A practice buy-in agreement the statute made void

The situation

A three-principal dental practice with two locations in the Greater Toronto Area brought in a long-serving associate. She paid $520,000 for 20% of the voting shares of the dentist corporation, funded by a bank facility against her own covenant, and signed the documents you would expect: a share purchase agreement, an amended shareholders’ agreement executed by all shareholders, an employment agreement and a personal guarantee of the equipment lease.

The shareholders’ agreement was where everything commercial lived: funding obligations, a drag-along, a shotgun, non-solicitation of patients, and a departure formula fixing an exiting principal’s price at 4.2 times normalised earnings on a rolling three-year average.

The problem

Each of the three original principals had at some point put non-voting shares into a family trust for tax planning. Two of those trusts came from the same accountant and the same template: the trustee was a numbered Ontario company controlled by the principal, and the beneficiaries were the principal’s spouse and children, all by then adults. That structure is unremarkable for an ordinary operating company. For an Ontario dentist corporation it fails twice, and the second failure took the whole shareholders’ agreement with it.

The rule that decided it

Start with the general rule, because it explains why the regulation exists. OBCA s.3.2(2) requires that “All of the issued and outstanding shares of the corporation shall be legally and beneficially owned, directly or indirectly, by one or more members of the same profession.” On that rule a spouse, a child or a family trust cannot hold shares at all — still the position for a law firm or an accounting practice, and why the accounting-practice ownership question has a different answer.

Section 3.2(5) attacks the agreement rather than the shares: “a unanimous shareholder agreement in respect of a professional corporation is void unless each shareholder of the corporation is a member of the professional corporation”. Section 3.2(4) does the same to a voting arrangement.

Health professions get an exemption, and only health professions. Section 3.2(6)(a) empowers regulations “exempting classes of health profession corporations, as defined in section 1 (1) of the Regulated Health Professions Act, 1991, from the application of subsections (1) and (5)”. The regulation made under that power is O. Reg. 665/05, three sections long: definitions, physician corporations, and dentist corporations. Two professions, on identical terms.

For a dentist corporation, s.3(1) replaces the ownership paragraph: “Each issued and outstanding voting share of the corporation shall be legally and beneficially owned, directly or indirectly, by a member of Royal College of Dental Surgeons of Ontario.” Non-voting shares may be held three ways — by a College member, by a family member of a voting dentist shareholder, or on the terms in subparagraph 2 iii: “It shall be owned legally by one or more individuals, as trustees, in trust for one or more children of a voting dentist shareholder who are minors, as beneficiaries.”

Every clause of that subparagraph is load-bearing. The trustees must be individuals — a numbered company is not one. The beneficiaries must be minor children of a voting dentist shareholder; s.1 defines family member as “the shareholder’s spouse, child or parent”, which a sibling is not. Two of the three trusts failed on the trustee and on the age of the beneficiaries.

Then s.3(4), which decided the file. It replaces OBCA s.3.2(5) for a dentist corporation: “A unanimous shareholder agreement in respect of a dentist corporation is void unless each voting shareholder of the corporation is a member of the Royal College of Dental Surgeons of Ontario and each non-voting shareholder of the corporation is,” a College member, a family member of a voting dentist shareholder, or “a trustee under a trust described in subparagraph 2 iii of subsection 3 (1)”.

A numbered company holding for adult beneficiaries is none of the three. The agreement was void — not voidable, not unenforceable against the trusts alone, not saved by severance — including as against the associate who had just paid $520,000 in reliance on it.

The numbers

Nineteen months after the buy-in the eldest principal gave notice of retirement. Under the departure formula his 26.7% would have been worth $1,290,000. On a fair market value appraisal, with no agreed multiple and a minority discount argued, the range was $2,340,000 to $2,670,000 — a $1,380,000 spread at the midpoint, in issue because the document that fixed the number did not exist.

The associate’s position was worse in kind. Her $520,000 had bought shares plus governance rights, and the rights were why a 20% stake in a practice she did not control was worth buying. Without a valid agreement there was no drag, no shotgun, no funding obligation and no agreed valuation mechanism.

The outcome

The two offending trusts were unwound: one principal took his non-voting shares back personally, the other transferred them to his spouse, a family member under s.1. A fresh unanimous shareholder agreement was executed by all shareholders. The retiring principal’s exit settled at $1,620,000 — what a negotiation looks like when neither side can point to a binding number.

One point in the corporation’s favour throughout: OBCA s.3.2(3) provides that “No act done by or on behalf of a professional corporation is invalid merely because it contravenes this Act.” The billings, the employment contracts, the equipment leases and the share issuances were not undone. It is the agreement the statute voids, and only the agreement.

What it would have cost otherwise

The practice ran nineteen months believing it had a governance document. Had a principal died, been suspended, or tried to sell to a consolidator in that window, there would have been no drag, no pre-emption and no price. The $1,380,000 spread on one retirement is the visible cost; the invisible one is that every decision taken on the strength of the agreement, including the associate’s own buy-in, rested on nothing.

The tell

The tell is on the share register, not in the agreement. Read the holder column for every non-voting line: a corporation as trustee breaches the regulation, which requires individuals, and adult beneficiaries breach it again. Neither fact appears in the shareholders’ agreement, which is why a document review will not find it and a minute-book review will.

The second tell is a trust template drafted for an operating company. The corporate-trustee-and-adult-beneficiary structure is sensible planning almost everywhere else; it is the professional-corporation regulation that is unusual, and in a direction most tax advisers have no reason to expect.

Takeaways

• • OBCA s.3.2(5) voids a USA in respect of a professional corporation unless each shareholder is a member. The Act’s own words are “a member of the professional corporation”, not a member of the profession — quote it as it reads.
• • The s.3.2(6) exemption power reaches health profession corporations only, and O. Reg. 665/05 covers exactly two: physician corporations and dentist corporations, on identical terms.
• • For a dentist or physician corporation, a trust may hold non-voting shares only where the trustees are individuals and the beneficiaries are minor children of a voting shareholder. A corporate trustee, or adult beneficiaries, breaks it.
• • “Family member” is defined as the shareholder’s spouse, child or parent. A sibling or a nephew is not one.
• • The consequence lands on the agreement. Section 3.2(3) keeps the corporation’s acts valid; nothing keeps the USA alive.
• • For a law or accounting practice there is no equivalent regulation: OBCA s.3.2(2) para 1 requires all shares to be owned by members of the same profession.

Sources

• • Business Corporations Act (Ontario), R.S.O. 1990, c. B.16, ss.3.1–3.2 — s.3.1(1) definitions of member and professional corporation; s.3.2(2) the conditions, including the same-profession ownership paragraph; s.3.2(3) acts not invalid; s.3.2(4) voting agreements void; s.3.2(5) unanimous shareholder agreements void; s.3.2(6) the health-profession exemption power. e-Laws serves the consolidation in full to a plain client.
• • O. Reg. 665/05, Health Profession Corporations, under the Business Corporations Act — s.1 definitions of child, family member, dentist corporation, physician corporation and voting dentist / voting physician shareholder; s.2 physician corporations; s.3 dentist corporations, including s.3(1) share ownership, s.3(2) officers and directors, s.3(3) voting agreements and s.3(4) unanimous shareholder agreements. Consolidation period from 23 February 2018.
• • Treadstone Law — family trust shares in a professional corporation — the closest match in the library and the right starting point. It addresses whether a trust may hold shares; it does not deal with the effect on the unanimous shareholder agreement, which is the mechanic here.
• • Treadstone Law — a spouse holding non-voting shares in a professional corporation — on point for the permitted family-member route used in the fix above.
• • Treadstone Law — voting rights of a non-professional shareholder — adjacent: it covers the s.3.2(4) voting question rather than s.3.2(5).
• • Treadstone Law — the certificate of authorization for an Ontario professional corporation — background on the authorising document that makes a corporation a professional corporation in the first place. It does not address share-ownership defects.