Picture: 123RF/FLYNT
Picture: 123RF/FLYNT

Last month, we looked at the issue of covering a "keyman" in a company. This month we will discuss the issue of shareholder continuity. A buy-and-sell agreement is one where the shareholders in a company [or partners in a partnership, or members in a close corporation, loosely referred to as shareholders here] undertake that on the death or disability of one of them, the surviving shareholders will buy, and the deceased or disabled shareholder will sell, their shares. The agreement normally determines a method of valuing the shares on death or disability.

Life insurance is normally taken out on the shareholders' lives to provide the cash to finance the structure.

Here are questions you should consider when structuring a buy-and-sell agreement:

Do the shareholders want to cover disability?

This is a double-edged sword. If disability is covered, then at least if a shareholder is disabled the other shareholders can buy him or her out, but the disabled shareholder may not want to be forced to exit the business. You should discuss in depth with your financial adviser and co-shareholders whether you want to be forced to exit in the event of disability.

If you do include disability, make sure it is objectively defined and the insurance covering your life is linked to your occupation. Most insurers have a tailor-made business assurance disability product linked to an inability to carry on with the life assured's occupation only, and this is the appropriate product.

How have the shareholders valued the business?

One approach is that on the death or disability of a shareholder, the company auditor values the business and the individual's shares. This has the advantage that the value paid will be objective and up to date, but it may lead to conflict.

There are many different methods to value a business, and, of course, the disabled shareholder or the dead shareholder's estate will want to place as high a value on the shares as possible, whereas the remaining shareholders will want to place as low a value as possible. This will drag the auditor into the dispute and create a potential for litigation. If this method is adopted, make sure the agreement specifies the valuation method to be used by the auditor.

Another approach is for the shareholders to update their share values in an annexure to the actual agreement every year and specify a fixed rand value.

This method ensures there is no conflict on a death or disability, as the values are clear. However, there is a risk of the values becoming out of date if the shareholders do not update it every year.

Again, the answer is what works best for you. It may even be a combination of the two. However, make sure you understand the consequences of whichever method you choose, and keep your agreement up to date.

What happens if the policy values become outdated?

The problem that often arises is that the policies become more/less the value of the shares over time. If the policies are more than the value of the shares, there could be estate duty and income tax consequences, particularly if the remaining shareholders overpay for the shares.

If the policies are below the value of the shares, the remaining shareholders will be short of funds.

Remember, that in such a case, it is for the taxpayers to prove they have paid the correct value, not for Sars to prove otherwise, as the taxpayer has the onus of proof. Check the value of your policies are in line with the value of the shares at least once a year. It is dangerous to put a clause in a buy-and-sell agreement stating that the shares will always be deemed to equal the value of the policies, as it indicates to the South African Revenue Service that the shares are not being properly valued.

If the shares have dropped in value, and the policy proceeds that the remaining shareholders pay over to purchase the shares on a death or disability are more than the shares are worth, this could lead to donations tax for the purchasers.

What if the shares are owned by a trust and not by the individuals?

If A and B do not own their shares personally, but rather through their family trusts, the buy-and-sell structure becomes more complex.

The trusts must own the policies, as they will be buying the shares on a death or disability.

The policies will be estate dutiable, as they do not then qualify for exemption under the Estate Duty Act. Discuss this with your financial adviser as the policies must be increased to cater for the extra estate duty.

In addition, the trusts must sign the buy-and-sell agreement, which must state that on the death or disability of A, the proceeds of the policy will be paid to family trust B, which will use the funds to buy the shares from family trust A, which undertakes to sell the shares to trust B, and vice versa.

If your shares are held in trust, make sure that your buy-and-sell agreement is specially tailored to the structure, and do not use an off-the-shelf traditional agreement.

Check, check and check again

The agreement is a vital part of the buy-and-sell structure. Make sure your agreement and policies correctly reflect your personal circumstances and are regularly reviewed to take account of any changes in share values and tax legislation.

• Joffe is head of legal services at Discovery Life