Legal agreements will help avoid conflict when friends or family members form business tiespar La rédaction | February 19 2013 09:00PM
Money matters and family/friends don’t necessarily mix.clients are protected when they make business arrangements with people who are close to them. Clients may think that friendship or family ties will mean that all parties will work in the others’ best interest, but this may not hold true. The best way to avoid conflict is to draw up legal agreements that set out the rights and obligations of everyone concerned.
“A legal agreement gets the important issues on the table and clears up assumptions,” said Ted Lebovics, president and managing partner at Lebovics Law Office Inc. in Montreal. “Many of my clients use our services as a preventative measure that can save them a lot of money down the road.”
Lending money to an adult child for the purpose of buying a home is the most prevalent private lending situation, according to Barry Fish, a Thornhill, Ont., lawyer and president of Fish & Associates Professional Corp.
Lending money to purchase a home
“It comes up time and time again in legal practices,” he said. “The ideal situation is for the child to take out a second mortgage [second to the first mortgage issued by a financial institution] with the parents. And a mortgage agreement should be drawn up that makes the young purchaser fully liable for the loan, and stipulates that the home is fully secured on behalf of the parent in the event that there is a default of payment on the first and on the second mortgage. And the purchaser and the parent should each have independent legal representation.”
The glitch to this ideal situation, Mr. Fish noted, is that financial institutions rarely allow a client to hold a parental mortgage. “In the process of underwriting the loan to the younger party, one of the things a financial institution looks for is ability to pay the mortgage. And a second mortgage will result in thinning out the equity in the home.”
If banks will not allow a second mortgage, he said the child and his or her spouse can both sign a promissory note to the parents that is payable on demand, with no fixed term of expiry. “We recommend that in the note the lender be described as ‘both parents on joint account with right of survivorship,’ so if one parent should die, the loan will not be subject to probate. If there is only parent, the lender should be described simply by his or her full name.”
The term “payable on demand,” he noted, “means that if the parents should need the money, all they have to do is send a notice of demand.”
Another option is for the child to sign a “deed of gift.” Mr. Fish recommends adding a clause to the deed that says the gift won’t form part of net family property in the event of a marriage breakdown.
Starting a small business with a friend
Clients or their children who start a small business with a friend or relative should have a legal agreement in place that determines several important things, Mr. Fish said:
- The decision on whether the business involves taking out a lease on rented property or will not require a lease because it’s run out of a home. “If the business is operated in leased premises, the landlord will want guarantees of payment so all parties will need to come clean with respect to their financial situations, including debts.”
- Anticipated timeframe. “The nature of some businesses – such as buying and renovating a building with the intent of selling it – means they have limited timeframes.”
- Relationship of the business parties. “For a business with a limited timeframe and a focus on a specific venture, a joint venture agreement is the way to go rather than a partnership,” Mr. Fish said. “In a partnership, the relationship is fiduciary, and each partner has a high level of responsibility to the other. Like it or not, there’s a lot of risk in becoming partners unless you are 100% sure of each other. What if one partner undertakes a high liability on behalf of the partnership? One of the clauses in a joint venture agreement is that neither party is agent to the other, and that the joint venture is limited in time and limited to the object to be accomplished.”
- Partnership or corporation? For businesses that don’t have a limited timeframe and a specific object to be accomplished, the question is whether the parties should establish a partnership or a corporation. “The advantages of a corporation,” Mr. Fish said, “are tax advantages and less risk for the shareholders if the business goes the wrong way because they won’t be liable to creditors. The advantages of a partnership are cost savings because a corporation is a more costly vehicle to initiate and maintain.”
- An exit clause. “In the event that one party wants to sell and move on, and the other doesn’t,” Mr. Fish said, “legislation in common-law provinces allows the party who wants to exit to force a sale. The parties will have to agree on a price and if they can’t, the party who wants to exit can make a court application, which will generate the need for appraisals. In Ontario, the remaining party can buy the property, which will be contingent on his financial situation.”
- How the property will be maintained. “Will it be 50-50,” Mr. Fish asked, “or will one party be responsible for physical maintenance with compensation or without compensation?”
- Use of the property. “This needs to be agreed on beforehand,” he said. “Will both parties live on the premises, will one live on the premises or will it be a rental property?”
- And the agreement should stipulate that no third party can come into the premises or the agreement without the consent of both parties, Mr. Fish added.
Buying a property with a friend or relative
Younger clients may decide to buy their first home with a friend or a sibling. Mr. Fish noted that in the common-law provinces, there are two ways for the parties to hold title to the property: as joint tenants or as tenants in common. “Joint tenants is applicable to a marital or common-law relationship because if one party dies, the survivor becomes the sole owner. For a non-marital or common-law relationship, the parties would hold the property as tenants in common; in the event of a death, the survivor would own the property in partnership with the estate of the deceased. And the mortgage application to the bank will disclose the financial situation of each party.”
The legal agreement should also include:
In the province of Quebec, Mr. Lebovics noted that real estate can be held in four ways: co-ownership, partnership, as a corporation and in a trust. With co-ownership, the property is registered by a notary in the names of the two parties. “Each has an undivided half-interest in the property,” Mr. Levobics said. “The disadvantage is there is no defined way of exiting. If one party wants to sell his interest and the other doesn’t, he has to go to court saying he no longer wants to stay in co-ownership and the court will order the property to be put up for sale.”
With a partnership, the parties form a partnership by registering the partnership’s name and then buying the property under that name. “The partnership agreement will determine how the property will be maintained,” Mr. Lebovics said. “If one partner wants to sell, he will sell his partnership interest to the other. We usually recommend a shotgun buy-sell provision that allows one partner to offer to buy out the other’s interest; the other partner must then either accept the offer or sell the property. And if one partner dies, the partnership is deemed dissolved and the property deemed sold at fair market value – triggering all the attending tax consequences.”
If the parties decided to form a corporation, each will hold shares that reflect his financial interest in the property. The shareholders’ agreement will determine how the property will be maintained and what will happen if one shareholder wants to sell his holdings. “The advantage over a partnership,” Mr. Lebovics said, “is that if one party dies, the corporation is not be deemed dissolved because it is a legal entity, and the shareholders’ agreement sets out what happens then. We usually recommend that the survivor has the right to buy the holdings of the deceased.”
Clients with revenue-bearing properties may also consider transferring them to a family trust and naming their children as beneficiaries, Mr. Lebovics added. “The drawback is there is a deemed disposition when the property is transferred to the trust, triggering tax consequences.”