What happens if a business partner passes away? The hidden tax trap every owner should know

It’s a scenario most business owners prefer not to contemplate: the sudden passing of a business partner. While the emotional toll is enormous, the financial consequences can be devastating and, as many discover too late, can be complicated. Even if you believe you’ve covered your bases with a shareholder agreement and life insurance, subtle details in how these arrangements are structured can leave your business and your family vulnerable and at risk of having to face substantial tax bills.

• The situation at a glance
• The problem: hidden tax and CDA impact
• The fix: a tax-efficient buy-out
• Implementation checklist
• Next steps and support

The Unexpected Complexity of Business Succession

Let’s start with the basics. You and your business partner have built something valuable together, perhaps a company worth $10 million. You’ve both acted responsibly by drafting a shareholder agreement and taking out life insurance policies designed to ensure the surviving partner can buy out the deceased’s shares, keeping the business running smoothly and providing for the family left behind. On the surface, it seems you’ve handled succession planning like a pro.

But here’s the hard truth: the way your shareholder agreement is worded could mean the difference between a smooth, tax-efficient transition and a costly financial disaster. What appears to be a straightforward process—using insurance proceeds to buy out a deceased partner’s shares, can quickly become a minefield if not structured with tax consequences in mind.

A Common but Costly Scenario

Consider the following example, which is all too common among small businesses in Canada:

• Your business is valued at $10 million, with each partner owning 50%
• You’ve taken out a $10 million life insurance policy to fund the buyout if either partner passes away
• If tragedy strikes, the insurance company pays the business the $10 million
• The company then uses the proceeds to buy the deceased partner’s shares from the estate or family

At first glance, this arrangement seems watertight. The surviving partner retains control, the family receives fair compensation, and the business can carry on. However, there are details that need to be addressed.  In many shareholder agreements, the company is required to purchase the shares directly and quickly from the deceased’s estate, often before the deceased’s spouse or family legally owns the shares but this comes with other implications.

The Tax Trap

Here’s where things get tricky. When the deceased’s estate sells shares directly to the company, the estate receives the insurance payout and after that, is hit with a hefty tax bill. In this scenario, the transaction is treated as a sale, and the gain on the shares is taxed as a capital gain to the estate.

The numbers can be staggering. Done improperly, the deceased’s estate may end up owing more than $1.3 million in taxes just to pass along the company shares. Beyond this, the surviving shareholders lose access to a powerful tax advantage associated with having a capital dividend account (CDA), which could have allowed them to pay out future profits tax-free. Instead, the opportunity is lost, and both the family and the business are worse off—all because of a technicality in the agreement’s wording.

A capital dividend account is a notional account that’s used to track certain tax-free capital dividends accumulated by a private corporation. The dividends can be distributed as tax-free capital to the Canadian shareholders of the corporation.

Addressing Technicalities 

The root of the problem lies in the timing and ownership of the shares. If the deceased’s family or estate never formally owns the shares before the buyout, the government treats the transaction as a direct sale from the estate to the corporation, triggering capital gains tax. Conversely, if the agreement allows the shares to pass briefly to the spouse or estate before being sold, the tax burden can be avoided.

The Missed Opportunity: An Expensive Mistake

Using our example:

• Business valuation: $10 million
• Insurance proceeds: $10 million
• Estate receives payout, but faces over $1.3 million in taxes on the capital gain
• Surviving shareholders lose the chance to pay out $5 million in future profits, tax free

In this scenario, the insurance, which was meant to protect the business and its families, triggers, 

• A massive capital gains tax bill for the grieving family
• A loss of tax-free future value for the surviving shareholders
• A windfall for the government

All this from a well-intentioned but flawed agreement.

The Simple Fix (That Many Miss)

The silver lining is this problem is entirely avoidable, if you act in advance. If your shareholder agreement is structured to allow the deceased partner’s estate or spouse to briefly own the shares before selling them to the surviving partner (or the company), 

• The estate receives payment equal to the full value of the shares
• There’s no capital gains tax on the transaction
• The company doesn’t lose access to the capital dividend account
• The entire buyout is funded by insurance, just as intended

This simple tweak shifts the taxation from a costly capital gain to a tax-free transaction, preserving value for both the business and the family.

How it Works

Here’s a step-by-step breakdown of the optimal process:

1. The deceased’s shares pass to their spouse or estate, as stipulated in a revised shareholder agreement
2. The estate sells the shares to the surviving shareholder(s) or the corporation
3. The purchase by the surviving shareholder(s) or the corporation is funded the proceeds of the life insurance
4. Because the shares passed through the estate, the transaction qualifies for more favourable tax treatment, often eliminating the capital gains tax entirely
5. The business retains access to the capital dividend account, allowing future tax-free distributions

What Every Business Owner Should Do Now

It’s not enough to simply have a shareholder agreement and life insurance. The details of how these documents are structured are critical. Here’s what you can do today to protect your life’s work and your loved ones:

1. Review your shareholder agreement. Examine the wording around what happens when a partner passes away. Does the agreement allow the deceased’s estate or spouse to temporarily own the shares?
2. Consult with a qualified advisor. Tax laws and succession planning are complex and subject to change. Work with an accountant, lawyer, or succession planning expert who understands these nuances.
3. Coordinate your life insurance strategy. Life insurance should be set to fund the buyout while maximizing tax efficiency. Ensure the ownership and beneficiary designations align with your succession plan.

Plan for the long term. Business succession is not a one-time event. Revisit your plan regularly, especially as your business grows or circumstances change.

The Cost of Inaction

The consequences of ignoring these details can be severe: families facing unexpected tax bills, surviving partners losing future value, and businesses destabilized at the worst possible moment. Worse, these outcomes often play out during periods of grief and crisis, compounding stress and hardship.

By proactively structuring your shareholder agreement and insurance policies, you can prevent these pitfalls and ensure our business and loved ones are protected, no matter what the future holds.

Conclusion

Business succession planning is more than just a checkbox, it’s the foundation for protecting your company, your partners, and your families. Even if you think you’re prepared, the wording in your shareholder agreement and the structure of your insurance can make all the difference.

Take the time to review your agreements, consult experts, and make strategic changes as necessary. The cost of a mistake can be enormous but with proper planning, the transition can be smooth, tax-efficient, and true to your intentions.

Don’t wait for the worst to happen. Protect your legacy now to ensure your business and loved ones are shielded from unexpected tax bills and financial turmoil.