Introduction

Most incorporated business owners with partners know they should have a shareholders agreement. Fewer have one that includes a properly funded buy-sell mechanism. And almost none have had a specific conversation about what happens on day one if a co-owner dies or becomes permanently unable to work.

A buy-sell agreement without funding is a legal right with no practical means of exercise. A well-funded buy-sell agreement, by contrast, allows a business to continue operating and an estate to receive fair value — without requiring either party to scramble for liquidity in a moment of crisis.

The Problem Without a Buy-Sell Agreement

Consider a two-person professional corporation — two lawyers, two physicians, two contractors — each owning 50% of the shares. One owner dies.

Without a buy-sell agreement, the deceased's shares pass to their estate. The estate is now a 50% co-owner of a business it cannot participate in and likely wants to liquidate. The surviving owner is now in business with their partner's estate — a relationship that serves no one well.

The surviving owner wants to buy the shares. The estate wants to sell them. But at what price? And with what money? If neither party has the liquidity to execute a transaction, the impasse can last for years, damaging the business and reducing the ultimate value for everyone.

The Buy-Sell Agreement Structure

A buy-sell agreement is a provision in the shareholders agreement — or a standalone agreement — that:

Obligates the surviving shareholders to purchase the deceased's shares (or the shares of a disabled partner)

Specifies how the purchase price is determined — either a fixed formula, an agreed valuation method, or a third-party valuation process

Specifies when the purchase must be completed

Specifies the funding mechanism for the purchase

The two most common triggering events are death and permanent disability. Voluntary departure, retirement, and disagreement provisions are also common, though these events allow more time for a negotiated process.

Funding the Buy-Sell: Corporate-Owned Life Insurance

The most common and tax-efficient funding mechanism for a death-triggered buy-sell is corporate-owned life insurance. The corporation purchases a life insurance policy on each shareholder. On the death of a shareholder, the corporation receives the insurance proceeds, tax-free (with the excess over the policy's adjusted cost basis flowing to the capital dividend account — as discussed in Article 67).

The corporation uses the insurance proceeds to purchase the deceased shareholder's shares from the estate. The estate receives cash; the surviving shareholders own 100% of the corporation.

The tax efficiency of this mechanism is significant. Insurance proceeds received by a corporation are not taxable income. The proceeds that exceed the policy's adjusted cost basis flow to the capital dividend account, from which they can be distributed to shareholders (including to facilitate the purchase) tax-free. Without insurance funding, the corporation would need to use taxable retained earnings or arrange external financing — both of which are more costly.

Disability Buy-Sell: A Different Problem

Death can be funded with relatively straightforward life insurance. Permanent disability — where a partner can no longer work but is alive and in need of income — is a different challenge. Disability buyout insurance is available and provides a lump sum benefit triggered by a qualifying disability event. It is less commonly in place than life insurance, in part because the premiums are higher and the qualifying conditions more complex.

Without disability coverage in a buy-sell structure, a long-term disability can leave the business in a prolonged state of uncertainty — the disabled partner is technically still a 50% owner but unable to contribute, and the trigger for a buyout may be contested.

Keeping Valuations Current

A buy-sell agreement that specifies a fixed price set five years ago is outdated in a growing business. Agreements that use formula-based valuations — a multiple of revenue or EBITDA, or a book value approach — are more durable but require that the formula be reviewed periodically and that the parties agree it still reflects the business's value.

An agreement that specifies a third-party independent valuation on triggering event provides the most reliable outcome but introduces timing and cost uncertainty.

When to Speak With a CPA

The funding mechanics of a buy-sell agreement — insurance amount, policy structure, capital dividend account implications, and the tax treatment of the resulting share purchase — require input from both a CPA and a lawyer. The insurance advisor who sets up the policy should also be coordinating with the legal and accounting team to ensure the structure is cohesive.

Rotaru CPA works with incorporated business owners on shareholder agreement planning and the tax mechanics of corporate-owned insurance. Book a consultation to discuss your buy-sell structure.