Funding the Shareholders Agreement

Transcription

1 Funding the Shareholders Agreement Prepared for: Client Company Presented by: Bernie Geiss, TEP, FEA, CLU, CFP Cove Continuity Advisors Inc. June 2009

2 Executive Summary Developing a strategy to facilitate the funding of shareholder buyouts is imperative for the success of the buy sell agreement. This report explores some of the options available to the company with regards to funding the buy sell upon death. The first step in any buy sell funding analysis is to make certain that the agreement is reviewed to ensure that the considerations addressed in this report are resolved. So there is no doubt that liquidity is available and that taxes on the share sale are minimized life insurance should be established on the lives of each shareholder for the full amount of their share value. Without sufficient life insurance funding, there is no guarantee of sufficient liquidity. A life insured buy out upon death will provide the survivor with the necessary funds and afford the maximum tax efficiencies for the deceased s beneficiaries through the use of the capital dividend account A life insurance policy can be a flexible and valuable planning tool. The plan design and use can be modified depending on the specific objectives of the shareholders.

3 Shareholders Agreement General Considerations Is there a signed agreement? It is unclear as to who determines that the shareholder is disabled. This may lead to conflict between the shareholders. There is also no requirement for insurance funding on disability. It may be helpful to establish a disability buy sell policy which will perform the necessary adjudication upon disability and provide much needed capital. This is important even if the amount insured only provides a down payment for this purchase. The value of the shares is determined by a chartered business valuator. If this amount is disputed the shareholders can engage a certified business valuator. Is a difference in valuators intended. Also, the valuation of the shares should be reviewed by the shareholders on a regular basis to ensure the calculated value is appropriate. The agreement requires the life insurance policies to be owned by Corporation. It may be more appropriate for the policies to be owned by individual holding companies or subordinate companies with Corporation as the beneficial owner (irrevocable beneficiary). As well, the transfer of a life insurance policy may be onerous for both Corporation and the shareholder (tax cost on transferring and sale price to shareholder). This could be alleviated through a different ownership structure as discussed above. The agreement gives power to the deceased s representative to decide if a cross purchase or a corporate redemption is to be used. However the agreement does not include details on how these transactions will be performed. The share purchase provisions on death do not address capital dividends, safe income or sharing of general rate income pool dividends. If the shares are to be redeemed by the company it would be good for the agreement to address the use of a spouse put call option for personally owned shares and allow the deceased s estate to employ a roll and redeem strategy. There are no provisions that deal specifically with the share purchase shortfall if insurance proceeds are insufficient. If these issues are to be addressed, the agreement should be modified appropriately. Without sufficient insurance funding, there is no guarantee of sufficient liquidity. The lack of sufficient funding creates two significant problems: The cost of purchasing shares on death or disability without insurance is excessive. The deceased s estate will pay unnecessary tax unless there is a sufficient balance in the capital dividend account

4 High Cost of Funding the Buy Sell One of the options available to fund a share purchase on death or disability is through making installment payments. While the interest on the borrowed funds should be deductible, the capital required to fund the loan repayments should be grossed up for tax. The following table outlines the total cost of this option. Borrowing to Fund Buyout Total Required Capital $ Loan Payment Duration Interest Rate 6% 5 years Tax Rate 30.0% Interest Deductible Years Principal Tax Interest 42,000 33,600 25,200 16,800 8,400 Total 327, , , , ,114 Total cost of underfunding $1,554,571 The Cost is $1,554,571 to fund $ This assumes the company remains profitable enough to complete the terms of the shareholders agreement.

5 Universal Life Insurance The use of life insurance can significantly reduce the cost of funding the buy sell upon death. As well, when a buy sell on death is fully funded using life insurance it may be possible to reduce or even eliminate a potential tax liability. Universal Life insurance provides for lifetime insurance protection and allows a policy owner to choose between minimum lifetime deposit schedules or shortened payment schedules known as prefunding. Universal Life provides coverage on a level, guaranteed cost of insurance basis until the death of the insured. The key advantage of Universal Life coverage is certainty. As long as all premium payments are made on time the insurance policy will remain in force and the life insurance benefit will be paid upon the death of the insured. All premiums are guaranteed and level for the lifetime of the contract. But, as with traditional term coverage, there is very little flexibility with the premium deposit options. One missed premium can cause the policy to lapse leaving the insured without any coverage. Therefore, owners of Universal Life 100 products must continue to pay level premiums until the death of the life insured. Cash Flow Analysis Insureds See Assumptions Company RBC Insurance Plan Universal Life Coverage Type Life Insurance Coverage Amount See Assumptions Minimum Lifetime Deposits Guaranteed level cost of insurance Year Total Annual Cash Flow 1 17, , , , , , , , ,422 $17,422 Year

6 Share Redemption and the Capital Dividend Account The redemption of the Opco shares upon death of a shareholder can be facilitated with or without insurance proceeds and corresponding CDA credits. However, the tax consequences to the holding company and the deceased s beneficiaries are substantially different. CDA dividends arising from life insurance proceeds can be used to redeem the shares. However, if the life insurance proceeds are less than the redemption amount, and additional CDA credits cannot be created, the shortfall could be taxable. The result to the holding company would be somewhere between paying full tax and paying no tax. The surviving spouse would then be able to choose the most appropriate method of accessing the capital inside the holding company to mitigate the taxes payable. However, using life insurance proceeds and the capital dividend account credit the deceased s spouse could redeem the shares on a tax free basis using the roll and redeem method. Option 1 No Life Insurance Option 2 Funding with Life Insurance Buy Sell Proceeds Tax CDA Credit Shares Redeemed Tax Free Capital Dividend Taxable Dividend Tax Due Residual Capital Gain Taxable Gain (50%) Tax Due (43.7% of taxable gain) Combined Tax Due Tax Reduction 500, , , ,500

7 Appendix: Ownership Structure of the Life Insurance Policies The agreement states that Corporation is to be the owner of the life insurance policies. To provide maximum benefit for Corporation and the shareholders, each shareholder, either personally or through a holding company (Holdco), could be the owner of the policy. This would provide creditor protection and allow for the maximum credit to the capital dividend account. If Corporation is the owner and beneficiary of the policy, the CDA credit is reduced by the ABC of the policy. Corporation would be made beneficiary of the policy. Consideration should be given to utilizing an irrevocable beneficiary designation to maintain control. An agreement could be written to establish the parameters of this relationship (sample copy is available). Corporation, as beneficiary of the policy, can make deposits to the policy directly to the insurance company or through intercorporate dividends to each Holdco. If a universal life insurance policy was established, each shareholder could make additional deposits to the policy for their own benefit.

8 Appendix: Use of Life Insurance Policy Post Retirement Buyout The life insurance policies are a useful financial tool both pre and post retirement. After an inter vivos sale, the purpose and use of the life insurance policy may change. Corporation may deem that the life insurance policy is no longer required by the company. Under this scenario Corporation could remove the irrevocable beneficiary designation effectively transferring all rights of the policy to the shareholder. The shareholder could then choose to retain the policy in a manner that suits the personal estate needs of the shareholder. This may include: Retention of total risk amount Reduction of risk amount Minimization of the risk for maximum accumulation In a retirement buyout scenario, Corporation may decide to retain their rights to the policy to provide capital recovery to the company upon death of the retired shareholder. An irrevocable beneficiary designation would be preferred. This type of scenario is common with insurance funded buy sell agreements as it helps provide some certainty of capital for the new generations of shareholders. If the decision to retain the policies by Corporation is likely, some thought should be given to establishing a new common company (Insure Co.) for purposes of owning the life insurance policies. This would remove any possible frustrations of having a retired shareholder s company owning a life insurance policy for the benefit of Corporation

9 Some Important Notes This presentation is for general information purposes only and does not form any part of a policy. It does not provide an indepth analysis of the differences between policy contracts. Please refer to each insurance company s quotation and sample policy contract for detailed information pertaining to coverage and exclusions. This presentation includes values which are provided on a best efforts basis to be the most up to date figures from insurance companies. Prices and values are subject to change at any time prior to an application for coverage being received by an insurance company. Values may be different depending on the life insured s health; occupation and lifestyle. Consult a professional tax planner if you require any tax advice pertaining to the products discussed in this presentation.