Reasonable Compensation

Reasonable Compensation

AUTHOR:  RICK EVANS - CPA, CA, CFF, ABV, CVA, CFE, CPA (CALIFORNIA)

One of the most subjective and discretionary expenses for many small closely held businesses or professional practices is owner compensation. Reasonable compensation is a key assumption in the valuation model as it can have the most impact on the profits of the closely held business. This is due to the fact that compensation recorded in the Company’s books and records and presented in the financial statements is not always at market rates and it is not required to be. For example, owner compensation may have been established for tax planning purposes.

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When Do You Charge HST?

When Do You Charge HST?

AUTHOR: APRIL WHEELER - CPA, CGA

Whether you are self-employed or your business is incorporated it is your responsibility to ensure you register and collect HST when you meet certain conditions set out by the Canada Revenue Agency (“CRA”). Many small business owners are not aware that whether you are self-employed or incorporated, if your business earns greater than $30,000 in world-wide taxable supplies over any four consecutive calendar quarters you must register for HST, and collect HST, and remit it to CRA.

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Importance of a Shareholder Buy/Sell Agreement

Importance of a Shareholder Buy/Sell Agreement

AUTHOR:  RICK EVANS - CPA, CA, CFF, ABV, CVA, CFE, CPA (CALIFORNIA)

Business partners set up shop with the best of intentions. But no matter how strong a personal or professional relationship is at the outset, shareholder conflicts and other events may occur that can affect the continuity of the business operations. A buy/sell clause in the shareholder agreement that is understood by all the parties is an important tool that provides a mechanism and process to ensure an orderly transfer and the continuity of the business operations.

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Red Flags that will get you Audited

Red Flags that will get you Audited

AUTHOR:  APRIL WHEELER - CPA, CGA

The Canada Revenue Agency (CRA) audits people or companies whose tax returns seem suspicious.  CRA is more likely to audit self-employed individuals and small businesses than employees with a T4 slip.

CRA has significant industry and demographic data that they utilize to analyze a wide range of tax claims. Any real or perceived differences or outliers to this data could lead to an audit.  Often, the first step is not a full audit but a request for further information. However, if full and valid support for the claim is not provided, it could lead to a full audit.  You want to avoid an audit if at all possible.

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Tax Time: Tax Planning Using Private Corporations

Tax Time: Tax Planning Using Private Corporations

AUTHOR:  GREG KAUFFELDT

On July 18, 2017, the Department of Finance released a consultation document and draft legislation containing proposals that, if enacted, will significantly affect many private companies and their shareholders. Here is a brief summary of the proposed changes and how they will impact business owners.

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Changes to Reporting Principal Residence Sales

AUTHOR: Greg kauffeldt, CPA, CA

While the thrust of their proposals was directed towards preventing the use of the principal residence exemption (“PRE”) by non-residents as well as limiting its use for properties owned by certain trusts, all taxpayers who own a residence and use it (or a portion thereof) for their personal use will be affected by these proposals.

Prior to this announcement, the Canada Revenue Agency (“CRA”) had a long-standing administrative position which allowed the majority of home sales to go unreported where there was no capital gains tax owing on the sale.

With this announcement, all principal residence sales must now be reported, regardless of whether they are fully exempt from tax. This applies to sales which occur in the 2016 and subsequent taxation years. Taxpayers will have to report the sale on schedule 3 of their tax return for the year in which the property is sold.  If the property was your principal residence for every year that you owned it, you will make a principal residence designation on schedule 3. The CRA has indicated that you will need to include the following information when reporting the sale of a principal residence:

  • The year that the property was acquired;
  • The proceeds of disposition and related selling costs of the sale;
  • A description of the property that was sold.

For the sale of a principal residence in 2016 or later tax years, the CRA will only allow the PRE if you report the sale and designation of the principal residence in your income tax return. The proposed changes will allow the CRA to reassess a return after the end of the normal reassessment period for a gain on disposal of a property where the taxpayer did not initially report the disposition.  The CRA may accept a late filed principal designation but penalties may apply. These penalties can range from $100 for each month that the designation is late up to a maximum of $8,000. Therefore, accurately reporting the sale of a principal residence is now of utmost importance.

This change also applies to deemed dispositions of property including situations where you change all or part of your principal residence to a rental or business operation or vice versa.

The required schedule 3 reporting of all residence sales will allow the CRA to more easily identify and audit those sales that might not qualify for the PRE, such as;

  • Claiming a PRE on sale of a second residence, such as a seasonal cottage property where those particular years of ownership have already been designated towards another principal residence,
  • Home builders or renovators (“flippers”) who may have taken advantage of the PRE to shelter short-term profits on sale of those residences which should have been reported as business income.

The CRA has provided more information for individuals on this important change on their website.

If you have any questions about how these changes may impact your tax situation, please contact your McCay Duff advisor.

2016 ESTATES AND TRUSTS TAX COMPLIANCE AND POST MORTEM PLANNING — IT’S A NEW WORLD OUT THERE!

AUTHOR: Trevor Smithers, CPA, CMA

Just around the corner a series of new tax rules kick in that will impact the taxation of trusts and estates. These new rules will result in significant changes to existing and future tax planning arrangements. The current rules allow estates, testamentary trusts and grandfathered inter-vivos trusts indefinite access to the same graduated tax rates as an individual taxpayer. This often results in a lower overall tax liability where trust beneficiaries have access to more than one set of graduated rates.

The new rules come into effect January 1, 2016. With the exception of Graduated Rate Estates (GRE) and Qualified Disability Trusts, all testamentary trusts including estates as well as grandfathered inter-vivos trusts will now be taxable at a flat rate equal to the top federal personal tax rate. Additional changes include a mandatory December 31 year-end, quarterly instalment requirements, and no access to the $40,000 AMT exemption. The ability to retain and tax income inside a trust will only be allowed to the extent that losses are realized or carried forward. The loss carry-back provisions of subsection 164(6) of the Income Tax Act, which are widely used to reduce estate taxes, will now be restricted to those estates designated as a GRE. Finally, income and capital gains arising from the deemed disposition of trust assets upon the death of the life tenant of certain life interest trusts will now be included in the income of the deceased individual and taxed in the terminal tax return and not the trust.

Graduated Rate Estates (GRE):

As noted above, these changes will not apply to GRE’s and Qualified Disability Trusts. A GRE is an estate that arose upon the death of an individual. It qualifies as a GRE if no more than 36 months has passed since the date of death. The GRE is considered a testamentary trust for tax purposes. These trusts will have access to graduated tax rates, a $40,000 AMT exemption, and will not have to pay tax instalments for the period it remains as a GRE. If the estate is not wound up within 36 months of death, it loses its GRE status at which point the estate will then be taxed at the top marginal tax rate. Only an estate can qualify as a GRE and it must be designated as such in its first post 2015 year-end income tax filing.

Items to Consider:

  • Trustees will have some additional compliance requirements resulting from the new rules. As noted above, new and existing GREs will need to be designated as such in the first T3 Trust tax filing after December 31, 2015. While GREs will be able to file using a non-calendar year end, non-GREs and other testamentary trusts having non-calendar year-ends will be required to file a stub period tax filing in order to comply with the mandatory calendar year-end.
  • In circumstances where individuals may have set up multiple wills with differing executors and residual beneficiaries, it will be important to review the wills to ensure that the desired tax planning objectives can still be achieved with the ability to name only one estate as a GRE.
  • Going forward, will planning resulting in multiple testamentary trusts being created strictly to access the graduated tax rates will no longer be possible. However a discretionary testamentary trust that is used as an income splitting device still has merits. Furthermore, testamentary trusts still offer a number of non-tax benefits, such as independent control and management over the capital from beneficiaries who may be minors or spend thrifts, or possibly to shield trust assets from the beneficiary creditors.
  • Life Interest Trusts will be impacted by the new changes. Take for example a spousal trust where the life interest beneficiary (the surviving spouse) has subsequently remarried. Under the old rules, the spousal trust was deemed to have disposed of its’ property upon the death of the surviving spouse and the resulting capital gain was taxed inside the spousal trust. The spousal trust would pay the tax and the net assets distributed to the residual beneficiaries, typically being the children from the first marriage. Under the new rules, the deemed capital gain will now be taxed in the deceased individual’s estate. The assets that could be liquidated to pay the deceased’s tax liability are still in the spousal trust. The spousal trust cannot pay the tax of the life beneficiary since this would taint that estate and its GRE status. Difficulties could arise where the spousal trust and deceased estate’s residual beneficiaries are not the same parties.
  • Also, effective January 1, 2016, there are new donation rules for gifts made by will which will provide greater flexibility to the executors in terms of the timing and location of the claim. For non-GREs charitable donations can only be claimed in the first five years of the estate whereas GREs have several different options for claiming the donation including taking the credit as part of the terminal tax filing. Also, only a GRE can take advantage of the zero capital gains inclusion rate for an in-kind donation. All non-GREs will be taxed on the capital gain that arises from the disposition of the in-kind asset.

In light of these significant changes we recommend that you revisit your wills to determine their impact with your current tax planning arrangements. Please don’t hesitate to contact your McCay Duff representative to discuss your particular situation in further detail.

Beware of new telephone scams

AUTHOR: Paul SPare, CPA, CA

The following article appears originally on the CRA website and was posted originally on June 10th, 2015.

The Canada Revenue Agency (CRA) is noting an increase in telephone scams where the caller claims to be from the CRA but is not, and is asking Canadians to beware—these calls are fraudulent and could result in identity and financial theft.

Some recent telephone scams involve threatening taxpayers or using aggressive and forceful language to scare them into paying fictitious debt to the CRA. Victims receive a phone call from a person claiming to work for the CRA and saying that taxes are owed. The caller requests immediate payment by credit card or convinces the victims to purchase a prepaid credit card and to call back immediately with the information. The taxpayer is often threatened with court charges, jail or deportation.

If you get such a call, hang up and report it to the Canadian Anti-Fraud Centre.

These types of communication are not from the CRA. When the CRA calls you, it has established procedures in place to make sure your personal information is protected. If you want to confirm the authenticity of a CRA telephone number, call the CRA by using the numbers on its Telephone numbers page. The number for business-related calls is 1-800-959-5525. The number for calls about individual concerns is 1-800-959-8281.

To help you identify possible scams, use the following guidelines:

The CRA:

  • never requests prepaid credit cards;
  • never asks for information about your passport, health card, or driver's licence;
  • never shares your taxpayer information with another person, unless you have provided the appropriate authorization; and
  • never leaves personal information on your answering machine or asks you to leave a message containing your personal information on an answering machine.

When in doubt, ask yourself the following:

  • Is there a reason that the CRA may be calling? Do I have a tax balance outstanding?
  • Is the requester asking for information I would not include with my tax return?
  • Is the requester asking for information I know the CRA already has on file for me?
  • How did the requester get my email address or telephone number?
  • Am I confident I know who is asking for the information?

The CRA has strong practices to protect the confidentiality of taxpayer information. The confidence and trust that individuals and businesses have in the CRA is a cornerstone of Canada's tax system. For more information about the security of taxpayer information and other examples of fraudulent communications, go to www.cra.gc.ca/security.

Canadian Anti-Fraud Centre

For information on scams or to report deceptive telemarketing contact the Canadian Anti-Fraud Centre online atwww.antifraudcentre-centreantifraude.ca or toll free at 1-888-495-8501.If you believe you may be the victim of fraud or have given personal or financial information unwittingly, contact your local police service.

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Eight Tips for Preventing Fraud in Not-For-Profit Organizations

AUTHOR: April Wheeler, CPA, CGA, B.COMM

Many organizations feel that, due to their small size, they are not susceptible to fraud. Unfortunately, this is not true.

Even the smallest of organizations have been, and can be, targets of fraud.

In fact, smaller organizations have disproportionately large losses from asset misappropriation, and are much less likely to recover from a fraud. This is due to the fact that they often employ friends, family and other “trusted individuals,” and rely on trust rather than internal controls to minimize their exposure to fraud. Trust, without verification in the form of internal controls, is ineffective and provides the opportunity for employees to commit fraud.

There are several simple and inexpensive steps that every not-for-profit organization can implement to prevent fraud. They are as follows:

  • Perform background checks on employees – Obtain information on a potential employee from an independent third party. About 15% of employees who commit fraud are repeat offenders.
  • Create an environment where honesty is practiced.
  • Maintain current and accurate accounting records – Accurate accounting records makes hiding fraudulent activity more difficult.
  • Periodically test to determine whether the internal controls are being followed – This lets employees know that others are watching and may deter them.
  • Insist employees take time off and cross-train employees – This will reduce an organization’s reliance on one individual and make it more difficult for an individual to hide fraudulent activities.
  • Physically secure the organization’s premises and assets.
  • Limit access to accounting software – Access should be limited to job functions and include offsite back-ups.
  • Use electronic payments – This will eliminate the use of cheques and reduce the likelihood of an individual passing a fraudulent cheque through the system.

Fraud and employee theft will always be concerns for an organization. Nothing can eliminate the possibility of an organization being a victim of fraud. However, a few simple policies and controls can minimize this risk by reducing the opportunities for fraud to be committed.

To Buy or To Lease – That is the Question

Author: Paul Spare, CPA, CA

One of the questions that we get asked a lot by clients is whether it is better to lease or to buy a vehicle. The tax consequences are quite different depending on what option you choose:

Buying:

If you purchase a vehicle then you can only claim a percentage of the vehicle’s cost as capital cost allowance (i.e. depreciation) each year. The first year you are entitled to claim 15% of the cost and in subsequent years you are entitled to claim 30% of the remaining portion of the unamortized cost. For certain vehicles that the Canada Revenue Agency considers “luxury vehicles” the amount that you can capitalize and amortize is capped at $30,000.

If you financed the purchase, you are able to claim the interest costs subject to an annual maximum amount that is set out in the tax legislation. The annual maximum interest deduction is the lesser of the interest paid for the year and $10 multiplied by the number of days for which interest was payable in the year (i.e. a maximum of $3,650 unless it’s a leap year!). The other benefit to owning the vehicle is that if you are a GST/HST registrant you may be able to claim some or all of the Input Tax Credits (ITC) when you purchase the vehicle.

Leasing:

Some people prefer to lease vehicles so that they can enjoy a new vehicle every couple of years. The lease payment is claimed as a deduction (again subject to annual limits set by the government – currently $800 + Sales Tax). If you are a GST/HST registrant the GST/HST that is included in the monthly lease payment can be claimed on that period’s HST return as an ITC.

While one option may result in a higher tax deduction in the first year or two – the overall tax impact will usually be pretty close under each option.

There are other factors that come into play in the lease vs. buy decision:

  • How many kilometres do you expect to put on the vehicle each year? Lease agreements specify the number of kilometres that can be accumulated over the term of the lease and there are penalties for excess kilometres driven. If your life is spent commuting and you drive over 20,000 kilometres a year then a lease may not be cost-effective due to those penalty provisions.
  • How much do you want to spend on a monthly basis? Usually, lease costs are much lower than monthly payments on a car loan.
  • Will the vehicle be purchased or leased by a company for use by an employee? A taxable benefit would have to be reported by the employee each year for their use of the vehicle. The amount if the benefit depends on the value of the vehicle, the kilometres driven each year and the mix of business vs. personal use by the employee.
  • For some, the bottom line is whether you want to own something outright in the end or whether you like something new to drive every couple of years.

What is your preference? Lease or buy?

Succession planning: Don’t blame the taxman if you failed to prepare

Two Sales Assistant At Vegetable Counter Of Farm Shop
Two Sales Assistant At Vegetable Counter Of Farm Shop

Author: Paul Spare, CPA, CA

Your retirement plan is to sell your business.

Fair enough. But will the proceeds be sufficient to support your desired standard of living in retirement?

This is my last post on the subject of succession planning. In my previous post, I presented some of the considerations and options that pertain to passing on a business to heirs that may be children or other family members.

Selling to a third-party outside of family can be more challenging. As my colleague Rick Evans has written before, some businesses, and some industries, simply do not lend themselves to a profitable sale that will support a retirement plan.

A long-term planning horizon is crucial to determine the best way to unlock value from your business, and put all the necessary pieces in place. This takes years – I can’t emphasize that enough.

If you do have a worthy asset to sell …

There are a few different paths to take.

One option is to sell shares in an incorporated business rather than its assets. This will result in a capital gain or loss, only half of which is taxable to the business owner. The after-tax proceeds can be used at your discretion to invest or as income.

Another option is to have the operating business owned by a holding company, and then sell assets or shares of the operating business. This results in sale proceeds being taxed within the corporation. Different tax implications kick in depending on the type of asset being sold, and whether the income generated is active business income or investment income.

Either way, the owner ends up with a corporation that holds the after-tax proceeds of the sale. The choice is to then either close down the corporation or continue it. Both options open up a host of new possibilities in terms of how to derive monetary value, create income and minimize the tax implications for the owner and their heirs.

Look out for the fine print of capital gains

Regardless of what path you take, always be mindful of potholes that could trip up your eligibility to claim the capital gains exemption.

A well-designed succession plan can save you well above $100,000, depending on your individual circumstances.

Over the course of its existence, however, your business can acquire a number of assets that may throw a possible claim for the capital gains exemption offside. For example, only 10 per cent of your business’s assets can be non-active assets. These include surplus cash that may be in GICs or term deposits, and any investment properties that don’t contribute to the growth or operation of the business.

It may take time to liquidate or transfer these assets to ensure that you qualify for the capital gains exemption.

Time is not on your side

Successfully navigating all this requires a trusted team of advisors to maximize your net after-tax proceeds. Otherwise, you could find yourself paying tens, or even hundreds of thousands, of dollars in excessive tax.

As I said in my first post on the subject of succession planning, a robust and comprehensive succession plan is a three-to-five-year exercise, regardless of how you want to exit your business. Take a moment to consider that. If you want to retire in 2019 or 2020, the time to start planning is now.

Succession planning: Keeping it in the family, without starting a feud

Author: Paul Spare, CPA, CA

In my previous post, I emphasized the importance of long-term and comprehensive planning to ensure that a business succession is as trouble-free as possible, and will leave the most after-tax dollars in your pocket.

When that succession plan involves passing the business to a child or other family member, a host of considerations come in to play. Many of these have nothing to do with dollars and cents. Interpersonal relationships can quickly complicate, even sink, any business transaction.

But, regardless of who is involved, this is a business transaction. The best way to minimize the potential for conflict and financial loss is to develop a plan that addresses all of the possible tax, income and legal issues that can arise.

Cap your expectations

In a majority of cases, business owners are accustomed to pulling whatever available cash from the business they want, for whatever purpose, at their discretion. But that cash is an asset of the business, and your successor(s) may have something to say about how it’s expended.

Your successor(s), on the other hand, must appreciate that you will likely maintain some ownership in the business. This stake may represent a source of passive retirement income on which you will depend for a number of years. They are obligated to ensure the business decisions they make don’t put that in peril.

It’s vital for both parties to appreciate that a relationship of give, take, and mutual consideration and respect, must reign for years, if not decades, to come.

Then cap your tax liability

The next step is to consider how this transfer of ownership will take place. Will it be in the form of a gift, a sale at fair market value or an estate freeze? There is no one right answer. Each scenario has its own considerations and implications for you and your successor(s). This is where you need that group of trusted tax, legal and financial advisors to help you clarify your needs and identify the most beneficial course of action.

One approach is an estate freeze. In most instances, the owner will exchange their existing common shares for fixed-value preferred shares. The company then issues common stock to the successors. This allows the current owner to “freeze” the value of their shares and their ultimate tax liability, while continuing to control the asset. The successors, meanwhile, can benefit from (and be liable for the taxes payable on) the increase in value of the asset after the date of the estate freeze.

To decide which course of action is best, everyone must be at the table. Clear and honest communication among all your business’s stakeholders and advisors is crucial.

And remember – if your intent is to pass the business on to your children, you must have a plan in place now, regardless of how far off that transition may be. Tragedy strikes when we least expect it. Take the time to sort out your will and consider the role that family trusts can play in your estate planning.

In my final post on the subject, I’ll discuss the options and challenges related to a third-party sale.

7 reasons why an up-to-date valuation is an asset to your business

7reasons

Author: RICK EVANS, CA, CPA(CA), ABV, CFF, CVA, CFE

Many business owners only obtain a valuation of their business when they are considering a sale, or reacting to an unforeseen situation. But there are benefits to always having an up-to-date valuation in hand. It’s a proactive measure that ensures you are acting from a position of strength when the unexpected does happen.

Here are some reasons why you should have a current valuation of your business:

  1. You are ready if you receive a purchase offer for your business that has to be acted on quickly.
  2. Value changes over time. A business valuation helps you to understand, on a timely basis, the impact of variables such as changes in the economy, your industry, your expense structure and staffing.
  3. A business valuation will highlight areas of strength and weaknesses in your business relative to your industry peers.
  4. Further to points 2 and 3, this gives you the insight you need to take appropriate corrective action.
  5. You understand your capacity to borrow if business opportunities present themselves.
  6. Your business can be quickly put up for sale if family tragedy or other misfortune demands a fast exit.
  7. A valuation can help separate individual goodwill and business goodwill.
  8. Individual goodwill is transferable, if you recognize it and take the time to substitute other people with similar skills and experience into your role.

An up-to-date business valuation prepares you for when opportunities present themselves, helps you understand how to create value in your business and reveals changes in the value of your business over time.

Most importantly, it gives you the power of choice, and protects you from becoming a victim of circumstance when the unexpected happens. An up-to-date business valuation allows you to act in your best interests, as well as those of your family, employees, customers and fellow shareholders.

How do you pass the torch without getting burned?

How do you pass the torch without getting burned?

SuccessionPlanning A succession plan that leaves the most dollars in your pocket is years in the making

By Paul Spare Two years ago, the Canadian Federation of Independent Business found that about 54 per cent of its members planned to exit their businesses within five years, but only nine per cent had any formal written exit plan.

Around the same time, KPMG, on behalf of the Canadian Association of Family Enterprise (CAFE), found that only 11 per cent of 322 family businesses surveyed had succession plans for their CEOs.

This is a problem, and one that only worsens with each passing year. Considering that most of these owners and chief executives are aging baby boomers, the proportion of them nearing retirement age is growing by leaps and bounds. In its 2012 report, CAFE emphasized how this lack of planning is a root cause of why only 30 per cent of family businesses survive to the second generation and only 15 per cent reach the third.

As a business owner, you must ask yourself three questions:

  1. “When do I want to retire?”
  2. “How am I going to exit the business?”
  3. “What must I do between now and retirement to ensure I exit the business in a manner that allows me to maintain my standard of living?”

A robust and comprehensive succession plan is a three-to-five-year exercise. Take a moment to consider that. If you want to retire in 2019 or 2020, the time to start planning is now.

Why? Consider these questions:

  • First of all, whom are you going to pass the business on to?
  • If it’s children, are they willing and ready? What will it take to prepare them to pick up the ball and run with it?
  • Do you want to sell to a third-party? If so, who? Where do you find potential buyers? What shape must your business be in to solicit the best price?
  • How do you determine the value of the business? This of course requires a professional valuation, the domain of my colleague, Rick Evans.
  • In either scenario, how do you engage in the process in a manner that does not cause under stress or uncertainty for key employees, partners or clients?
  • Most importantly, how do you exit the business in a manner that maximizes your financial gain without leaving you stung with a huge tax bill?

These are all considerations that emphasize the need to begin the process years out, with the assistance of trusted legal and tax planning advisors.

But the devil is in the details. The options that are available to maximize your proceeds from the business, and reduce your tax burden as much as possible, differ depending on whether your intent is to pass the torch to the next generation, or sell to a third-party.

In my next post, I’ll discuss the options and challenges related to preparing to hand off the business to family, before looking at the scenario of a third-party sale.

When tragedy struck, these shareholders were prepared

GoodCase

AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

In my last post, I presented a case study about Howard, the owner of a successful manufacturing company.

When Howard passed away without a suitable buy-sell clause to ensure an orderly transfer of his ownership interest, all of the business’s stakeholders were caught in the crossfire. These included the other shareholders, his wife and his children.

Today, I have another case study that ends on a more positive note. Why? Because these shareholders did it right at the outset.

Chris and Tom were equal partners and shareholders in an electrical contracting company. When they commenced operations, they instituted a shareholders agreement that included a clear and comprehensive buy/sell clause.

This clause stipulated that, should one shareholder, or his estate, want to sell or transfer their shares in the company, the other shareholder had the right of first refusal. This ensured that no shares would be sold to an unknown third party. It also ensured there would be a market for selling or transferring the shares.

The clause that leaves nothing to chance A key element of a sound buy/sell clause is a defined mechanism for determining how the purchase price of the business’s shares will be determined. In this instance, Chris and Tom had agreed to use the adjusted book value of the company, plus goodwill. Goodwill was defined as one year of the company’s average earnings before interest, taxes, depreciation and amortization (EBITDA).

In addition, the buy/sell clause stated that:

  • The purchase price would be calculated by an independent valuation professional.
  • The valuation report would be paid for by the company.
  • The purchase price would be paid for with life insurance policies on the shareholders that listed the company as the beneficiary.
  • In the event there was not enough insurance in place, the remaining balance of the purchase price would be paid in 60 equal instalments of principal and interest.
  • To insure the partners remained adequately insured to cover the purchase price, a valuation of the company was performed every two years.

Put to the test Tragedy struck after Chris and Tom had been in business for over 20 years.  Tom lost his son in an automobile accident.

The loss had a profound impact on Tom. His focus on, and performance in, the business deteriorated to the point where Chris was bringing in most of the contracts and managing most of the projects.

The partners agreed it was time for Tom to exit the business. Because they had a clear and understandable buy/sell clause, Chris was able to quickly buy Tom’s shares. The only point of contention was the value of some of the machinery and equipment, and they agreed to defer to a valuation by a professional appraiser.

A year after the buyout, Chris decided he didn’t want to be a business owner any longer. With the advice of a valuation expert, Chris spent the next two years marketing the business to potential buyers, and ultimately sold it to a general contractor that had decided to open an electrical contracting division. As part of the deal, Chris was hired as vice-president of that division.

Tom got the quick exit he needed, under fair and equitable terms. Chris, at 52 years old, was able to finance his retirement, budget for his kids’ post-secondary education, and land a new job with the general contractor that paid $200,000 a year.

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In the absence of a buy/sell clause, everyone gets caught in the crossfire

BuySell

AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

In my previous post, I talked about what is arguably the most important, but often most overlooked, component of a shareholder agreement – the buy/sell clause. This mechanism establishes the ground rules for the orderly transfer of an ownership interest.

I’ve seen a lot of unfortunate situations in my work—shareholders who pass away, become ill, succumb to substance abuse, endure personal crises that derail their business focus, or simply fail to fulfill their obligations to their business partners. Without a well-written buy/sell clause, any of these scenarios can cause undue hardship and financial loss for all of a business’s stakeholders.

Take Howard, for example. He is the successful owner of a manufacturing company that makes products using composite technology. He owns 40 per cent of the shares in the company. Three other shareholders each hold 20 per cent.

Howard and his wife have three children. His wife doesn’t work, and depends on the income generated from Howard’s ownership interest in the company.

Then Howard dies, without a buy/sell clause in the shareholder agreement. This leaves his wife with his 40 per cent ownership interest in the company, but she has no intention of actively participating in the operations the company. She needs the proceeds from the sale of Howard’s 40 per cent interest to provide for herself and her children.

The other shareholders don’t want some unknown party acquiring Howard’s shares, but they do not have the funds available to buy Howard’s interest. They also have the added challenge of finding someone with Howard’s expertise to take over his role with the company.

Fifty per cent of the company’s revenue comes from a single customer. Seeing how uncertain the future of the company has become, this customer is considering taking its business elsewhere.

Without this customer, the company’s value could plummet. Employees could be out on the street. The potential loss of value may result in Howard’s wife having to sell her shares for a fraction of what they were worth when Howard was alive.

How much value will Howard’s wife lose? How will this impact her ability to provide for herself and her children?

Now, if there had been a proper buy/sell agreement, it would have:

  • Provided a mechanism for how and when the remaining shareholders could purchase Howard’s shares.
  • Defined how the other shareholders could have funded a purchase of Howard’s shares to ensure liquidity for his wife. Funding is often accomplished through a life insurance policy.
  • Ensured the shareholders would have agreed on the method that would be used to determine the purchase price of the shares.

In my next post, I’ll recount the outcome of a more positive scenario, in which the shareholders did it right from the outset, to their mutual benefit.

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A buy/sell clause helps prevent business divorces from getting messy

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AUTHOR: RICK EVANS, CPA, CPA(CA), ABV, CFF, CVA, CFE

Business partners set up shop with the best of intentions. It’s a relationship that must be built on mutual trust and respect. But no matter how strong a personal or professional relationship is at the outset, shareholder conflicts and other events may occur that can affect the continuity of the business operations. A mechanism and process that establishes the ground rules for the orderly transfer of the businesses shares caused by unforeseen conflicts or events is important. A suitable buy/sell clause in the shareholder agreement that is understood by the parties is an important tool to ensure this orderly transfer and the continuity of the business operations.

A buy/sell clause is often the most neglected feature of a shareholder agreement, either because it’s set forth in an arbitrary and confusing manner, or because it’s neglected altogether. It can be an uncomfortable subject to raise when fellow shareholders are close friends or family, since it‘s analogous to asking a fiancé to sign a pre-nuptial agreement. However, the lack of a buy/sell clause often results in disputes, costly legal proceedings, long delays in transferring of ownership and disruption in the business operations.

The buy/sell clause provides a mechanism for how and when the remaining shareholders can purchase a departing shareholder’s shares due to a triggering event, such as a shareholder retirement, disability, death or dispute. It also defines how that purchase will be funded to ensure liquidity. Funding is often accomplished through a life insurance policy.

Most importantly, it forces shareholders to agree on the method that will be used to determine the purchase price of the shares Here are some examples of methods used to determine price in a buy/sell agreement:

  • Price is determined by a business valuator.
  • The parties to the agreement negotiate a fixed price and update annually.
  • The price is determined by a formula.
  • Price is determined by a shotgun clause.
  • Price is determined by the right of first refusal.

Each of the methods has its advantages and disadvantages. To determine which is in the best interests of all shareholders, a business valuator should be consulted during the drafting of the buy/sell clause.

In my next two posts, I’ll feature two case studies that put this in perspective.

The first will explore the legal nightmare that arose in a business when a majority of shareholders wanted to force the rest to accept a buyout offer, without the guidance of a buy/sell clause. The second will examine a business that did it right from the outset, and how this ultimately played out to the benefit of all shareholders.