Gordon Berger, TEP PanFinancial Insurance Agencies Ltd. 265 Yorkland Blvd., Suite 401 North York, ON M2J 1S5 416.499.4222 FUNDING DISABILITY BUY-SELL AGREEMENTS USING INSURANCE February 2010
Funding Disability Buy-Sell Agreements Using Insurance Good morning. Today I would like to discuss with a topic that most of us tend not to think about until it impacts our clients in a negative way. I will be looking at insurance specifically disability insurance with the focus of funding shareholder agreements. But first I would like to share my almost 40 years of reviewing the specific part of a shareholder s agreement concerned with funding disability events within the buy-sell arrangement. It seems to me that this is one of the areas of a shareholder agreement, or buy sell arrangement, that is often not reviewed, but rather templates are used with common wording for this section. I know this because I see virtually the same wording in most of the shareholder agreements that I review. Why is this a problem? It can be a problem because most of the templates are merely that; they state a generic position and do not take into account any of the specifics of a given situation. What does this mean? It means that most shareholder agreements are sadly lacking when it comes to the specifics of what will take place in the event of a disability or even what a disability is. Story here. Maybe there are two brothers with a shareholder agreement and one of them becomes disabled. The shareholder agreement says that in the event of disability either brother would received x amount per month for the next 15 years. However the disabled brother can still work doing some different than he originally did. Is he disabled? Insurance is the easiest and cheapest solution to the problems confronted by a disability within the context of a shareholder agreement. There are a number of different disability products to select from and each of them can solve specific problems with funding aspects of buy-sell agreements. The needs are: Income protection Critical Illness protection Key Person disability protection Lump Sum Disability Buy-Out protection Disability Buy-Sell protection Obviously an entrepreneur could self-insure any of the potential requirements for funding in a buy-sell agreement. Self-funding generally creates problems. The company would have to set up reserves to make sure that if any of the above occurred, the funds would be available when required. The funds would have to be reserved at a predictable present value assessment and would have to be evaluated on an ongoing basis to determine the adequacy of the reserves. This would likely entail actuarial work. Most corporations would not be able to direct major working capital to cover these possible scenarios and especially to fund a number of different contingencies because separate reserves would need to be set up to cover different aspects of potential living benefits that may be required. Over the years I have reviewed many agreements that treat the entire area of disability with either form paragraphs or cookie-cutter wording that falls short of dealing with the possible occurrences. Many agreements simply say that if a shareholder is disabled after a number of days that they will be paid so much for so long. The major problem I have found is who determines whether the employee/shareholder/key-man is disabled? By that I mean what is the definition of disability and what is the process for determining whether or not the above actually qualifies for the payments?
Unfunded disability payments are generally paid to the employee as taxable benefits unless paid out of a Health and Welfare Trust. The funding of these different type of coverages need to be looked at very carefully so as to structure these benefits in the most advantageous way from both an efficiency and tax planning perspective. Solution: Based upon these issues, Disability Insurance Protection is generally chosen over the self-insured method. First, it is more tax-efficient to have the employee/partner pay for their own premium thus making the benefits, if received, tax-free. It is, however, possible to have the corporation pay the premium and gross up the coverage to cover the tax cost to the insured if benefits are paid out or set up a Health and Welfare Trust, in which case the corporation would pay deductible premiums into the Trust to pay for the insurance cost to the employee. By using this type of structure it is possible to create a benefit that would not be taxable when received. Moreover, the most important reason for utilizing a third-party insurer is they will determine whether or not one qualifies under a clear and precise definition of disability in the contract. Unfortunately, disabilities are somewhat gray and hard to assess even by experts. However, this is generally the best solution when initiating a buy-sell agreement. Critical Illness Insurance Critical Illness was first sold in the country about 25 years ago. The coverage was first created and initiated in South Africa with the famous Dr. Christian Bernard. Given the change in modern medicine, there is a growing feeling that Critical Illness protection is much more effective in covering health disasters than Income Protection. The eventualities that would have disabled people many years ago such as heart attacks, spine operations and the like, do not impair employees from going back to work for long periods of time. In the past, these kinds of problems would necessitate long periods of convalescence and sometimes even prevent one from returning to work. Nowadays such things as heart attacks, if not critical, are quickly rectified by angiograms, stents, balloons, or other simple methodologies. Back operations which would have disabled people for six months or longer are now done in one day, with a week or two convalescent period. In fact, let s run this through to determine which type of coverage would provide for the true need. We all remember hearing about a co-worker of our parents who suffered a heart attack 25 years ago. At that time the general protocol was several weeks in hospital, a three to six month convalescent period at home and then an additional six months of slowly progressive physiotherapy treatment and exercise. The return to work was in about 12 months from the date of the original heart attack. In this scenario, you can see that the disability insurance plan would provide a great solution. After 30 days of disability, the disabled partner would receive approximately 662/3% of his or her income for the remaining 11 months that they were disabled. These funds would be paid tax free. Now let s take a look at today. The same person would be kicked out of the hospital after about a threeday stay and would be home nursed for the first couple of weeks. After that time they would be encouraged to get up out of bed and, if there were no complications, to begin an exercise program consisting of diet, exercise (probably the mall walkers we all see) and various other things. By the end of the first month (or sometimes even sooner) they would be encouraged to return to work on some basis and slowly work themselves back into their regular lives. What would the outcome of disability insurance be in this scenario? Probably little or no payment. So what could fill this gap? Well there is another type of living benefit insurance that most of you have heard of by now and it should be integrated into the plan. It is called Critical Illness.
The Need for Critical Illness Protection Critical Illness Protection is thought to pay out in many more situations than Income Protection. It provides large tax-free dollars to fund income needs, liabilities, and medical expenses. Instead of purchasing up to approximately $20,000 per month of Income Protection, which could cost a fortune, require monthly doctor reports and the reporting other income with some types of these policies, and in many cases would not be enough to service ongoing income requirements, payment of monthly liabilities such as interest on bank loans, mortgage payments, premiums, credit card debt, etc. Critical Illness Protection can pay out as much as $2 million or more in some cases on qualified claims for such illnesses as heart attacks even silent ones, if proven, cancer, kidney disease, some forms of cancer of the prostate and many others. Best of all each of the illnesses that are covered are well defined and don t vary much from company to company. This means that making the determination of what constitutes a critical illness is fairly well put together in most circumstances. After the waiting period, most often 30 days or longer, if the insured is alive, the benefit will be paid out on a tax-free basis. For corporations, the premiums may be paid into a Health and Welfare Trust on a deductible basis and not taxable to the insured if paid out on a claim. I will touch on the use of Health and Welfare Trusts shortly. There are many choices for funding this form of lump sum insurance but one of the most creative methodologies is to use a split-dollar approach. The company owns and pays for the basic coverage. This protects the company against the risk of a critical illness that could result in the loss of a key person s services. In the event of a covered critical illness, the company will receive a tax-free lump sum payment that can be used to find a replacement, pay down debt or replace lost revenue until a suitable new partner or hire can be found. Under the split-dollar approach, the insured owns and pays for the Return of Premium benefit on cancellation or expiry, which returns the total returnable premiums paid by both parties if no critical illness claim is made by the time the policy is either cancelled or expires. If there is no critical illness event, the insured will receive the sum of all returnable premiums paid up to the time of cancellation, provided the policy stays in force for 15 years. In order to collect the returned premium, there are conditions that must be met and agreed to in the buy-sell agreement. Tax and Legal Considerations The tax treatment of critical illness depends on the policy meeting the provincial definition of accident and sickness insurance. Return of premium benefits are received tax-free provided they do not exceed the total premiums paid and, in a shared ownership scenario, do not impoverish the company. For example, if the insured cancelled the policy without the agreement of the corporation and later suffered a covered critical illness, the CRA may argue that the company was impoverished by this action and under this scenario, the Return of Premium benefit may be taxable to the insured. If the insured wishes to leave the company and wants to continue the policy in force, there may be a taxable benefit to the insured if he pays less than the fair market value of the policy at that time. The right to do this, however, may be restrained under the terms of the agreement. The shared ownership agreement is a private contract between the parties. Each party should get independent legal advice. A checklist of the clause that should be considered for inclusion in the agreement is can be provided if requested.
In a shared ownership arrangement, it is important that both parties agree to the cancellation in order to access the return of premium benefits. If only the insured has the right to cancel, then the CRA may argue that this has cost the company by removing the insurance protection it was paying for. In this event, the Return of Premium benefit could become taxable. Other Forms of Insurance to Contemplate Products have been created to solve individual contract needs, such as: Key Man Disability Protection Lump Sum Disability Buy-Out. This types of plan allows the corporation to put in place a type of disability plan that provides funds in the event of a catastrophic disability. They generally have waiting periods of one or two years and therefore are for situations where the disabled party is unlikely to ever to return to work. These funds could be used to buy out a partner in the event of a catastrophic disability by providing a lump sum payment that could be used by the corporation to repurchase shares, to buy our a spouse or other need And even Disability Buy-Sell payments over time These benefits are purchased in various ways to respond to the buy-out provisions of the Buy-Sell agreement. They are generally not tax deductible to the corporation and are generally not taxable when paid out. The Much Overlooked CRA Gift Most practitioners are not in the habit of missing the few gifts provided by CRA, however, Health and Welfare Trusts and Health Spending Accounts provide wonderful tax incentives for employees and shareholders alike. The problem is that they must be set up with extreme care and managed in the same way, but the benefits are worth it. Some of the basic rules to be dealt with: 1. Membership should be provided to more than one individual employed by the company. However, where there is only one individual employed, the plan should offer benefits to future hires. 2. Where there are different levels of employees, the plan need not be offered to all employees but must not discriminate within a class of employees. 3. Benefits may be offered to shareholders who are also employees of the company but may not be provided to them in consequence only of their being shareholders. CRA has issued various rulings concerning Critical Illness policies purchased by Health and Welfare Trust plans. I would strongly suggest that these trusts are not used to the fullest advantage and furthermore can provide tax benefits that are not available without using this structure. Sale of Life Insurance to Corporation A tax strategy is for a shareholder to sell a life insurance policy to their corporation. This strategy works best with permanent type policies that have no cash surrender value and shareholders who may now be in poor health but have no need for life insurance or no desire to pay premiums on a personal basis. The shareholder would have taxable income of the excess, if any of proceeds of disposition over the adjusted cost basis. Since the shareholder and corporation are non arms length, the proceeds of
disposition is deemed to be the cash surrender value. If the life insurance policy is low or zero cash surrender value, there may be little or no tax on the sale. The corporation would be deemed to have acquired the policy for its cash surrender value. This could potentially decrease the adjusted cost basis, which could give a favourable tax result on death. Ongoing premiums could now be paid from the corporations retained earnings rather than from the aftertax monies of the shareholder. On death, the proceeds in excess of the adjusted cost basis would be added to the capital dividend account, thereby allowing those monies to be paid as dividends without being taxable. A life insurance policy is property. It is reasonable for the corporation to pay the shareholder the fair market value of the property that it acquires. The CRA has felt that this is a loophole for some time and has indicated that they will eventually close it. The fair market value of a life insurance policy can be materially larger than its cash surrender value. Valuation must be performed by and actuary and includes such variables as: Shareholders life expectancy Future premiums Cash value, if any Interest rates Death benefit Adjusted cost basis Risks Selling the policy to a corporation could increase exposure to creditors. If corporation doesn t have ready funds to pay premium, policy could lapse. Reversing the transaction could be very costly. If there is cash value and the policy is surrendered the sale may have lowered the policies adjusted cost basis and result in a greater level of taxable income on disposition. Therefore it is good planning if the policy is kept until death but poor planning if the policy is surrendered. Conclusion So, in summary, you can see that there are many ways to skin the cat. In working together, you will find that our company, PanFinancial, has been created to serve the accounting and legal community and has done so for 40 years. Our mandate is to deliver, while working with you, solutions that are creative, individualized and will stand the test of time. We are committed to delivering value-add to you and your clients and most importantly, service excellence. What separates us from the pack is our dedication to our habits for success which I would like to share with you in closing. They basically guarantee anyone, that if followed, they too will be successful beyond belief in thir personal and business lives. The Habits for Success are: 1. If you promise to do something do it! 2. If you start something.finish it!
3. Do It with Service excellence 4. Personal Best 5. A little humor never hurt 6. And ALWAYS say please and thank you Thank you for allowing me this time to share some ideas with you