Buy and sell agreements - CGT implications you may not be aware of

Tiny Carroll, estate planner, Glacier by Sanlam

We regularly receive business assurance related queries and we have noticed that some of the capital gains tax (CGT) implications of buy and sell agreements are not well understood.

What is a buy and sell arrangement?

To avoid confusing terminology, the example used here will deal with co-shareholders of a private company. The same reasoning can be applied to the partners in a partnership or members of a close corporation.

By way of an example, Paul and Mary are equal co-shareholders in PM (Pty) Ltd. Paul is married to Susan. The current market value of their respective shareholding is R2 200 000 each. The base cost of each interest is R500 000.

In this context a buy and sell arrangement is an agreement entered into between Paul and Mary, in terms of which they each undertake to sell their shares in PM (Pty) Ltd to each other in the event of the death (and usually earlier disability) of either of them. The agreement is reciprocal in that they also agree that the survivor will buy the deceased (or disabled) co-shareholder’s interest.

The agreement is funded by life insurance policies which the co-shareholders take out on each other’s lives. In this way the deceased’s family is compensated for the loss of a breadwinner and the surviving shareholder is able to continue with the business without the concern of taking on new shareholders in the form of the deceased’s heirs. The concern with taking on heirs as new shareholders is that, besides being totally foreign to the business of the company, they may be more concerned with benefiting from their inheritance by way of short-term profits than contributing to the long-term growth of the company.

CGT

Assuming Paul dies, from a CGT perspective there are two primary transactions to consider.

1. The death of the shareholder – disposal to his estate

On Paul’s death, there is a deemed disposal, for the purposes of CGT, by Paul of all his assets, including the shareholding in PM (Pty) Ltd to his estate. The disposal takes place at market value (R2 200 000) and the estate is deemed to have acquired the interest at that market value. There is thus a gain of R1 700 000, being the difference between the base cost of R500 000 and the market value at the date of death.

Fortunately, Paul’s estate will qualify for the R750 000 concession (para 57). Therefore the first R750 000 of the gain may be disregarded for CGT purposes.

In terms of section 26A of the Income Tax Act the remaining R950 000, (R2 200 000 – R500 000 – R750 000), will be included in Paul’s taxable income for the period up to the date of his death. The CGT will thus be R95 000 (R950 000 x 25% x 40%).

2. The disposal by Paul’s estate – to Mary

The executor will give effect to the buy and sell agreement, by disposing the shares owned by Paul’s estate to Mary. The base cost for the estate will be the same as the market value at which the estate acquired the shares, being R2 200 000. Therefore no CGT is payable on this disposal.

The spouse’s roll-over

Paragraph 67 of the Eighth Schedule of the Income Tax Act, provides for roll-over relief in respect of assets transferred between spouses. Because Paul’s shares are sold to Mary and Paul’s wife, Susan, receives the proceeds of the sale of the shares (and not the shares), the CGT roll-over relief will not apply.

Conclusion

In this example, the CGT will be R95 000 – this is R95 000 that the surviving family members will have to do without. This liquidity short-fall will continue to increase in line with the growth in the value of the business. Once the value of the business exceeds R5 000 000, the small business concession will be lost and the liquidity shortfall will immediately jump by a further R75 000, being R750 000 multiplied by an effective rate of 10%. Co-shareholders are, quite correctly, advised to update their buy-and-sell agreements on an annual basis. This practice should be extended to their personal estate planning in order to assess the ever increasing liquidity shortfalls created by the estate’s exposure to CGT.