The family (whatever that looks like for you) is the fundamental unit of our society, and the family business a fundamental cog of our economy. Investing in both the family and the business by entering a family shareholders’ agreement, and updating it as family and business evolve, can help maintain family harmony and successfully transition the business to the next generation, at the same time. While unique – but surmountable – tax challenges apply to the family shareholders’ agreement, providing the family with as much certainty as is possible in any entrepreneurial venture, there are also some tax opportunities from which a carefully drafted family shareholders’ agreement can benefit.

The Family Business

Family businesses are both prolific and unique.

Economic Contribution. According to the GoForth Institute, in 2015 approximately 80% of all businesses in Canada were family-owned, and they were responsible for about 60% of Canada’s annual economic output. This makes family–owned businesses a crucial contributor to the Canadian economy.

Family Identity. The family’s identity and psyche almost universally includes the family business; after all, many of them include either the founders’ surname or a name of significance to them. Most frequently, a single familial generation founds a family business: an individual entrepreneur with an idea, a couple able to combine personal and professional relationships, or siblings able to extend the bonds of a common upbringing into business. This unique symbiosis between owner(s) and business can make it more difficult to make decisions from a business, rather than an emotional, basis.

Extended Leadership Tenure. Leadership in a family business might extend for 20 to 30 years, in contrast to the average leadership tenure in publicly-owned companies of less than six years. This extended tenure provides significant stability with a long-term focus, but comes with challenges that not all family businesses can overcome. Studies show that 70% of family businesses leave the family before a transfer of ownership to the succeeding generation. It can make it more difficult to adapt to shifts in the business environment, and requires balancing the dynamics of the business with the emotional nature of family relationships, particularly as founders age and begin contemplating their children’s assumption of active roles in the family business. Relationship complexity also increases with kinship distance, as ownership dilutes generationally from one individual, to siblings, to cousins …

The Family Shareholders’ Agreement

All business owners – including those of family businesses – can benefit from a shareholders’ agreement. A family shareholders’ agreement maximizes the probability of maintaining both family harmony and prosperity through the triumphs and trials of running a business. The nature of the familial relationship often results in a ready consensus on terms, and thus a relatively inexpensive investment in the family and the business. Reaching an agreement early and revising it periodically as circumstances change minimizes family discord by guiding ownership, decision-making, conflict resolution, and importantly, the distribution of money within the family.

Agreement Type. A unanimous shareholders’ agreement (USA) is a specific type of shareholders’ agreement recognized in most Canadian corporate legislation, with particular utility in the family context. The real benefit of a USA is that the corporate legislation deems a transferee of shares to be a party to the agreement. In the family context, this effectively means that by signing a USA, the founder (say, Mom or Dad) can set the rules of their children’s ultimate engagement with the family business, whether they receive shares directly from their parent(s), from a discretionary family trust or an inheritance. To qualify as a USA, the shareholders’ agreement must restrict, wholly or partly, the directors’ powers to manage the corporation’s business and affairs. Directors and shareholders share power in a corporation: directors manage the corporation’s day-to-day business and affairs; shareholders elect directors and must approve certain fundamental decisions (for example name changes, mergers and the sale of all assets). There are two keys ways to achieve USA status: 

• Under most Canadian corporate legislation, a USA is a written agreement among all of the corporation’s shareholders that restricts, in whole or in part, the directors’ powers to manage the corporation’s business and affairs.
• A declaration by a person who beneficially owns all of the corporation’s issued shares that restricts, in whole or in part, the directors’ powers to manage the corporation’s business and affairs is also a USA – allowing the individual entrepreneur founder of a family business to implement a USA, presumably after an easy negotiation.

The restriction of the directors’ powers can be as minimal as requiring shareholder consent to dividends or the purchase of assets in excess of a specified amount, or as extensive as a complete shift of responsibility for the management to the shareholders. This comes with the caution that any shift in responsibility from directors to shareholders carries the attendant shift in personal liability for those decisions.

Agreement Terms. A family considering a shareholder agreement can ask themselves these 20 preliminary questions to start to explore the terms to be included in the family shareholders’ agreement – but don’t be surprised when the answers to these questions lead to further questions to deepen that exploration:

• Would the business survive if divided?
• What debt covenants or other contractual restrictions bind the business?
• What is the current leadership structure?
• Which family members are now or likely to be actively involved in the business?
• How is compensation set for family members employed in the business?
• How are bonuses determined and disseminated?
• Are residual profits reinvested, used for other investments or declared as dividends?
• What short and long-term disability protection is available from the business?
• What financial disclosure about the business do family members receive?
• Who serves as directors of the corporation (recognizing the personal liability exposure)?
• How will the directors’ powers be limited?
• Are family members subject to restrictions, such as confidentiality or non-competition covenants?
• Can a family member pledge shares to secure a personal loan?
• Can a family shareholder sell shares?
• If yes, then to whom, at what price, and upon what payment terms?
• Are there any events that would result in a mandatory share transfer within the family?
• How is the business to be valued for the purposes of inter-familial transactions?
• How is inter-generational capital gains tax minimized and financed?
• How are disputes resolved at the business and family levels?
• What do you want included in the agreement?

Key tax Challenges

Unique – but surmountable – tax challenges apply to the family shareholders’ agreement that call for variation from the terms normally included in a shareholders’ agreement among unrelated shareholders.

“Arm’s Length”. The authors of the Income Tax Act (proudly celebrating its 100^th anniversary on September 20, 2017) have waged a long battle against transactions within family units, creating dozens of rules that only apply to transactions between related parties. The magic phrase in tax law is “arm’s length” (the definition of which has nothing to do with the actual length of anyone’s arm):  parents and their children are not at arm’s length; aunts and nephews are at arm’s length. The test can be complex to apply: Cinderella and her stepmother are not at arm’s length … but Cinderella and her stepsisters are; Cinderella’s mice friends Suzy, Perla, Jaq and Gus? That depends on whether they’ve been cohabitating in a conjugal relationship for 12 months (or less if they have a child together).

“Fair Market Value”. To be effective, the family shareholders’ agreement terms must work with the Income Tax Act provisions respecting transactions between family members not at arm’s length. In the context of the family shareholders’ agreement, the most important is the fair market value requirement:

• A non-arm’s length buyer that overpays for shares is deemed to have only paid fair market value; the seller, however, must report their capital gain based on the actual sale price. This cost reduction to the buyer results in eventual double tax in the family to the extent of the difference between the actual selling price and the fair market value because the buyer must also pay tax on that difference when they dispose of the shares.

• Similarly, a non-arm’s length seller that undercharges for shares is deemed to have actually received fair market value, and must pay capital gains tax based on the fair market value – an amount they didn’t actually receive. This, too, leads to eventual double tax because the buyer doesn’t receive a corresponding increase in their tax cost. The transfer of property for less than fair market value might also make the related buyer vicariously liable for any of the seller’s past tax liability.

In fact, the Canada Revenue Agency’s information circular on business equity valuations devotes an entire section to valuation in the context of family and group control, principles that are important when determining value for the purposes of transactions contemplated in the family shareholders’ agreement.

Leveraged Buy-Outs. The leveraged buy-out model most frequently employed in traditional shareholders’ agreements requires modification to fit the context of family shareholders’ agreements. Shareholders’ agreements between unrelated parties often contemplate holding company leveraged buy-outs within the shareholder group: a shareholder forms a holding company that then borrows the funds for the share acquisition; the holding company is amalgamated with the operating company after the acquisition. The corporation can thus deduct the interest expense from operating profits and it, rather than the individual shareholder, can repay the loan principal, avoiding tax on a dividend otherwise needed for the individual to repay the loan. The Income Tax Act transforms the proceeds received in a non-arm’s length leveraged buy-out from a capital gain into a taxable dividend, robbing the seller of both the benefit of the lower effective capital gains tax rate (the tax rate for dividends exceeds the effective rate for capital gains in every Canadian province and territory by up to 20%) and the benefit of the lifetime capital gains exemption (in 2017, slightly over $835,000 or $1M for farming or fishing property). 

Amicable Split. One option to contemplate as part of the family shareholders’ agreement discussion is a division of the family business (and other assets that might be in the family corporation) before an inter-generational transfer. If the business could survive if divided, division allows siblings to maintain a positive relationship by not working together in a single business, instead controlling separate businesses. Splitting-up a corporation is relatively easy where a related group controls it; however, for this single purpose siblings are deemed unrelated to each other. Therefore, carefully consider potential corporate divisions in the drafting of the family shareholders’ agreement.  

Key Tax Benefits

The government has made some concessions in its battle against transactions within family units – of which a carefully drafted family shareholders’ agreement can take advantage.

Partial Capital Gains Deferral. Where shares of the family business would qualify for the capital gains exemption, and the transaction is between parent and child, the selling family shareholder can spread the capital gain over the exemption amount across 10 years instead of the normal five. Where shares are destined to be transferred from a parent to their inactive children, the family shareholders’ agreement can instead cause active children to buy-out those shares followed by a gift of sale proceeds from the parent to the inactive child, reducing cash flow strain on the family business by facilitating a longer-horizon buy-out.

Complete Capital Gains Deferral. Transactions between spouses or common-law partners are generally tax-deferred in nature, with the transferor deemed to sell, and the transferee deemed to have bought, at cost. Tax-deferred inter-generational transfers are available for family farm and fishing property, along with family farm or fishing corporations and partnerships. For family farm or fishing corporations (with the terms ‘farming’ and ‘fishing’ receiving liberal interpretations by the courts), structuring the family shareholders’ agreement to take advantage of this tax-deferred inter-generational transfer both reduces current life insurance needs and multiplies potential access to the lifetime capital gains exemption.

Multiply Capital Gains Exemption. Including provision in the family shareholders’ agreement allowing a post-mortem transfer of shares to a surviving spouse or common-law partner before their purchase by other family members might multiply family access to the lifetime capital gains exemption.

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Please contact your McInnes Cooper lawyer or any member of the Tax Law Team @ McInnes Cooper to discuss this topic or any other legal issue.