Insurance and the business owner

“We have a tremendous opportunity to use life insurance to preserve a client’s wealth, and [for] tax planning and risk management,” says Garry Zlotnik, chair and CEO at ZLC Financial in Vancouver.

Buy/sell agreements, liabilities

Funding a buy/sell agreement using insurance allows the business owner to redeem the shares of a deceased, disabled or retiring third-party shareholder.

“Life insurance does a great job of providing that injection of cash when that event happens,” says Joël Campagna, assistant vice president of regional tax and estate planning, individual insurance, at Toronto-based Manulife Financial Corp. in Waterloo, Ont.

Problems can arise when a shareholders’ agreement is incomplete. “A lot of companies have unsigned buy/sell agreements,” says Cindy David, president and estate planning advisor at Cindy David Financial Group in Vancouver.

Other agreements aren’t explicit about using capital dividends, which are tax-free, to buy the deceased’s shares. If a taxable dividend is issued for the shares instead, the deceased’s estate will be on the hook for the associated taxes.

“Make sure there’s clear documentation on the use of corporately owned life insurance proceeds,” says Peter Wouters, director of tax, retirement and estate planning services at Kingston, Ont.-based Empire Life Insurance Co. in Toronto. The shareholders’ agreement should explicitly state whether a policy’s proceeds are to go toward buying the deceased’s shares, whether the capital dividend account (CDA) can be used to buy those shares and to what extent, he says.

When you discuss buy/sell details with a client, you open the door to connecting with the client’s accountant and lawyer, Wouters says, thus helping to prevent drafting errors and omissions. Financial advisors can help ensure that the terms and objectives of the shareholders’ agreement co-ordinate with the client’s will, he says.

Making sure that a shareholder’s liabilities, such as lines of credit, are repaid upon death may also be a concern. Creditors may want to recall or restructure loans when a shareholder dies, Wouters says. Shareholders’ agreements should include which liabilities will be covered by a policy’s proceeds, he says, and note the order in which the liabilities should be paid.

For a legacy business that will pass on to the next generation, a buy/sell agreement may best be funded with permanent insurance, Zlotnik says. Otherwise, term insurance can cover liabilities such as debt. “They’re often short-term needs,” David says.

Wouters suggests that advisors periodically stress-test the liability funding amounts, shareholders’ agreements and the firm’s corporate structure to ensure they continue to serve the company’s objectives. The Income Tax Act could change, for example, or the capital gains rate could increase, rendering existing planning ineffective.

Liquidity at death to fund capital gains tax

When a business owner dies, their estate will owe capital gains taxes on the deemed disposition of their shares in the firm — and that cost could be significant. Life insurance could cover the liability.

For example, David says, “If you own a lot of real estate with huge embedded capital gains, you have a liquidity problem” that insurance can solve. She notes that a quick sale of the business to a third party may not be feasible, depending on market conditions.

For a married couple with a non-professional corporation, the tax act allows shares to be rolled over tax-free to the spouse after the other spouse dies. As a result, David suggests a joint last-to-die policy, with premiums typically payable until the second spouse’s death. With such a policy, “I’ve dropped the risk to the insurance company by almost 50%,” she says. “As a result, they’ve dropped the cost of permanent insurance to my clients by almost 50%.” Clients often assume insurance will be too expensive, she says.

Be aware, however, that if the couple divorces, it’s difficult to unwind a joint last-to-die policy. “If they get a divorce, you don’t get the tax-free rollover of the shares,” Zlotnik says. The joint coverage would need to be replaced with individual coverage, which could present a challenge if one of the spouses is uninsurable at the time of divorce. Thus, Zlotnik suggests the couple have both individual term and joint last-to-die permanent policies.

If the owners plan to sell the business, term insurance would suffice.

Key person coverage

Another situation in which insurance coverage is needed occurs when one of the shareholders is the firm’s rainmaker. “If something happens to the key person, all of a sudden I’ve got a strain on my income-producing capabilities, and I need to go hire someone to replace them,” Campagna says. This could include a finder’s fee or large signing bonus, he says.

In a corporation with multiple active shareholders and employees, Wouters suggests business owners consider the five most important tasks that impact the business daily, as well as who performs them. That assessment may reveal that cash would be required to offset losses in the immediate aftermath of a key person’s death, he says, in addition to covering hiring costs.

Depending on the person’s importance to the business, a policy payout is typically five to 10 times the person’s compensation, Zlotnik says. For a relatively young person, term insurance of 10 or 20 years may be ideal, he says; for an older person, a yearly renewal term or 10-year term policy may work better.

Passive income considerations

Life insurance can also shelter a business owner’s investment income — an important consideration because passive income inside a corporation is taxed at the top marginal rate. Furthermore, access to the small-business deduction (SBD) drops by $5 for every $1 of passive income above $50,000, and is eliminated at $150,000 of passive income. (For example, a business with an investment portfolio of $3 million earning 5% would lose access to the SBD.)

If a business owner has a lot of retained earnings in a taxable investment portfolio, find out why, Wouters says. For example, a retail business could have plans to establish more stores.

If the retained earnings are meant to fund the owner’s retirement, and passive income levels have reached a concerning level, an option is to “reposition that money into a specially designed life insurance policy where you can tax-shelter the growth,” Wouters says — a.k.a. an exempt policy. (This planning requires that retained earnings aren’t notional and instead are readily available as investible cash, he says.)

Where the business owner will pay retained earnings to beneficiaries, and passive income levels are concerning, those earnings can be repositioned to an exempt policy, with the proceeds paying out tax-free to the corporation. Then those proceeds can be paid to the shareholders out of the CDA, Wouters says. (If passive income levels aren’t a concern and money deposited in the policy isn’t more than what’s needed to cover premiums, there should be no exempt concerns because there’s no overfunding or large cash accumulation.)

If the business owner lives long enough for the policy’s adjusted cost basis to reach zero, David notes, the CDA would be credited for the full proceeds, which could then be distributed as tax-free capital dividends.

By buying life insurance by using retained earnings, the client avoids paying the top marginal tax rate on passive income as well as the clawback of the SBD. “That combination is very compelling” and can be highlighted to clients, Wouters says.

If such an insurance policy isn’t purchased, clients subject to a full clawback of the SBD may have to take on significant risk in an investment portfolio held by the corporation to get results comparable to the performance of a life insurance policy — certainly regarding estate values and, potentially, cash values, Wouters says.

Furthermore, every year that earnings can be repositioned to the exempt policy instead of invested inside the corporation, the client continues to avoid or reduce the SBD clawback (depending on passive income levels). The client thus avoids a minimum 50% tax increase on active income — a benefit that’s often understated or missed, Wouters says. In Ontario, for example, the client with an exempt policy pays 12.2% instead of 18.5%.

A particular policy’s cash surrender value must also be considered. A high cash surrender value has potentially negative implications if the business owner wants to eventually sell the business. “If you have too much in passive assets — whether that’s cash surrender value of a life insurance policy or an investment portfolio — that can impact your ability to claim the capital gains exemption in the future,” Campagna says.

A cash surrender value that’s too high could cause the corporation’s shares to run afoul of the tax rules for qualified small-business corporation shares, thus negating eligibility for the capital gains exemption. That’s because a small-business corporation must use 90% or more of the fair market value of its assets to carry on an active business (among other requirements).

Not only would the policy impair the client’s ability to claim the capital gains exemption, but the policy would also require a transfer from the corporation to the owner before the business is sold, which can be significantly tax-ineffective, Campagna says. The transfer would result in a taxable benefit to the shareholder equal to the fair market value of the policy, which may be higher than the policy’s cash value, he says, with no corresponding deduction to the corporation.

Even if a business won’t be sold, when the owner dies and there’s a deemed disposition of shares, the owner may want to ensure the estate can qualify for the capital gains exemption, Campagna says. One recommended solution is to hold the insurance in a holding company or a sister company rather than the operating company.

Putting needs ahead of solutions

Clients wary of an insurance sales pitch will be won over by an advisor who comprehensively identifies needs instead of diving in headfirst with solutions.

When addressing liquidity, rather than assume a business-owner client requires insurance, “I start with a question,” says Peter Wouters, director of tax, retirement and estate planning services at Empire Life Insurance Co. in Toronto. Does the client have a plan for the business if a certain shareholder dies? If the client wants to buy out the shareholder, where will the money come from? Would removing money from the business cause undue strain? Could the client get a loan with an appropriate interest rate and payment schedule, and what would the tax implications be? (Loan payments are non-deductible to the business.)

Beginning the conversation with questions is “disarming,” Wouters says, and demonstrates that the advisor is a problem-solver rather than a salesperson.

This article is eligible for CE

To earn continuing education credits for reading this article, go to CEcorner.ca to complete a comprehension quiz.

Achieving a mark of 10/12 or better will earn you 1.0 credit hours from the Institute for Advanced Financial Education, the Insurance Council of Manitoba and the Life Insurance Council of Saskatchewan. You may also take the French version of this course and earn 1.0 credit hours from La Chambre de la sécurité financière.