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Key Questions About Using Life Insurance For Buy Sell Agreements:

What is A Buy-Sell Agreement?

Buy and Sell agreements are legal contracts that dictate how you and your partners handle the disposition of each other’s shares in the business.
When I explain it to clients, I often hear it referred to as the “will” for the business or a “prenup” for a business. 

There are certainly similarities.
At its core, it gives business partners an understanding of how to handle any event in the future that could lead to ownership transfers. 

Very similar to how a prenup could dictate the disposition or spit of assets due to marital breakdown, buy-sell agreements do the same thing.
Having the agreement in place ahead of time provides clarity for everyone involved when a triggering event occurs. After all, it’s far easier to have these discussions when there are no conflicts or third parties involved

But it’s not just a conflict resolution tool. It helps you and your partners continue your vision. Ultimately it can provide intentional business continuity. Buy-sell agreements can help cement the values you and your partners have built your business. It can safeguard the company from third-party interference because it can limit who can buy or sell stakes in the company.

The buy-sell agreement should address the following:

  • The valuation of the business and future determination of value.
  • Sales procedure or arrangement.
  • Triggering events, and
  • Funding sources.

How Much Will The Business Sell For?

Like most entrepreneurs, it’s likely that the majority of your wealth is tied to your business(es).   Wouldn’t it be great to have a baseline value for how much your business is worth after all your hard work?

Some of our clients are pleasantly surprised by their valuations while others are experiencing a sobering truth. However, whether the business is valued higher or lower, it pays to know it’s worth ahead of time. Either to improve valuations or to prepare for the potentially crushing tax liabilities down the road.

Determining business valuation could be difficult because there is no secondary market. In a closely held company, there may be varying expectations of business value between partners, this can cause discontent and extremely expensive legal battles. By having an agreed purchase value ahead of time, you and your partners will have control over its distribution. Having clear expectations also allows you to work efficiently which results in a win for everyone. 

There are endless ways of determining value, the most important part of this exercise, is coming up with a method of determining that works for all the partners and potentially the CRA. 

If the CRA believes that the sale believes that the company was purposely transferred at incorrect values to create tax benefits, the company and shareholders could potentially suffer from double taxation.

This guide does not go into detailed valuation calculations but here are some of the common methods of valuing a small company.

  • Arbitrary Agreement: Imagine a magician, say, abracadabra, this method is similar to that. The partners simply believe that their business is worth a certain amount and agree to purchase price.
  • Discounted Cash Flow: Discounts the future revenues of the company based on a “discount” rate. The calculation is not as important as the assumed rate itself. For the purposes of this guide, if the buyers use a higher discount rate, it’s reflective of a perceived risk. The higher the discount rate, the lower the final business value will be.
  • Multiple of Earnings: This method values the business by a multiple of EBITDA, Earnings Before Interest Taxes Dividends and Amortization. The higher the multiple, the higher the value. The issue here is coming up with an agreed-upon factor. The seller almost always believes that their businesses are worth more than the buyers do. You can combat this by using comparative company metrics. If the industry selling at 1X or 2X and you are negotiating in the 4-5x ranges, there needs to be economic justifications as to why that is reasonable.
 

If you are curious about how you can value a private company like your’s what this video by the guys from Mergers and Inquisition. But you don’t need to make these calculation yet, you just need to be aware that, there needs to be sound reason for the values you and your partners choose.

How Will The Sale Be Transacted?

Shotgun Clause

A “shotgun” clause could be looked at as a forcing your partner’s hand. In the event this is exercised, the buyer gives their partners a target sale price (valuation) and terms. 

If the partner refuses, the buyer has no choice but to sell their shares at the same target valuation and term.

The opposite also applies. If your partner offers to buy you out of business based on a low-ball valuation, you can force them to sell based on the appraisal and terms they offered.

Shot-gun clauses are ideal for simple partnership structures because there are few internal buyers. 

Using a shotgun clause could be a dangerous tactic because when you give an unfair target value. The provision forces you to execute at that price. 

Low-ball your partners; they can then buy you at that price. Overvalue your asking price; then, you’ll have to buy them out at that price.

Mandatory Buy- Sell

Specific conditions are listed in your agreement mandating the values, terms and individuals involved.

Right of First Refusal

The right of first refusal gives partners the right to purchase but not the obligation based on a third party offer(non-partner). (According to Reuters.ca’s practical law)

Before you can close the deal to sell your business stake to a third party. You are legally required to make your current partners the same offer.

Unless they turn it down, you cannot sell to an outside individual or entity.

What if the partners cant match the offer?

There should be a provision in place to give them time to match it or refuse it. At that time, you may be allowed to sell your stake to the third party.

Option Based(Put-Call)

Options are financial contracts giving holders the ability to control shares of a company.
When used in a Buy-Sell Agreement, it gives the holder certain rights and obligations.
Put Options: Gives the option holder the right to sell the shares at a specific price.
For example, your partner’s widow may have put options giving her the right to sell and you or the company an obligation to buy.
Call Options: Gives the option holder the right to buy shares at a specific price. For example, you or your company may have Call options on your partner’s. The call options can force his/her spouse to sell the shares back to you, but only if you exercise it.

Hybrid/Combination

These are some of the typical sale arrangements that could be in a buy-sell agreement. However, each method has its drawbacks and advantages. Using a combination of these arrangements could also be used to maximize benefits for you and your partners. The agreement itself can become highly complex, and you must consult with a team of professionals.

What Event Would Trigger The Buy-Sell Agreement?

A triggering event is any event which could lead to a change in ownership. Here are some examples:

Death of a Shareholder or Business Partners Trigger a Buy-Sell Agreement

If a partner or shareholder passes away, their assets pass on to their estate and heirs. Their spouse, their kids or other individuals will have a claim to their business holdings upon their death. This guide will dive deep into the buy out funding using life insurance.
In the absence of a buy-sell agreement, you could end up with a wholly unqualified or incompatible partner. If you’re lucky, your partner’s family members could be competent and share your beliefs. Even then, it is still worthwhile to address the transition of ownership and

Disability of a Shareholder or Business Partners Trigger a Buy-Sell Agreement

Successful partners usually bring complementary skill sets allowing the business to grow exponentially.
But, what if you or your partner can no longer contribute to the business’s operation because of a critical illness or disability?
Having provisions for long term disability protects you and your partners from being forced to sell your stakes too soon.
If you are only out of work for a short time, it’s not necessary to execute a buyout. There must be a consideration for the likelihood of recovery. It also provides some fairness to the ownership structure if a partner is no longer able to perform their duties to the business.

Living Buy-Outs

Life insurance, critical illness and disability insurance can quickly solve the issues of death and disability, but other triggering events require more thought. 

Living buyouts also referred to as inter-vivos transfers. Here are some everyday situations of living buyouts.

Resignation of an Owner or Shareholder

It’s not uncommon for employees to change careers, and the same thing goes for business owners. Your passion may change, or you simply find a more enjoyable or profitable venture. Creating provisions for a partner’s desired exit is crucial for continuity. This preparation will insulate you from the shocks that their departure may cause to your day to day operations.

Retirement of an Owner or Shareholder

How will you and the business handle the retirement of a partner? Will you buy their stake for a fixed price, or will they continue to receive some form of retirement compensation from business operations? 

Termination of an Owner or Shareholder

We live in the days of social media scandals and 5-second reputational ruins. It’s far easier for shareholders or partners to be booted out of their own companies, even if they are one of the founders.
There are many potential reasons for termination, but it’s undoubtedly an easy example to understand.
How will you and your partner(s) handle a co-owner whose reputation could harm the business?
What if they could no longer perform a significant responsibility? Imagine a senior partner from a law firm dis-barred? Or a doctor’s license is revoked? You need to be able to address circumstances when partners are no longer able to perform a material responsibility.

Marital Breakdown of an Owner or Shareholder

Why is a marital breakdown considered a triggering event?

For most provinces, businesses built or grown during a marriage will likely be considered in the division of property upon marital breakdown. (This article will not go through the financial impact of a divorce, you can find more info here.)

This means if your partner is married and ends up in divorce, their shares may be subject to the division. The law could force your partners to transfer some ownership to their ex.  

If the personal relationship ended up in divorce, imagine how pleasant working with them would be.

Having provisions in the buy-sell agreement that addresses marital break downs can help reduce the chances of working with your partner’s ex.

Bankruptcy of an Owner or Shareholder

A successful business does not guarantee personal financial success. Your company may be doing well, but your partners may be in financial distress.

So why do this matter to you and the business?

Aside from the fact that financial distress could lead to poor long term decision-making, you could end up being partners with their creditors.

Creditors and lenders can seize assets if borrowers are unable to pay their debts and lead to bankruptcy,

This lack of protection means the shares your partners once owned, could fall in the hands of there creditors or lenders.

 

These are some key areas to consider when drafting your buy-sell agreement.

You can download our ultimate guide checklist here.

What Kind of Business Needs a Buy-Sell Agreement?

We generally recommended that a buy-sell agreement is in place when a business has more than one shareholder or owner.

We work primarily with partnerships and closely held private Canadians companies and professional corporations. Typically stable businesses with less than 50 employees and about 12 partners. 

Here are some examples.

  • Accounting Firms.
  • Advertising/Marketing Media Agency
  • Architectural Firms and Engineering Firms.
  • Tech Companies with multiple founders.
  • Medical Clinics (Family Physician Networks).
  • Law Firms.
  • Dental Practices.
  • Manufacturing Companies with less than 50 employees, typically.

How Do You Fund a Buy-Sell Agreement?

Having a predetermined value for the business may mean nothing if there is no access to cash to finalize the purchase.
The Buy-Sell Agreement must have provisions for funding to make sure there is cash available to buy out a departing shareholder. Whether it’s because of choice, conflict, death or disability, your family deserves to receive the full value of the business you’ve built.

Establishing a Sinking Fund to Fund Your Buy-Sell Agreement.

A sinking fund is simply a stockpile of cash. The business will then set aside a certain amount of money solely for the purchase of buying a partner’s interest.
Saving up the cash is the simplest solution. However, it could prove the be the most expensive. Most businesses don’t have resources to stockpile hundreds of thousands of dollars for this purpose.
Even if your business can set enough cash aside, revenue-generating activities such as marketing would provide higher returns.

You Can Borrow Money From a Bank or Another Financial Institution.

You can apply for a loan specifically for the purchase. Due to the size of the loan, the lender will likely require collateral and additional debt covenants and encumbrances on the business.
The bank can put limitations on the company’s

  • Use of Assets
  • Dividend Payments
  • Minimum Profit
Requirements to prevent the loans from being called. 

The loan interest will add to the overall cost to purchase. Depending on the business, it’s profitability and stability, interest rates may be reasonably low, or it could be painfully high.
The banks may be unwilling to lend money to the business. If the exiting partner out is a key person, they see this as an added risk. The banks may not think you can repay the loans unless you have a proven path to profit.

You Can Pay Your Partners in Installments

This method can be simple enough, come up with an internal payment plan with the departing partner and following the scheduled payments.
This arrangement is sometimes referred to as vendor financing or vendor take back because the selling party is essentially acting as a banker.
There may be built-in provisions that would protect the buyer if there’s a decline in business. The biggest concern for the company is tying up future profit without getting any value for the cash outlay.
This delayed ins payment is also unfavourable for partners who need the cash upfront.

You Can Fund a Buy-Sell Agreement Using Life Insurance

In most cases buying life insurance is the cheapest option because it provides a cash injection if a business partner passed away.
There are also additional tax and cash flow benefits that are unique to life insurance plans. SEE THE NEXT SECTION

What Are The benefits of Funding a Buy-Sell Agreements with Life Insurance?

The Cost Of Purchase Is Covered

Because there is a predetermined source of funding, it’s likely that the buy-sell will be executed at the fully agreed upon price. Because the life insurance policy covers the purchase, there are minimal additional costs for transferring ownership.

 When structured correctly, the cost premiums will never exceed the total coverage provided. 

If a key-shareholder passes away, the banks could decline the loans, that is not an issue with an insurance funded buy-sell agreement.

Sinking funds may not have enough time to fund adequately while the death benefit is guaranteed even if there has only been a few premium payments.

Insurance Policy Cash Values Can Be Used to Buy Out Partners Tax-Free.

A permanent policy like universal life or whole life policy is ideal for long term buy-sell agreement structures. Permanent policies generate cash values. The cash values can be accessed using policy or collateral loans to access the cash values tax-free. 

If there are sufficient cash values, you can fund it entirely. If there are insufficient cash values, the cash values can is available as a deposit for the loan purchase.

There are also specific provisions to access cash values tax-free if the partner is leaving because of a disability.

Corporate Owned Life Insurance Can Lower Your Company's Tax Liability

Starting 2019 Companies who qualify for the Small Business tax rate are must focus on deploying extra cash towards active income.

The federal business tax rate, after the small business deduction, is applied to end up at 9% for the first $500,000 of business income.

However, if the corporation has investments that generate passive income exceeding $50,000, it will reduce the $500,000 small business deduction limit. The business will pay the general tax rates if you end up with $100,000 of passive income.

If you are building a sinking fund, it’s not ideal to store it all as cash. You would likely deposit it interest-bearing accounts. The income from the invesments could lead to higher taxes because of the new income rules.

Depositing the amounts into a permanent life insurance policy owned by the corporation does not trigger passive income taxes.

Simplicity of Administration

Having the business purchase the life insurance policy for the owners and partners allows for transparency.
Paying life insurance premiums from a central account will reduce the likelihood of lapsing policies due to missed premiums.

How Can I Structure a Life Insurance Funded Buy-Sell Agreement?

Before getting too involved with the varying structures, it’s important to understand who the named parties in a life insurance contracts. 

This is because the funding structures depend heavily on the parties in a life insurance policy.  

Altering the structure could lead to serious tax implications in the future therefore, we strongly suggest you get expert advice. 

Working with the right insurance professional could save you tens or hundreds of thousands later on.

Policy Owner, Insured and Payor can be different individuals.

Policy Owner

Life Insured

Payor

Beneficiary

Different structures of life insurance-funded buy-sell agreement utilized to provide the most benefit to your company and your family. We will discuss the following Life Insurance Funding Structure for buy-sell agreements.

  1. Criss Cross Buy-Sell Agreements Using Life Insurance.
  2. Trusteed Criss Cross Buy-Sell Agreements Using Life Insurance.
  3. Promissory Note Buy-Sell Agreements Using Life Insurance.
  4. Corporate Redemption Buy-Sell Agreements Using Life Insurance.
  5. Hybrid Corporate Buy-Sell Agreements Using Life Insurance. 

What is a Life Insurance Funded Criss Cross Buy Sell Agreement?

The Criss-Cross method involves purchasing life insurance on a partners’ life based on their proportionate share of the company and its value. Your partners will then purchase life insurance on your life based on your ownership percentage and the predetermined valuation.

Example: 

Jane and Theresa are digital marketing experts from Calgary. They started up the agency from $10,000 of savings. ($7,000 from Jane and $3000 from Theresa). Their recent valuations put the company at $2,000,000.

If Jane controls 70% of the company, Theresa needs to purchase a $1,400,000 of Life insurance on Jane’s life. Theresa will be the beneficiary and owner of this policy. 

Jane must then purchase $600,000 of life insurance on Theresa’s life. Jane will be the beneficiary, owner and will be responsible for paying the policy.

They would own the policies personally and would be responsible for the premiums.

If Jane passes away, Theresa will receive $1,400,000 tax-free as the beneficiary of the life insurance policy. The buy-sell agreement will obligate her to purchase Jane’s business shares.
Tax Consequences to Jane (Final Tax Return)
She would be deemed to have sold the business for $1,400,000 and will have a gain of $1,397,000.
If she has not used her lifetime capital gains exemption before, she will be able to shelter to use it now. $883,384 of the gain will be exempted based on 2020 limits.
The deduction leaves her with a capital gain of $513,616.
Because only 50% of Capital gains are taxable, she would only need to pay taxes on $256,808.
With Alberta’s top tax rate of 48% for 2020, she would need to pay $123,267.84.
This payable portion equates to 8.80% of the $1,4000,000 Proceeds.
Tax Consequences to Theresa
After the closing date, Theresa will own 100% of the business. She will have an adjusted cost base of $1,403,000.
The $1,400,000 Paid to Theresa’s Estate and the original $3,000 she funded the business with
When she decided to sell the business, later on, she would only need to pay income taxes if it exceeds her adjusted cost base. In this case, any proceeds under $1,403,000 are tax-free.

Issues with Criss Cross Life Insurance Agreements

Insurance Premiums Could Be Unfair

The cost of insurance may be unfair to the younger, healthier and less risky partners. Each partner is responsible for paying the premiums out of pocket. The total costs they pay may be higher or lower than what their partners are paying. 
Example:

If Jane is 30 years old and Theresa is 50, even though the life insurance policy she needs to purchase for Theresa is smaller, she may need to pay more.

Criss-Cross Buy Sell Agreements become costly and difficult to manage if there are more partners

In this case, each partner only needs to purchase 1 policy each. However, if there are 4 partners, each of them would need to buy 3 life insurance policies on their partner’s lives.
Example:

Tom, Sherry, Jason, and Preet own Smile Labz Calgary Inc. a chain of dental clinics. They each contributed $100,000 to fund the company and control 25% each. Currently valued at $7,000,000 to properly execute a criss-cross life insurance strategy, they would need to buy 3 life insurance policies each with $1,750,000 of coverage.

It’s hard to police premiums
If your partners fail to keep up with their premiums, leaving your family without a buyer for your shares. Unless they have access to alternative funding, there may be no one else willing to purchase your shares if you pass away.

What is the Trusteed Criss-Cross Buy-Sell Using Life Insurance?

The Trusteed agreement is very similar to the Criss-Cross Buy-Sell without a trustee. However, it aims to add a layer of transparency and simplicity to the policy ownership structure. It reduces the number of policies you must maintain. You would also have a way to verify that their partners are up to date on their premium contributions. You can simply ask the trustee.

Based on our example above,

  • Tom would need to buy three life insurance policies on 1 for Sherry,1 for Jason and one more for Preet. 
  • Sherry would do the same for her partners, and so on. 
  • This structure leads to 12 policies for four partners, 20 for five partners and 30 for 6 Partners. That would be an administrative nightmare!

 

With a Trusteed, Life Insurance Funded buy-sell, there would only be one life insurance policy on each partner, four policies in this case.

They would need to establish a trust and appoint a trustee. The trustee would be the owner and beneficiary of the life insurance policies. 

Each partner would be a beneficiary of the trust. They would be responsible for contributing personal funds into the trust, which the trustee uses to pay premiums.

Should Tom pass away, the trust will purchase Tom’s shares from his estate, using the life insurance benefits. The trustee then distributes the shares among Sherry, Jason, and Preet based on the buy-sell agreements.

The trustee could also stipulate that every owner contributes an equal amount of life insurance premiums. This arrangement makes total premiums more “fair” compared to buying personally owned life insurance on your partners. If they were older or suffer from unfavourable health conditions, you could find yourself paying more than they do.

Setting Up the Life Insurance Funded Trusteed Criss-Cross-Buy-Sell.

Step 1.) They would set up a trust and appoint a Trustee.

Step 2.) The trustee would purchase life insurance policies for $1,750,000 on Tom, Sherry, Jason, and Preet. They will make the trust the owner and beneficiary.

Step 3.) The trust will require each partner to contribute 25% of the total cost of all life insurance premiums into the trust. (I’m assuming equal splits upon purchase, your case may vary)

Considerations upon death.

If Tom passes away, the life insurance policy on his life will pay the tax-free death benefit to the trust. 

  • The trust will buy Tom’s share from his family/estate. 
  • The trust then transfers the shares to Sherry, Jason and Preet.  
  • Sherry, Jason and Preet will then own 33.33% of the company.
  • The tax considerations for a Trusteed Criss-Cross Life Insurance strategy is similar to the non-trusteed plan. Trusts are designed to flow-through the original tax characteristics of the investments held. 

Tax Notes for the Trusteed-Criss-Cross-Buy-Sell Agreement.

To Tom:
Tom will be “deemed” to have sold his shares at the predetermined value of $1,750,000.
His adjusted cost base is $100,000, leaving him a gain of $1650,000.
If he hasn’t used his lifetime capital gain exemption, he will exclude $883,384 based on the limits for 2020.
Thes means his capital gain $766,616. The taxable portion will be $383,303.
Based on the highest tax rate in Alberta (48%), his tax owing to the sale would be.
$183,987.84
To the Trust:
Life Insurance Death Benefit, $1,750,000
Taxes: 0
To the  Surviving Partners:
They would receive 8.33% of the total company shares valued at $583,333. Making their new cost base $683,333.

Drawbacks

  • Forming the trust adds costs to this strategy. It becomes a separate legal entity that must file taxes yearly. If they use a professional trustee, this becomes an additional ongoing administration cost.
  • The division property rules for divorce typically exclude life insurance death benefits. This provision also applies assets purchased using the funds. However, because the death benefit is distributed through the trustee, the newly acquired shares will be added to the net family assets.

What is the Life Insurance Funded Promissory Note Buy-Sell Agreement?

This strategy still works similarly to the criss-cross life insurance strategy where the owners purchase the shares of the deceased partner personally.
The corporation owns and administers the life insurance policies on each partner’s lives.
There are tax advantages of paying the premiums using corporate income instead of personal income.
The buy-sell agreement obligates the shareholders to purchase the shares of a deceased partner based on the values specified by the buy-sell agreement.
However, the surviving shareholders do not immediately purchase the deceased’s shares with cash.
Upon the death of a shareholder, the corporation receives the life insurance benefits tax-free.
The life insurance benefit creates a notional account known as the Capital Dividend Account.

When corporations receive a tax-free life insurance benefit, it’s added into the CDA, net of the adjusted cost base.

Example:

$1750,000 of insurance -Adjusted cost base of $100,000 will lead to a new CDA balance of $1650,000.
The CDA will allow the life insurance proceeds to flow out to the shareholder’s tax-free, unlike a regular dividend.
However, just like a regular dividend, every shareholder with the same share class is entitled to the dividends proportionate to their ownership. 

The promissory note addresses this issue.
The surviving partners will issue promissory notes or “I-Owe-Yous” to the family of the deceased shareholder.
They issue the notes because they have yet to receive funding personally.
By buying out the deceased partner’s shares before the capital dividend is declared, they will no longer be eligible to receive the dividends. Proceeds. The capital dividend is needed to purchase the shares from the deceased family personally.
The corporation then pays the surviving shareholders the life insurance proceeds, and they use it to purchase their deceased partner’s shares.

Back to Our Example

  • Smile Labz Calgary Inc. will own four life insurance policies, 1 for Tom, 1 for Sherry, for Jason and 1 for Preet.
  • The corporation will pay the premiums for the policies and becomes the beneficiary of all policies.
  • The corporate life insurance premiums are not tax-deductible; however, it is not a be taxable benefit for the shareholders either.
  • If Sherry passed away, the corporation would receive $1,750,000 tax-free. We assume the Adjusted cost base of Sherry’s policy is $0.
  • Smile Labz Calcgary Inc. will have a capital dividend account balance of $1,750,000.
  • Tom, Jason and Preet will issue a promissory note to buy a third of Sherry’s shares. Each will amount to $583,333.33. 
  • The promissory note will stipulate a redemption time-frame. At that time, Tom, Jason and Preet must pay off the promissory notes.
  • After the promissory notes are issued, Smile Labz Calgary Inc. will issue a tax-free capital dividend of $1,750,000.
  • The capital dividend will be divided equally between Tom, Jason and Preet. They’ll receive $583,333.33 each, the exact funding requirement to settle the promissory notes.

Tax Consequences

To Sherry.

  • She will be “deemed” to have disposed of or sold her shares for $1750,000.
  • Her adjusted cost base is $100,000; this gives her a gain of $1650,000.
  • If she hasn’t used his lifetime capital gain exemption, he will exclude $883,384 based on the limits for 2020.
  • His capital gains will be $766,616. The taxable portion will be $383,303.
  • Based on the highest tax rate in Alberta (48%), his tax owing to the sale would be.
  • $183,987.84

To Tom, Jason and Preet

  • The surviving partners will have a new Adjusted Cost Base of $683,333 (583,333 +$100,000) 
  • They will receive 8.33 additional shares. Bringing each of their holdings to ⅓ pf the company.

To the Corporation

  • No Tax Payments 

ADDITIONAL DRAWBACKS AND CONSIDERATIONS

Life Insurance Proceeds to the corporation is not creditor protected. If the company has existing loans, the death of a shareholder may trigger a repayment demand. Creditors could seize the life insurance proceeds.

Alternatively, if there are loans for business operations or other covenants and solvency requirements in place, barring the company from distributing dividends. This restriction will trap the cash inside the corporation.

What is the Life Insurance Funded Corporate Redemption Buy-Sell Agreement?

A life insurance funded corporate redemption agreement forces the corporation to purchase or redeem the shares from the deceased shareholder. The corporation is the owner, beneficiary and payor in this structure. 

The corporation will buy life insurance for each shareholder.

Most corporations in Canada have the ability to buy-back or redeem its shares, make sure your company has no corporate bi-laws preventing this.

A crucial point for corporate redemptions is that it falls under the deemed dividend rules in the income tax act

The lifetime capital gains exemptions do not apply if the corporation purchases the shares directly from you or your partners upon death or wind up of the corporation.

This classifications also means that the adjusted cost base of the remaining shareholders does not increase because of the purchase.

The tax treatment for corporate redemption will vary based on the age of the corporation. Corporations that set up agreements for redemption before April 27, 1995, will have “grandfathered” treatment, meaning they can use the old rules. While company’s that did not have this set up before April 27, 1995, will be “non-grandfathered,” making the set-up slightly more complicated because of differing tax considerations. If you’re curious about a newer company, skip to the non-grandfathered section. The following will give you an overview of corporate redemption. Due to its complexity, this will be addressed separately in another article.

Grandfathered Shares. (OLD RULES)

The corporation receives the insurance proceeds tax-free. The proceeds get added to the Capital dividends account net of the Adjusted Cost bases.

The life insurance proceeds are what the corporation uses to redeem the deceased’s shares from the estate/family members.

With grandfathered shares, there are minimal tax consequences to the deceased shareholder or their estate. The estate will likely only pay taxes on proceeds exceeding the CDA, which will be considered taxable dividends.

Example:

If Sherry passes away while her policy had a CDA of $50,000. Calgary Smile Labz Inc. will purchase Sherry’s shares from her estate for $1750,000.

The company will issue 2 different dividends to the estate.

  • Capital Dividend: $1,700,000 ($1,750,000-$50,000)
  • Taxable Dividend: $50,000
  • Based on 2020s Tax Rates: Tax owing will be minimal.

Non-Grandfathered shares. (NEW RULES)

  • The corporation receives the life insurance proceeds tax-free, but the tax on the distribution to the estate is complicated.
  • With the old rules, the shareholder receives a capital gain upon death. However, the estate can offset this with a capital loss. The capital loss deduction will wipe out the majority of the gain.
  • The new rules reduced the capital loss available to:
    • The Lesser of:
      • Capital Dividends received by the estate, or,
      • The Capital Loss -any taxable dividend received by the estate.   
    • Minus 50 percent of the lesser of the following:
      • The deceased’s capital gain from the disposition at death, or,
      • The estate’s capital loss.

I know this is a head-scratcher, but this hi-lights the importance of a proficient legal and accounting team. If you don’t have one, my team and I can get this started for you. If, however, you’re keen on learning how to calculate this, check out this detailed article. 

The stop-loss rule has effectively increased potential tax liability. Carefully structuring your corporate redemption plan is crucial. There are key “Tax Planning” strategies that can combat higher taxes. 

BUT(Yes, I capitalized that for dramatic effect.)

Just like Buy-Sell agreements, they need to be put in place ahead of time.  

Here are strategies to save your family and the estate some taxes:

Rollover and Redeem: 

Shares are transferred to the deceased shareholder’s spouse and get’s a rollover benefit. The rollover allows transfers of assets between spouses without triggering any tax consequences to the deceased. 

For rollovers to be accepted, the shares must be “indefeasibly” transferred. Meaning, there is no mandate from the buy-sell agreement forcing the spouse to sell the shares back to you or your partners.

Options are used instead of having the buy-sell agreement mandate the sale of the shares. Options, as the word implies, provides optional benefits. 

Put Options

The surviving spouse will have the option to sell shares back to the business at a given price but not an obligation. 

Call Options

The company has the option to buy the shares from the surviving spouse at a set price, but not an obligation.

Combined Put-Call.

The net effect is similar to having a mandated resell, or purchase agreement once executed simultaneously. 

The 50% Solution.

The name refers to the allocation between taxable and capital dividends. 50% is distributed as a “capital dividend,” while the rest is treated as a “taxable dividend.”

This allocation provides the highest tax advantage to the group collectively.

What is the Life Insurance Funded Hybrid Redemption Buy-Sell Agreement?

The Hybrid Method uses life insurance to fund a buy-sell agreement that uses both a share redemption and promissory notes.

I’ve heard a colleague ask clients if their buy-sell agreements are structured to benefit the diseased shareholders or the ones who are sticking around.

He told me that it’s usually met with blank stares, but the question is valid. It’s something that I now ask my clients as well.

This statement illustrates how the methods, clauses and restrictions in a buy-sell agreement can be heavily biased. Providing the maximum benefit to the company could be punitive to the estate or the family of the deceased partner.

As mentioned above, share redemptions are “deemed dividends” rather than capital gains. The tax implication for corporate redemptions and purchases using promissory notes are drastically different.

Through redemption, the buyer is the corporation. While, in the promissory note method, other shareholders purchase the shares personally from the estate.

Using the hybrid approach creates a scenario where the owners purchase a percentage of shares while the corporation redeems the remainder.

The optimal blend is found by coordinating what deductions and capital gains exemptions are available to the estate and maximizing that. The corporation will then redeem any amount exceeding this.

How Can You Get Started?

We’ve seen cases where Poorly planned buy-sell agreements have forced business liquidations.
Countless families get pennies on the dollar because there was no plan in place for them to get the right value for the business.
It may have been years since you last updated your agreement.
Maybe you’ve never done one, I get it, it could be a challenging conversation, but it’s far easier to do it now. Don’t leave your family’s future up to the generosity of your partners or your creditors.

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