Co-owning a small business with a partner can be a recipe for success for many entrepreneurs. The partners’ different skills and experience can come together to make a stronger business than either of them would have separately.
With all the demands on their attention, busy entrepreneurs can easily overlook important long-term planning, such as creating a shareholders’ agreement. These agreements can ensure that shareholders’ rights and obligations are clearly understood and can protect the company’s future in case something goes wrong.
Of course, it’s vital that these agreements achieve their business objectives but it’s also important to carefully consider their tax consequences. A shareholders’ agreement sets ground rules for important issues such as who can own shares of the business. For example, is ownership restricted to the partners and their family members or will key employees be able to own shares as well? And how will the shares be valued if they’re transferred among the owners?
These agreements also deal with more difficult issues, such as what will happen in case of a future disagreement or death or disability of one of the key shareholders, usually by specifying a process for one side to buy out the other and how the buyout will be funded.
Though business partners may be reluctant to bring up these issues, it’s best to create a shareholders’ agreement when things are going well. In my experience working with private company owners, people often regret not having put things in writing when disagreements arise and they realize they misunderstood each other’s intentions. If you’re a co-owner and you are considering the options for your shareholders’ agreement, keep in mind that the tax implications of your choices can be significant. For example, you’ll need to consider what will happen to a shareholder’s shares on his or her death. Private companies often take out life insurance policies on their key shareholders so the business will have funds to redeem the shares. Many flexible insurance products are available to create these arrangements. When you’re considering the options, remember that the arrangement’s structure will affect its tax consequences to the company and the shareholder’s estate. In some cases, a tax benefit can be available to one party but not the other. It’s important to specify your intentions for this benefit in the shareholders’ agreement to help prevent future conflict.
One benefit of company-owned life insurance is that the proceeds increase the company’s capital dividend account, which can be paid to shareholders as tax-free capital dividends. Along with capital dividends, another potential tax benefit is the $800,000 lifetime capital gains exemption available to individuals who dispose of qualifying small business shares.
If your company’s shares qualify, you may want to structure your shareholders’ agreement so the party
selling the shares can claim the exemption.
Once you have your agreement, you should review it often, about every three to five years, or as family or business circumstances change.
A shareholders’ agreement is a critical part of any co-owned private company’s succession plan. It’s like a prenuptial agreement or a will – no one likes to think about needing one. But if something does go wrong and a key shareholder wants to leave or dies, a good shareholders’ agreement can help save the business’ value by providing for an orderly transition and ensuring that the company or the surviving shareholder has the funds needed to buy the departing shareholder’s shares.
Among all the decisions you and your partner will have to make when creating your agreement, you’ll want to make sure it’s structured tax-efficiently, both to save tax and to help avoid costly litigation.
