents an alternative approach
A more realistic probability is that the remaining owners want to retain control of the business they helped build, while the surviving spouse would prefer to receive the cash value of the shares now that their spouse has passed away. Fortunately, upon the death of a shareholder, there is an efficient way to achieve these outcomes for both the remaining shareholders and the surviving spouse. This is known as the “roll and redeem” strategy.
A “roll and redeem” arrangement occurs where the shares of a deceased shareholder are rolled over to their surviving spouse on a tax-deferred basis and then redeemed by the corporation. Thus, the deceased’s spouse receives cash proceeds and the remaining shareholder(s) retain ownership of the corporation. In order to work properly, however, planning in advance is extremely important and usually begins with the unanimous shareholders agreement (USA).
When the terms of a deceased shareholder’s Will stipulate that their surviving spouse receives their assets, this usually includes their ownership of shares in the business. Therefore, an important first step is to have a USA that is properly written to take advantage of the opportunities that exist under this scenario.
Roll and redeem: A case study example
Consider the following scenario: Albert, Betty, and Charles are old friends, and Canadian residents who started their company, ABC Inc., and have built it into a successful business. ABC Inc. is a private corporation operating as an active business in Canada with Albert, Betty and Charles as equal shareholders, each with one-third ownership. They are not related to each other and each is married to a spouse that is not involved in the business.
Albert, Betty and Charles started ABC Inc. from scratch and built it into the success it is today with a current fair market value of $9 million. The cost base of their shares is nominal.
Unanimous Shareholder Agreements and the use of life insurance
Albert, Betty and Charles have a USA, which was prepared many years ago when the business was new, and not worth nearly what it is today. During a planning meeting with one of their advisors, Albert, Betty and Charles agreed to update their USA, including considerations for the purchase and sale of shares on each of their deaths. In doing so, they also agree that there should be provisions that involve each of their respective spouses having certain options under the USA, even though none of the spouses are currently shareholders or active in the business. As part of their planning, it is decided that insurance policies will be purchased by ABC Inc., making it the owner and beneficiary of insurance policies with a death benefit of $3 million on the life of each shareholder, an amount equal to the fair market value of each respective owner’s shares.
Death of a shareholder
In an unfortunate circumstance, Albert passes away. His wife, Debra, survives him and is the sole beneficiary of his estate under the terms of his Will. The value of Albert’s share ownership is one-third of the fair market value of the company, $3 million.
Upon death, in the absence of an available spousal rollover, Albert would be deemed to immediately dispose of his shares. This would cause a taxable capital gain on his terminal tax return for an amount equal to one-half of the difference between fair market value and his adjusted cost base. However, Albert’s spouse Debra is named as the beneficiary of his shares through his Will so Albert’s shares can be transferred to her on a tax-deferred basis through the rollover provisions available to a surviving spouse. But this is only half of the story because we now need to consider Debra being the new owner of the shares, now in partnership with Betty and Charles.
Strategic tax planning with respect to the deceased’s shares
In an ideal situation, Betty and Charles would retain exclusive ownership of ABC Inc. Afterall, they, along with Albert, built the business. Of course, as Albert’s beneficiary, Debra should also receive the value of his shares. This is where the benefits of planning in advance, including the USA, are realized. The necessary terms would include either an option that gives Debra the right to sell her shares to the corporation, or the corporation the right to acquire the shares from Debra, at fair market value. But where are Betty and Charles going to get $3 million to buy the shares from Debra?
Recall that, as a result of their good planning, ABC Inc. is the owner and beneficiary of insurance policies for $3 million on the life of each shareholder. Upon Albert’s death, the insurance proceeds would be paid to the company. With these insurance proceeds available to the corporation, it has the funds available to redeem the shares from Debra under the requirements agreed to in the USA. The net proceeds of a life insurance policy (less the adjusted cost base of that policy) may also be added to the company’s capital dividend account (CDA). The balance of the CDA can be paid to its shareholders as a capital dividend, which is tax-free at the shareholder level.
Redemption of shares by the corporation provides Debra with a deemed dividend of $3 million. Normally this would cause a large tax liability for Debra, but wasn’t the intent to be as tax efficient as possible? This presents the other item that needs to be documented in the USA - how the dividend paid to Debra is to be declared by the corporation. The USA may stipulate that upon payment of this dividend, it is to be treated as a tax-free capital dividend. Structured in this way, Debra will receive $3 million which leaves her, Albert, and his estate with little or no taxes owing on the disposition of the shares. With this strategy, it appears that taxes have been avoided entirely but that’s not quite true. Taxes will need to be paid eventually, but when and by whom?
Tax implications for surviving shareholders
Remember that the corporation redeemed the shares, Betty and Charles did not buy them. In a transaction where shares are redeemed by a corporation, they are no longer outstanding. The total value of the company is still, of course, $9 million, and Betty and Charles are now the only remaining shareholders. Where the value of each shareholder’s shares was previously $3 million, Betty and Charles’ share ownership is now worth $4.5 million each. In essence, they have benefited by $1.5 million each without having to pay anything. That’s the benefit and drawback though. Those “unpaid” taxes that Albert and Debra escaped now reside in the increased value of Betty and Charles’ shares. Upon disposition of their shares, Betty and Charles will each be taxed on a gain of $4.5 million (according to today’s value) instead of $3 million. Effectively, Betty and Charles each share in the tax liability that has risen as a result of the transaction. But that’s still not a bad deal, given that they paid nothing for an additional $1.5 million in value each.
Effective business transition calls for professional advice
There are many moving parts to the “roll and redeem” strategy and it is important that this strategy only be implemented with proper legal and tax advice applicable to your situation.
The “roll and redeem” strategy is just one several strategies that can ensure the smooth transition of your business in the event of the death of a shareholder. If you wish to explore corporate life insurance options that may fit the unique circumstances of your business, our ATB Insurance Advisors can work together with your other advisors to explore your options.
Business Transition Guide
Learn the steps you should take to successfully sell and transition out of your business.
This document has been prepared by ATB Wealth. ATB Investment Management Inc., ATB Securities Inc. (Member Investment Industry Regulatory Organization of Canada and Canadian Investor Protection Fund) and ATB Insurance Advisors Inc. are wholly owned subsidiaries of ATB Financial and operate under the trade name ATB Wealth. The information provided in this article is a simplified general summary and is not intended to replace or serve as a substitute for professional advice. Professional tax advice should always be obtained when dealing with taxation issues as each individual’s situation is different. This information has been obtained from sources believed to be reliable but no representation or warranty, expressed or implied, is made as to their accuracy or completeness. This information is subject to change and ATB Securities Inc. (Member Investment Industry Regulatory Organization of Canada and Canadian Investor Protection Fund), ATB Investment Management Inc. and ATB Insurance Advisors Inc. reserves the right to change the information without prior notice, and does not undertake to provide updated information should a change occur. ATB Financial, ATB Investment Management Inc., ATB Securities Inc. and ATB Insurance Advisors Inc. do not accept any liability whatsoever for any losses arising from the use of this document or its contents.