Buy-Sell Agreements

In the unfortunate circumstance of the passing of a business partner or owner-shareholder, often the most realistic option for the remaining partners or owners is to buy out the deceased’s share of the business from the deceased’s heirs… rather than inviting heirs to become business partners themselves (and/or risking that the deceased’s share in the business is sold to a unrelated third party.) Without a legally binding agreement in force, determining fair market value of the deceased’s share of the business may be difficult.

While a Buy-Sell Agreement is not a guarantee against discord amongst owners and/or heirs, it does provide a defined and agreed-up mechanism to value an owner’s shares should he/she wish to opt-out, retire from the business, or should he/se become disabled or die. Buy-Sell arrangements may be drawn up between owners or shareholders of a corporation, between partners of a partnership and/or between an employer and a key employee of the organization.
Professional (planning, valuation and legal) advice should be sought at each stage of the agreement process and by each party to the agreement. Moreover it may be wise to conduct periodic business valuations, both in an effort to ensure that adequate funding is in place, but also to help eliminate the potential for disagreements over share valuations at what might be an emotionally charged time.

Funding of Buy-Sell Agreements

Funding options may include using current cash flows where a former owner’s share in the business will be paid by way of installments, borrowings or proceeds from life insurance.
Installments – While this option may be highly suitable for retiring business owners, especially in circumstances where the company is passed (sold) to children, in situations where an owner-shareholder or partner has died, the deceased owner’s heirs are more often reluctant to assume the risk of continued business success. Remaining owner-shareholders and/or partners may also find this option to be a drain on operating resources…

Borrowing – Even where a company’s financial position and credit-worthiness is strong, the passing of a partner or key owner-shareholder may be cause for concern for a lender; making it difficult and costly to secure a loan. Moreover, lenders may require the loan to be personally guaranteed, adding the potential for significant liability.

Life Insurance – often referred to as Key Man insurance, a life insurance policy (Term coverage often owned to age 65) is the not only the most common, but also most cost effective means of funding a Buy-Sell Agreement. In the case of a partnership, partners own life insurance on each other in what is referred to as a criss-cross arrangement. Upon the death of a partner, proceeds consistent with the deemed value of the deceased owner’s share of the business are payable to his/her heirs or estate.

In a corporate setting, the tax-exempt death benefit payable from a life insurance policy is generally paid into the corporation itself; to be used to buy the deceased owner-shareholder’s shares from his/her estate or heirs.

Where there is an obligation on the part of other business owners to buy out the interest of an owner who retires or otherwise leaves the business, it is often desirable to consider a permanent insurance solution over Term coverage – a Universal Life and/or Whole Life policy may be used whereby surplus savings not needed for operational or other business purposes, overfund the policy and build cash value over time. Accruing cash values may then used as form of sinking fund to provide for a retirement allowance or severance benefit for retiring (exiting) employees. As with Term coverage noted above, the UL or Whole Life policy’s associated death benefit will fund the Buy-Sell Agreement in the event of an owner-shareholder and/or Key Man.

• Where the value of the business is expected to grow over time, selecting a death benefit option which increases automatically over time (paid up dividends and/or indexing benefits etc.) is prudent. Often policies include a guaranteed insurability rider which allows for the purchase of additional coverage without a re-qualifying medical.

Retirement of a Sole Proprietor

While more often the focus is on protecting a corporation or partnership from the exit or passing of a key owner-shareholder, a Buy-Sell Agreement may also play a role in the sale of a Sole Proprietorship. Generally, such an agreement would specify how ownership would be transferred to a key employee or family member in life (using continuing cash flows and/or accrued cash values from within a UL or Whole Life insurance policy) or upon the owner’s passing, whereby the business may be purchased from the estate. If an insurance solution is preferred, the key employee will purchase life insurance on the Sole Proprietor (whom he has a vested interest) and names himself as the beneficiary of the policy.

Upon the passing of the sole proprietorship, tax exempt proceeds payable to the employee may be used to fund the Buy-Sell Agreement. As above, a permanent life insurance solution may also be structured; whereby accruing cash values may be used (often in combination with continued cash flows and/or borrowings) to fund the purchase of the business as the Sole Proprietor exists the business upon retirement.

Key Man

The untimely death or disability of a person who integral to the success of an organization can have a detrimental effect not only on workplace morale, but potentially on the viability of the business itself. Whether or not this individual’s unique skill-set can be replaced internally or whether it may be necessary to recruit from outside of the organization, the cost of hiring (often a signing bonus involved, and (re)training, let alone the impediment to a company’s productivity may be significant.

Ensuring adequate funding is key – often businesses attempt to estimate the value of a key employee’s contribution to the success of the business in terms of net profits and/or the discounted value of foregone future earnings. As in the case of funding a Buy-Sell Agreement above, life and/or disability insurance solutions are often the most feasible option for offsetting related business risks which may arise as a result of the disability or death of a key employee. As you might expect, the insurance premiums are not significant when compared the cost; which would otherwise need to come from earnings or be borrowed (if possible?)

Generally the business itself is not only the policy owner but beneficiary. Insurance premiums are paid by the business itself and are not deductible; however the death benefit payable upon the passing of a key employee is exempt from tax. As above, a permanent life insurance policy solution may be used to build accruing cash values which can be utilized by the business.

Disability

Another concern might be the effect on the business should the key employee suffer a prolonged disability. While a typical disability policy pays a tax-free monthly stipend directly to the employee, a key person disability policy pays benefits to the business. The intent of such a policy is twofold – to offset a loss in productivity (and related profit) but also provide resources should a temporary employee need to be hired as a replacement.

For business owners suffering from a prolonged disability, a buy-out agreement may be a consideration, whereby a disability buy-out insurance policy can be structured to pay lump-sum payment based upon the disabled owner’s value to the business is paid. in the event of a prolonged disability

Taxation of Life Insurance Proceeds

Per the Income Tax Act, death benefits payable to a private corporation (CCPC) from a life insurance policy, segregated fund or variable life annuity (GMWB,) may give rise to a credit in the corporation’s Capital Dividend Account (CDA) equal to the proceeds of the policy less the policy’s Adjusted Cost Base (ACB) representing all premiums paid less all dividends declared. Credits (proceeds) may essentially then pass outside of the corporation and into beneficiaries’ hands without tax consequences – a tax-free capital dividend; ideal for estate planning and legacy goals.

• CDA is referred to as a “notional” tax account and contains tax-free surpluses (the non-taxable portion of gains and other incomes) accumulated by a private corporation.

Taxation of Disability Benefits

While disability insurance premiums are not deductible as a business expense, benefits payable to receiving employees and/or a business in the case of a key person disability plan and/or disability buy-out coverage are generally not taxable, however there are circumstances where proceeds from buyout coverage may generate a taxable capital gain. Considering the nuances and complexity involved, professional tax advice should be sought.

• Noteworthy is that unlike the proceeds of a life insurance policy, the payment of disability benefits to a private corporation does not give rise to a credit the corporations CDA account.

Overhead

For the majority of businesses, the day-to-day costs of running of the business exist whether or the not the owner is then contributing to its success. A business overhead insurance policy can provide a temporary (up to 2 years) monthly stipend to offset continuing business expenses (other the cost of salaries and capital expenditures,) during an owner’s period of disability. Unlike the tax treatment of Life and Disability Insurance premiums, the premiums for Business Overhead Coverage (BOC) may be considered a tax deductible expense, and consequently the monthly benefits are taxable to the corporation; though considering these moneys offset a related deductible expense, the net result is tax-neutral.