Buy-Sell Insurance: Death Funding

Executive Summary

When a business partner dies, their shares need to be transferred. A buy-sell agreement defines how this happens, but it needs funding. In Canada, life insurance is the most common way to fund buy-sell agreements. Here's what matters:

• The problem: Without funding, surviving partners may not have cash to buy out the deceased partner's shares, and the deceased partner's family may not receive fair value
• The solution: Life insurance provides guaranteed liquidity exactly when it's needed:at death
• The tax benefit: Corporate-owned life insurance creates a credit to the Capital Dividend Account (CDA), allowing tax-free distribution to shareholders
• The methods: Three main structures exist:corporate redemption, criss-cross purchase, and promissory note methods:each with different tax implications
• The coordination: This requires coordination between your lawyer, CPA, and insurance advisor to ensure the agreement, insurance, and tax structure align

This article explains how life insurance funds buy-sell agreements on death and what to consider when structuring the funding.

Mindset: Protecting Business Continuity and Family Interests

Before diving into the technical details, let's think about buy-sell funding from a long-term perspective.

When a partner dies, two things need to happen:

1. The business needs to continue under the surviving partners' control
2. The deceased partner's family needs fair value for their shares

Without a funded buy-sell agreement, both can fail. The surviving partners may not have cash to buy the shares. The family may be stuck with shares they can't sell or operate. The business may face uncertainty that affects operations, employees, and clients.

Life insurance solves this by providing cash exactly when it's needed:at death. The insurance proceeds fund the share purchase, ensuring:

• The surviving partners gain control without taking on debt
• The family receives fair value in cash
• The business continues without disruption

This is about protecting what you've built over decades, not just managing a transaction.

Mechanics: How Life Insurance Funds Buy-Sell Agreements

A buy-sell agreement defines what happens when a partner dies. It specifies:

• Who buys the shares (surviving partners or the corporation)
• How the price is determined (fixed value, formula, or valuation)
• How payment is made (cash, promissory note, or other terms)

Life insurance provides the cash to make this happen. Here's how it works:

The Basic Structure

1. Insurance is purchased on each partner's life, with a death benefit equal to their share value
2. The policy is owned by either the corporation or the surviving partners (depending on the method)
3. Premiums are paid regularly to keep the policies in force
4. When a partner dies, the insurance pays out
5. The proceeds fund the purchase of the deceased partner's shares

The Capital Dividend Account Benefit

When a corporation owns life insurance and receives death benefits, something important happens:

• The insurance proceeds are received tax-free by the corporation
• The proceeds (minus the policy's adjusted cost basis) create a credit to the Capital Dividend Account (CDA)
• The corporation can pay capital dividends from the CDA, which are received tax-free by shareholders

This tax-free flow makes corporate-owned life insurance particularly efficient for funding buy-sell agreements.

Funding Methods: Three Ways to Structure Buy-Sell Funding

There are three main methods for structuring buy-sell funding with life insurance. Each has different tax implications and works better in different situations.

Method 1: Corporate Redemption

How it works:

• The corporation owns life insurance on each partner
• When a partner dies, the corporation receives the insurance proceeds
• The corporation uses the proceeds to redeem (buy back) the deceased partner's shares
• The proceeds credit the CDA, allowing tax-free capital dividend distribution

Tax treatment:

• The deceased partner's estate receives a dividend (or capital dividend if elected)
• If paid as a capital dividend from the CDA, it's tax-free to the estate
• The surviving partners' adjusted cost base of their shares increases

When it works well:

• When you want simplicity:one policy per partner owned by the corporation
• When the corporation has sufficient CDA to pay tax-free capital dividends
• When shares are grandfathered under stop-loss rules (pre-April 26, 1995)

Considerations:

• The redemption creates dividend treatment (not capital gains) for the deceased partner's estate
• This may affect the ability to claim the capital gains exemption
• Corporate creditors may have claims on the insurance proceeds

Method 2: Criss-Cross Purchase

How it works:

• Each partner owns life insurance on every other partner
• When a partner dies, the surviving partners receive the insurance proceeds directly
• The surviving partners use the proceeds to purchase the deceased partner's shares from their estate

Tax treatment:

• The deceased partner's estate receives capital gains treatment on the sale
• This allows the estate to claim the capital gains exemption if available
• The surviving partners' adjusted cost base increases based on what they paid

When it works well:

• When you want capital gains treatment for the deceased partner's estate
• When there are only two partners (simpler policy ownership)
• When you want to avoid corporate creditor issues

Considerations:

• With more than two partners, policy ownership becomes complex (each partner needs policies on all others)
• Premium costs may be uneven if partners have different ages or health
• A trust can simplify this for multiple partners

Method 3: Promissory Note Method

How it works:

• The corporation owns life insurance on each partner
• When a partner dies, the surviving partners purchase the shares using a promissory note
• The corporation receives the insurance proceeds and pays a capital dividend to the surviving partners
• The surviving partners use the dividend proceeds to repay the promissory note

Tax treatment:

• The deceased partner's estate receives capital gains treatment (from the sale to surviving partners)
• The surviving partners receive tax-free capital dividends from the CDA
• The capital dividend is used to repay the promissory note

When it works well:

• When you want capital gains treatment for the deceased partner's estate
• When you want corporate-owned insurance (simpler administration)
• When you want to combine benefits of both methods

Considerations:

• More complex than corporate redemption
• Requires coordination between the promissory note, share purchase, and dividend payment
• The timing of transactions matters for tax purposes

Corporate-Owned vs. Personally-Owned Insurance

One key decision is whether the corporation or the partners should own the insurance. Here are the main considerations:

Corporate-Owned Insurance

Advantages:

• Premiums are paid with corporate dollars (often at lower tax rates)
• Simpler administration:one policy per partner
• Easier to monitor premium payments
• Cost is shared proportionally among partners

Considerations:

• Insurance proceeds may be subject to corporate creditors
• More complex tax rules apply
• In Ontario, Family Law Act considerations may apply

Personally-Owned Insurance

Advantages:

• Simpler tax treatment
• Proceeds may be protected from corporate creditors (if no personal guarantees)
• In Ontario, life insurance proceeds are excluded from net family property

Considerations:

• Premiums are paid with after-tax personal dollars
• Uneven premium burden if partners have different ages or health
• Harder to ensure all partners maintain coverage

Holding Company Structure

Many partnerships use holding companies to own the operating company shares. In this structure:

• The holding companies can own the insurance
• This may protect proceeds from operating company creditors
• Premiums can be funded with tax-free intercorporate dividends

This adds complexity but may provide creditor protection and tax benefits.

How to Apply: Steps for Structuring Buy-Sell Funding

If you're considering buy-sell funding with life insurance, here's how to approach it:

Step 1: Establish the Buy-Sell Agreement

Work with your lawyer to create or update your shareholders' agreement. The agreement should:

• Define triggering events (death, disability, retirement, etc.)
• Specify how shares are valued
• Define who buys the shares and how payment is made
• Include insurance provisions

Step 2: Determine the Funding Method

Work with your CPA and insurance advisor to choose the right method:

• Consider your corporate structure (individual shareholders vs. holding companies)
• Consider tax implications (capital gains vs. dividend treatment)
• Consider creditor protection needs
• Consider administrative simplicity

Step 3: Value the Business

Determine fair market value for buy-sell purposes:

• Use a formula (e.g., book value, multiple of earnings)
• Use annual valuations
• Use an independent business valuator
• The insurance coverage should match this value

Step 4: Structure the Insurance

Work with your insurance advisor to:

• Determine coverage amounts for each partner
• Choose policy ownership (corporate vs. personal)
• Set up premium payment mechanisms
• Include provisions for future value increases

Step 5: Coordinate with Your Professional Team

Ensure your lawyer, CPA, and insurance advisor coordinate:

• The agreement matches the insurance structure
• Tax elections are made correctly
• Premium payments are monitored
• The structure is reviewed regularly

Worked Example: Corporate Redemption Method

Let's say three partners (A, B, and C) each own one-third of a corporation worth $1.5 million. Each partner's shares are worth $500,000.

Setup:

• The corporation owns three $500,000 life insurance policies (one on each partner)
• The buy-sell agreement requires the corporation to redeem shares on death
• Premiums are paid by the corporation

When Partner C dies:

1. The corporation receives $500,000 in life insurance proceeds
2. Assuming the policy's adjusted cost basis is nil, the corporation receives a $500,000 credit to the CDA
3. The corporation redeems Partner C's shares for $500,000
4. The corporation elects to pay this as a capital dividend from the CDA
5. Partner C's estate receives $500,000 tax-free
6. Partners A and B now each own 50% of the corporation

Result:

• Partner C's family receives $500,000 tax-free
• Partners A and B gain control without taking on debt
• The business continues without disruption

Decision Checklist

This approach might be right for your partnership if:

• [ ] You have business partners (two or more owners)
• [ ] There's no buy-sell agreement, or the existing agreement lacks funding
• [ ] One partner's death would create uncertainty about share transfer
• [ ] The business has significant value that needs protection
• [ ] You want to ensure fair value transfer to families while protecting business operations
• [ ] You want guaranteed liquidity (insurance) rather than relying on business cash flow or borrowing

If several of these apply, consider discussing your situation with your lawyer, CPA, and insurance advisor to explore whether a funded buy-sell agreement makes sense for your partnership.

Important Notes

This is educational information. Buy-sell agreements are legal documents that should be prepared by lawyers familiar with business law and partnership structures. Insurance funding requires coordination with insurance advisors, and tax implications should be reviewed with your CPA. Always consult with your professional team.

Every situation is unique. Funding methods, insurance structures, and agreement terms depend on many factors including business type, corporate structure, partner relationships, and legal considerations. What works in one case may not be appropriate for your circumstances.

Insurance is offered through iAssure Inc. Insurance products and related services are provided through iAssure Inc., an independent firm in the insurance of persons and in the group insurance of persons. These activities are neither the business nor the responsibility of WhiteHaven Securities Inc.

Next Steps

If this approach resonates with your situation:

• Assess your current situation: Do you have a buy-sell agreement? Is it funded? When was it last reviewed?
• Understand your business value: Work with your CPA and potentially a business valuator to understand how your business might be valued
• Coordinate with your team: Discuss buy-sell agreements with your lawyer, CPA, and insurance advisor to ensure all aspects align
• Consider funding options: Explore how life insurance might fund your buy-sell agreement and provide guaranteed liquidity

If you'd like to discuss your specific situation, request a structure review to see if there's a fit.