If you have a shareholder agreement, it probably has a clause that deals with the purchase of your shares in the event of your death.  But does it provide enough flexibility to allow your executor and the remaining shareholders to structure the buyout in a way that minimizes the tax and, thereby, maximizes cash to your estate?

One of the first things to understand is the tax treatment of life insurance proceeds.  Life insurance proceeds received by a corporate or individual beneficiary of the policy will normally be received tax free.  However, to protect the tax-free nature of the life insurance proceeds, a corporate beneficiary on the policy will be able to set up a notional account called the capital dividend account.  An amount equal to the proceeds less the adjusted cost basis of the policy can be added to this account and can be paid out to the shareholders tax free as a capital dividend.

Assume that there is corporate-owned life insurance in place to finance the buyout of your shares.  If the agreement requires your shares to be bought by the remaining shareholders, your final return will likely report a capital gain that may be eligible for the $750,000 capital gains exemption.  If this is the case, the capital dividend account will be available for the benefit of the remaining shareholders.

If your agreement has the corporation redeem your shares, your estate will likely report a dividend.  The dividend can be received by the estate tax free to the extent of the balance in the company’s capital dividend account, perhaps as a result of life insurance being received by the company as a result of the death.  This sounds good, but if a capital dividend is used, there will still likely be a capital gain taxed on your final return.

However, if the agreement is structured properly and if there is a surviving spouse, your shares can be transferred to your spouse tax free.  Then your spouse can redeem the shares and have the resulting dividend received tax free to the extent of the capital dividend account.  In this way, there could be no tax on your final return and no tax to the surviving spouse.  In other words, the full proceeds can be received tax free.

Similarly, if the corporation has either a “grand fathered” insurance policy or shareholder agreement, the same tax-free result can be achieved without the involvement of a surviving spouse, through a redemption of shares by the corporation.

If there isn’t any corporate-owned life insurance, the tax-free result cannot be achieved.  Instead, there will be either a capital gain or a deemed dividend reported.

Obviously, the proper structure and financing of the buyout under your shareholder agreement can have a major impact on the after-tax cash available to your surviving family members.

Conclusion

If you have any questions regarding the structuring of your shareholder agreement or any income tax or business issues, do not hesitate in calling Joe Truscott at 905-528-0234 or email Joe at [email protected].