Buy/Sell Agreements An Overview of Funding with Life Insurance

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1 Buy/Sell Agreements An Overview of Funding with Life Insurance Introduction For individuals, no estate plan is complete without a will. Similarly, no business plan is complete without a shareholder's agreement. A shareholder s agreement sets out the rights and obligations of the both the shareholder(s) and the corporation. It is a contract that relates specifically to the relationship between some or all the shareholders and the corporation. A shareholder s agreement is a way to capture the intention of the shareholders as to the nature of their relationship to one another and to the corporation. A well drafted shareholder s agreement can address a variety of topics and in doing so will prevent potential misunderstandings or issues between the shareholders. An important component of a good shareholder s agreement is buy/sell provisions which allow for the orderly transfer of shares upon retirement, disability, death, bankruptcy or matrimonial breakdown. This Tax Topic deals with structuring the transfer of shares upon the death of a shareholder as outlined in the shareholder s agreement. In considering the various methods for structuring a buy/sell arrangement, it should be borne in mind that there is no "right" way to proceed. Each method has its own pros and cons and must be considered in light of the circumstances of a given case. Business advisors generally agree that life insurance is the most efficient means of funding a buy/sell agreement on the death of a shareholder. The purpose of this Tax Topic is to describe the basic methods of buying out a shareholder at death and to outline a number of issues involved in deciding whether to fund a buy/sell arrangement with corporate-owned or personally-owned life insurance. Structures for Life Insured Buy/Sell Arrangements at Death At a high level there are two basic ways that buy/sell arrangements at death can be structured. Either the surviving shareholders can purchase the deceased s shares, or the corporation can purchase the deceased s shares by redeeming the shares. If life insurance is used to fund the buy/sell obligation at death, then there must be a life insurance policy (or policies) on the life of each shareholder with a death benefit equal to the value of that shareholder s shares as specified or calculated pursuant to the agreement. If the agreement provides that the surviving shareholders will purchase the deceased s shares, then the buy/sell obligation may be funded with insurance owned by the shareholders using the Criss-Cross Purchase method, or it may be funded with insurance owned by the corporation using the Promissory Note method. 1

2 If the agreement provides that the corporation will purchase the deceased s shares, then the buy/sell obligation may be funded with insurance owned by the corporation. This structure is often referred to as the Corporate Redemption Method. It is also possible to use a combination of the Promissory Note and Corporate Redemption Methods (often called the Hybrid method). In this case the shareholder s agreement provides that some of the deceased s shares will be purchased by the corporation, and some of the deceased s shares will be purchased by the surviving shareholders. In this situation the obligation is funded with insurance owned by the corporation. To more fully understand these buy/sell methods let s look at an example. Assume that a corporation (Opco) has three shareholders (A, B, & C) who each own one third of the shares. Assume that Opco has a value for the purposes of the buy/sell agreement of $1,500,000 so that each shareholder owns shares worth $500,000. Also assume that buy/sell agreement is fully funded with life insurance; that is, there is $500,000 of life insurance in place on each shareholder. The sections below describe how each of these buy/sell methods would work in this scenario. Criss-Cross Purchase Method In this arrangement the agreement specifies that on the death of a shareholder, the surviving shareholders are obligated to purchase the shares of the deceased shareholder. Each shareholder of the corporation is the owner and the beneficiary of a life insurance policy on every other shareholder. If one of the shareholders dies, then the life insurance proceeds would be paid to the surviving shareholders and they would each use the proceeds to purchase the deceased s shares. In this fact situation A would be the owner and beneficiary of a $250,000 policy on the life of B, and another $250,000 policy on the life of C. Similarly B would be the owner and beneficiary of a $250,000 policy on the life of A, and another $250,000 policy on the life of C etc. If shareholder C died, then A and B would each receive a life insurance death benefit of $250,000 on the policies they own. A and B would use these funds to purchase C s shares from his estate. After the purchases, A and B would each own $750,000 worth of shares representing 50% of Opco. Promissory Note Method When this method is used, just as in the Criss-Cross Purchase method, the agreement specifies that on the death of a shareholder the surviving shareholders are obligated to purchase the shares of the deceased shareholder at the value as specified or calculated pursuant to the shareholder s agreement. However in this arrangement, instead of purchasing the shares for cash, the agreement specifies that the surviving shareholders will purchase the shares with a promissory note (due from the survivors to the deceased s estate). The corporation is the owner and beneficiary of a life insurance policy on the life of each shareholder. After the shares have been purchased, the corporation is required under the agreement to pay the insurance proceeds out to the surviving shareholders as a dividend. (This dividend can be paid tax-free to the shareholders to the extent of the Capital Dividend Account (CDA)). The surviving shareholders are then obligated to use the dividend proceeds to repay the promissory note. In this fact situation instead of A, B, and C owning life insurance policies on each other, Opco would be the owner and beneficiary of three $500,000 policies: one on each of the lives of A, B, and C. If shareholder C dies, Opco would receive the $500,000 death benefit from the policy it owns on C. If the policy s adjusted cost basis is nil, Opco would receive a $500,000 credit to its CDA. (For more information on the CDA refer to the Capital Dividend Account Tax Topic). Then A and B would purchase C s shares from his estate by each issuing a $250,000 promissory note to C s estate. Following the purchases, A and B 2

3 would each own $750,000 worth of shares representing 50% of Opco. After the shares have been purchased, Opco would pay out a $500,000 capital dividend: $250,000 to A and $250,000 to B. The capital dividend would be non-taxable to A and B. They would then use the dividend proceeds to repay the promissory notes. Corporate Redemption Method In this arrangement the agreement obligates the corporation to repurchase, or redeem, the shares of a deceased shareholder at the value as specified or calculated pursuant to the shareholder s agreement. The corporation is the owner and beneficiary of a life insurance policy on the life each shareholder. If one of the shareholders died, then the life insurance proceeds would be paid to the corporation, and it would use the proceeds to redeem the deceased s shares. In this fact situation Opco would be the owner and beneficiary of three $500,000 policies: one on each of the lives of A, B, and C. If shareholder C dies, Opco would receive the $500,000 death benefit from the policy it owns on C. If the policy s adjusted cost basis is nil, Opco would receive a $500,000 credit to its CDA. (For more information on the CDA refer to the Capital Dividend Account Tax Topic). Then Opco would redeem C s shares from his estate for $500,000. Following the redemption, A and B would each own $750,000 worth of shares representing 50% of Opco. Assuming C s shares have nominal paid up capital, for tax purposes the $500,000 received by C s estate would be treated as a dividend. If Opco elects to pay this dividend as a capital dividend, then it would be nontaxable to C s estate. For a more detailed discussion of the different structures and the tax implications of each refer to the following Tax Topics: Buy/sell Agreements - Criss-Cross Purchase Method, Buy/Sell Agreements - Promissory Note Method, Buy/Sell Agreements - Corporate Redemption Method and Buy/Sell Agreements - Hybrid Method. Corporate owned vs Personally Owned Insurance One of the key factors in deciding which buy/sell structure is appropriate in a given situation is whether it is more desirable for the insurance to be owned corporately or personally. The following sections discuss issues to be considered with respect to corporate owned vs. personally owned insurance. Tax Leverage The premiums payable on a life insurance contract are generally not deductible for income tax purposes. Therefore, it may be advantageous to have insurance owned at the corporate level in order to have the corporation pay the premiums. Where the corporation is in a lower tax bracket than the individual shareholders a tax saving may be generated and this factor alone is often decisive in favoring ownership of the insurance at the corporate level. For example, an individual shareholder with a marginal tax rate of 47% would require about $1,900 of income to pay a $1,000 insurance premium. A corporation paying tax at the small business rate of 20% would require only $1,250 of income in order to pay the premium. Policing of Policy Premiums Where the insurance policies are individually-owned, it may be difficult for one shareholder to be certain that the other shareholders are continuing to make the necessary premium payments. This difficulty is magnified as the number of shareholders is increased. A shareholder's failure to pay premiums may only come to light at the death of the "insured" shareholder, when it is discovered that there are no insurance proceeds to fund the 3

4 buy/sell agreement. Furthermore, where a death benefit is received directly by a shareholder, there is the risk that the beneficiary may ignore his obligations under the agreement and misappropriate the funds. (These issues may be mitigated by using a trust to hold the life insurance policies. For more details refer to the Buy/sell Agreements - Criss-Cross Purchase Method Tax Topic.) On the other hand, if the policies are owned by the corporation, each shareholder has access to the corporate records to ensure that the policies are being kept in force. On the death of the shareholder, his personal representative may also take steps to ensure that the death benefit paid to the corporation is in fact used to fund the purchase of the deceased s shares held by the estate, as set out in the buy/sell agreement. Cost of Premiums Where one shareholder is significantly older than the others, or is in poor health, personal ownership of the policies places a heavy premium burden on the other shareholders. While it may be argued that this is an equitable sharing of risk, this unequal financial burden frequently dictates against the use of personally-owned insurance. Where corporate-owned insurance is used, the cost will be shared among the shareholders according to their pro rata interest in the company. This is often viewed as being more equitable. Ease of Administration Where there are several shareholders who are parties to the buy/sell agreement it may become expensive and confusing for each shareholder to own policies on the lives of all the others (i.e. five shareholders necessitates the purchase of twenty separate policies). The requirement would be reduced to one policy on the life of each shareholder where corporate-owned insurance is used. This could also lead to lower expense costs and lower aggregate premium costs. (This issue may also be overcome by using a trust to hold the life insurance policies. For more details refer to the Buy/sell Agreements - Criss-Cross Purchase Method Tax Topic.) Family Law (Ontario) The Ontario Family Law Act (1986) provides spouses with a claim in respect of the other spouse's "net family property" upon separation, divorce or death. Proceeds from a life insurance policy which are received as a result of the death of the life insured will be excluded from the beneficiary's net family property. In addition, any property acquired with these proceeds (i.e. shares in a corporation) will be excluded from the beneficiary's net family property. However, where a corporation owns the life insurance policies on the lives of its shareholders, the death benefit loses its character as "life insurance proceeds" when flowed out to the shareholders to fund the buy/sell arrangement. As a consequence, the value of the surviving shareholder's net family property will increase, ultimately increasing the equalization claim that could be made by the shareholder's spouse under the Family Law Act. A policy that is owned by a corporation should not be connected or form part of the estate for the purposes of making a claim against the policy for child support. The Ontario Case of Goodis (Litigation guardian of) v. Goodis Estate, (2003) O.J. No confirmed this premise. 4

5 Thus, for Ontario residents, it may be advantageous to have life insurance owned at the personal level, to reduce potential claims under the Family Law Act. Many other provinces have similar legislation. Tax Complexity The provisions of the Act applicable when corporate-owned insurance is used to fund a buy/sell agreement are generally more complex than those applicable when personallyowned insurance is used. As a result, the shareholders may want to use individuallyowned insurance, since they can more easily understand the tax consequences of this type of funding arrangement. The tax consequences of using either corporate-owned or personally-owned insurance to fund a buy/sell arrangement are complex and beyond the scope of this Tax Topic. They are dealt with in detail in the Tax Topics noted earlier which cover each method of buy/sell arrangements. Creditor Protection Where corporate-owned insurance is used to fund a buy/sell arrangement, the proceeds payable to the corporation on the death of one of the shareholders will be subject to the claims of the corporation's creditors. Additionally, as a condition of lending funds to a corporation, banks and other creditors may place restrictions on the corporation's ability to pay dividends and/or salary to shareholders. These restrictions could impair the ability of the corporation and/or the surviving shareholders to fulfill the terms of a buy/sell agreement. These problems may be avoided by incorporating separate companies to hold each shareholder's interest in the operating company. These holding companies would also own the life insurance on the lives of the shareholders. Provided the holding companies have not guaranteed the obligations of the operating company, the life insurance proceeds may be protected from the creditors of the operating company. Since the holding companies do not carry on business in their own right, they are unlikely to have creditors which would attempt to seize the insurance proceeds or place restrictions on the use of corporate funds. Another advantage of using a holding company to own the insurance is that it may make a future sale of the operating company easier. The benefits of incorporating holding companies should be weighed against the increased administration costs. Where personally-owned insurance is used to fund the buy/sell arrangement the likelihood of corporate creditors seizing the insurance proceeds is reduced, provided the shareholders have not personally guaranteed the debts of the corporation. Conclusion This article has outlined the different methods of structuring the transfer of shares at the death of a shareholder and some of the factors to be considered in deciding whether to use corporate-owned or personally-owned life insurance to fund buy/sell arrangements. In each case, it will be necessary to analyze the client's particular circumstances, to determine whether it is more appropriate for the individual shareholders or the corporation to own the life insurance. 5

6 The Tax & Estate Planning Group at Manulife Financial write new Tax Topics on an ongoing basis. This team of accountants, lawyers and insurance professionals provide specialized information about legal issues, accounting and life insurance and their link to complex tax and estate planning solutions. Tax Topics are distributed on the understanding that Manulife Financial is not engaged in rendering legal, accounting or other professional advice. If legal or other expert assistance is required, the services of a competent professional person should be sought. Last updated: November 2007 This document is protected by copyright. Reproduction is prohibited without Manulife's written permission. 6

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