Making a plan for the storm when the weather is still good is the fundamental basis of estate planning and business succession planning. It allows everyone involved to set out their intentions, have open and clear communications, and set a plan in place that they feel will allow their successors to succeed.
One of the key tools used for this planning is a unanimous shareholders agreement (“USA”). Where estates and businesses intersect is often in the buy-sell options upon death and life insurance clauses in a USA.
The buy-sell upon death clause typically requires the estate to sell the shares of the corporation back to the corporation at a fair or agreed price. But how will the corporation fund the repurchase? That is where life insurance and capital dividends come in.
Corporations may take out life insurance on the lives of the shareholders. Upon the death of a shareholder, the insurance proceeds will be paid to the corporation and be added to the capital dividend account balance. The capital dividend account represents amounts that a private corporation may pay out to shareholders as tax-free dividends, called “capital dividends”. The capital dividend account is maintained “on-paper”. It is not a dollar balance that appears on financial statements or tax returns.
The corporation will then use the insurance proceeds to repurchase the shares. However, in fairness, the corporation should elect that the addition to the capital dividend account as a result of the insurance proceeds should be used to repurchase the shares. This allows the estate to then receive those funds as tax-free capital dividends. If the life insurance proceeds are insufficient to cover the entire repurchase price, the difference will usually be treated as a taxable dividend.
This is helpful for the corporation, as it provides a means to deal with the shares of deceased shareholders, and it is helpful for the estate, as it provides a tax efficient way to deal with the shares of a private corporation.
However, unless a USA obligates the corporation elect that capital dividends be paid out as part of the repurchase, under corporate law, the corporation can theoretically keep the capital dividend account balance for the other shareholders, leading to significantly worse tax results for the estate. Since this is usually not the parties' original intention, this regularly leads to expensive litigation.
Therefore, when estate planning for individuals who own shares in private corporation, not only will the individual’s will be important, but also a USA for the corporation. You should contemplate including in a USA clauses that:
1. require or permit the corporation to maintain life insurance on the lives of the shareholders;
2. gives the corporation an option to repurchase any shares owned by the deceased shareholder at the time of his/her death from his/her estate;
3. set outs a formula or definition for the repurchase price for the above-mentioned option that is reasonable for both the estate and the corporation;
4. sets out that the repurchase price paid will be designated as a capital dividend to the extent that the capital dividend account balance was increased by the receipt of life insurance proceeds related to the deceased shareholder.
It is worth remembering that the cost of establishing a proper USA prior to death can save the estate and corporation significant litigation and/or tax costs after death. McLennan Ross has an experienced and talented Wills & Estates Team as well as a skilled Tax Team able to assist you with estate and business planning and its related tax implications.
 Income Tax Act (“ITA”), subsection 89(1). Other items that are included in the capital dividend account include the non-taxable portion of capital gains, and capital dividends received from other corporations.
 ITA, see definition in subsection 89(1). Generally, a Canadian resident corporation and not controlled by one or more public corporations, prescribed federal Crown corporations, or any combination thereof.
 ITA, section 83.