Buy-Sell Agreements - An Overview of Funding with Life Insurance

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					Buy/Sell Agreements – An Overview of Funding with
Life Insurance
Introduction
For individuals, no estate plan is complete without a will. Similarly, no business plan is
complete without a shareholder's agreement. A shareholder’s agreement sets out the rights
and obligations of the both the shareholder(s) and the corporation. It is a contract that
relates specifically to the relationship between some or all the shareholders and the
corporation. A shareholder’s agreement is a way to capture the intention of the shareholders
as to the nature of their relationship to one another and to the corporation. A well drafted
shareholder’s agreement can address a variety of topics and in doing so will prevent potential
misunderstandings or issues between the shareholders. An important component of a good
shareholder’s agreement is buy/sell provisions which allow 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 the shareholder’s 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. The purpose of this Tax Topic is to
describe the basic methods of buying out a shareholder at death and to outline 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.




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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 shareholder’s
agreement provides that some of the deceased’s shares will be purchased by the
corporation, and some of the deceased’s shares will be purchased by the surviving
shareholders. 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
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 would be paid to the surviving shareholders and they would each use the
proceeds to purchase the deceased’s shares. In this fact situation A would be 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 would be 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 shareholder C died, 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 shareholder’s 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 from the survivors to the deceased’s
estate). The corporation is the owner and beneficiary of a life insurance policy on the life of
each shareholder. After the shares have been purchased, 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 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 “Capital
Dividend Account” Tax Topic). Then 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


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would each own $750,000 worth of shares representing 50% of Opco. After the shares
have been purchased, Opco would pay out a $500,000 capital dividend: $250,000 to A
and $250,000 to B. The capital dividend would be non-taxable to A and B. They would then
use the dividend proceeds to repay the promissory notes.

Corporate Redemption Method
In this arrangement the agreement obligates the corporation to repurchase, or redeem, the
shares of a deceased shareholder at the value as specified or calculated pursuant to the
shareholder’s agreement. The corporation is the owner and beneficiary of a life insurance
policy on the life each shareholder. If one of the shareholders died, then the life insurance
proceeds would be paid to the corporation, and it would use the proceeds to redeem the
deceased’s shares.

In this fact situation Opco would be the owner and beneficiary of three $500,000 policies:
one 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 “Capital Dividend Account” Tax Topic). Then 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, then 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”,
         “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 insurance to be owned corporately or
personally. The following sections discuss issues to be considered with respect to corporate
owned vs. personally owned insurance.

Tax Leverage
The premiums payable on a life insurance contract are generally not deductible for income
tax purposes. Therefore, it may be advantageous to have insurance owned at the
corporate level in order to have the corporation pay the premiums. Where the corporation
is in a lower tax bracket than the individual shareholders a tax saving may be generated
and 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 be certain 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



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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 “Buy/sell Agreements -
Criss-Cross Purchase Method” Tax Topic.)

On the other hand, if the policies are owned by the corporation, each shareholder has
access to the corporate records to ensure that the policies are being kept in force. On the
death of the shareholder, his 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 would be reduced to one policy on the life of each shareholder where
corporate-owned insurance is used. This could also lead to 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 “Buy/sell Agreements - Criss-Cross
Purchase Method” Tax Topic.)

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.

A policy that is owned by a corporation should not be connected or form part of the estate
for the purposes of making a claim against the policy for child support. The Ontario Case
of Goodis (Litigation guardian of) v. Goodis Estate, (2003) O.J. No. 3564 confirmed this
premise.




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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.

Tax Complexity
The provisions of the 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, since they can more easily understand the tax consequences of this type
of funding arrangement.

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 which cover each method of buy/sell
arrangements.

Creditor Protection
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 which would
attempt to seize the insurance proceeds or place 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.

Conclusion
This article has outlined the different methods of structuring the transfer of shares at the
death of a shareholder and some of the factors to be considered in deciding whether to use
corporate-owned or personally-owned life insurance to fund buy/sell arrangements. In
each case, it will be 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.




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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.


Last updated: November 2007



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