For individuals, no estate plan is complete without a Will. Similarly, no business plan is complete without a shareholders agreement. A shareholders agreement sets out the rights and obligations of both the shareholder(s) and the corporation. It is a contract that relates specifically to the relationship between some or all of the shareholders and the corporation. A shareholders agreement is a way to capture the intention of the shareholders as to the nature of their relationship with one another and the corporation. A well-drafted shareholders agreement can address a variety of topics and in doing so prevent potential misunderstandings or issues between the shareholders. An important component of a good shareholders agreement is the buy/sell provisions allowing 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 a shareholders 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. This Tax Topic describes the basic methods of buying out a shareholder at death and outlines 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.
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 shareholders agreement contemplates that the corporation will purchase some or all of the deceased’s shares and the surviving shareholders will purchase some or all of the deceased’s shares. 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 the 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 are paid to the surviving shareholders who would each use the proceeds to purchase the deceased’s shares. In this fact situation, A is 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 is 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 C dies, 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 shareholders 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 to the deceased’s estate from the survivors). The corporation is the owner and beneficiary of a life insurance policy on the life of each shareholder. After purchasing the shares, 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 policy 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 Tax Topic entitled, “Capital Dividend Account”). Next 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 would each own $750,000 worth of shares representing 50% of Opco. After purchasing the shares, Opco would pay out a $500,000 tax-free capital dividend of $250,000 to A and $250,000 to B. A and B would repay the promissory notes with the dividend proceeds.
Corporate Redemption Method
In this arrangement, the agreement obligates the corporation to repurchase (redeem) the shares of a deceased shareholder at the value as specified or calculated pursuant to the shareholders agreement. The corporation is the owner and beneficiary of a life insurance policy on the life each shareholder. If one of the shareholders dies, the life insurance proceeds are paid to the corporation and the proceeds used to redeem the deceased’s shares.
In this fact situation, Opco is the owner and beneficiary of three $500,000 policies on 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. Assuming the policy’s adjusted cost basis was nil, Opco would receive a $500,000 credit to its CDA. (For more information on the CDA, refer to the Tax Topic entitled, “Capital Dividend Account”). 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, it would be non-taxable 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 (without trustee)”;
“Buy/sell Agreements – Criss-Cross Purchase Method (with trustee)”;
“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 corporation or the individual to own the insurance. The following sections discuss issues to consider with respect to corporate owned vs. personally owned insurance in the context of buy-sell funding.
Generally, the premiums payable on a life insurance contract are not deductible for income tax purposes. Therefore, it may be preferable to own insurance in the corporation so that the corporation pays the premiums. Where the corporation is in a lower tax bracket than the individual shareholders, a tax saving may be generated. 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 ensure 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 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 Tax Topic entitled, “Buy/sell Agreements – Criss-Cross Purchase Method (with trustee)”.)
On the other hand, if the corporation owns the policies each shareholder has access to the corporate records to ensure that the policies are being kept in force. On the death of the shareholder, the 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 is reduced to one policy on the life of each shareholder where the insurance is held in the corporation leading to potentially 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 Tax Topic entitled, “Buy/sell Agreements – Criss-Cross Purchase Method (with trustee)”.)
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.
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.
The provisions of the Income Tax Act applicable when corporate-owned insurance is used to fund a buy/sell agreement are generally more complex than those applicable when personally owned insurance is used. As a result, the shareholders may want to use individually owned insurance as the tax consequences of this type of funding arrangement are more easily understood.
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 covering each method of buy/sell arrangement.
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 attempting to seize the insurance proceeds or placing 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. However, a personally owned insurance policy and any proceeds from the policy may be exposed to personal creditors or creditors who have obtained a personal guarantee of corporate debts.
This article outlined the different methods of structuring the transfer of shares on the death of a shareholder and some of the factors to consider in deciding whether to use corporate-owned or personally-owned life insurance to fund buy/sell arrangements. In each case, it is 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.
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.
by Manulife Financial, Dec 2012