Mortality and Tax: The Ultimate Hand-Off

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All references to a spouse include common-law partners. All references to the ‘Act’ mean the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. All references to the ‘Regulations’ mean the Income Tax Regulations. The following should not be construed as legal nor tax advice. Consultation with your usual tax/legal professional is advised. Please contact us to discuss the contents of the article herein.

Good morning Toronto! When a shareholder or key executive passes away, their death can trigger significant tax liabilities and potentially disrupt the continuity of the business. Life insurance provides a way to fund these obligations, ensuring that the business can continue to operate smoothly while also protecting the financial interests of the family and other stakeholders. In today's article, we will discuss the role of life insurance in estate planning for the owner-manager.

On the death of the shareholder, there is a deemed disposition of the shares of their corporation, which can trigger significant tax liability through capital gains. However, if there is a surviving spouse, the shares can rollover to the spouse on a tax-deferred basis under subsection 70(6) of the Act. After the surviving spouse passes away, any capital gains taxes will be fully due and payable if no further estate planning was done. Commonly, permanent life insurance is used to fund final taxes due without forcing the sale of personal/corporate assets.

In sole proprietorships, the business and the owner are not considered separate legal entities. Hence, when the owner dies, the sole proprietorship is also legally considered to be dissolved, with all of the business assets/liabilities forming part of the owner's estate. In partnerships, in the absence of continuity provisions in the partnership agreement, the partnership may also dissolve.

In contrast, corporations are separate legal entities which survive the death of shareholders. However, the death of an employee-shareholder in a corporation in which they are significantly involved tends to create a significant loss of value in the deceased's share. In these businesses, shareholders are often also active managers or employees. Thus, the corporation loses its expertise and ability to generate revenue. Secondly, shares of a privately held company are fairly illiquid. If the business is unable to generate revenue or find a buyer, the shares have little tangible value for the deceased's estate.

For corporations and some partnerships, there are commonly shareholder/partnership agreements that contain provisions for shareholders to purchase the shares of other shareholders in a buy-sell agreement in the event of a specified event – usually death, but could also be retirement or permanent mental/physical incapacitation. The goal of these agreements is to ensure business continuity while protecting both the interests of the company and the departing shareholder. These agreements are almost always funded by life insurance.

In a cross-purchase agreement, the remaining shareholders are each obligated to purchase the shares of the other shareholder after a specified event occurs. Likewise, the other shareholder (or their estate) is also obligated to sell the shares. With this arrangement, each shareholder personally owns a life insurance policy on the lives of the other shareholders, naming themselves as the beneficiary. If a shareholder dies, the proceeds of the policy are used to fund the purchase of the shares.

A cross-purchase agreement is very simple in principle, but becomes increasingly complex as the number of shareholders increases. Furthermore, personally owned insurance is paid out of post-tax income, which is costlier than if the business owned the policies. For example, if there were 5 equal shareholders of a company, it would become economically unfeasible for each shareholder to take out 4 separate policies. Also, if the shareholders all drastically differ in age, health, and ownership stake, these factors each vary the cost of insurance. For these reasons, a cross-purchase agreement is generally suited for small groups of shareholders that are similar in life stage and share ownership.

Generally, it tends to be more common and efficient for the corporation to own insurance on its shareholders. One such arrangement is a promissory note arrangement, where the corporation owns insurance policies on the life of its shareholders, with the corporation as the beneficiary. When a shareholder dies, the proceeds of the policy, less the Adjusted Cost Basis (ACB) of the policy, are placed in the Corporation’s Capital Dividend Account (CDA).

The CDA is a notional account that tracks the amount of capital dividends that the corporation can distribute to its shareholders. All capital dividends are distributed and received on a tax-free basis. This will allow a tax-free buyout of the shareholder's interest.

The ACB represents the ‘cost’ of the life insurance policy and is used in both calculating policy gains (if the policy were sold or transferred) and to calculate the amount that can be placed into the CDA (see above). While the definition of ACB is contained in §148(9) of the Act, it is a complex calculation that varies based on when the policy was acquired, dividends paid, and withdrawals. In general, ACB is increased by premiums paid, and annually decreased by the Net Cost of Pure Insurance (NCPI). As life insurance also tends to incorporate a ‘savings’ component, NPCI is a way to approximate the actual annual cost of providing the death benefit coverage in a given life insurance, separated from the savings/investment components. As age increase, the NCPI also increases. At a certain point in time, the NCPI will exceed the premiums paid, slowly eroding the cumulative ACB. ACB can never become negative.

From a tax planning perspective, as the life insured gets older, it is more preferable for the corporation, as the erosion of ACB allows for a greater portion of the eventual insurance payout to be distributed as a tax-free capital dividend. However, consequently, if the policy were to be transferred, surrendered, or sold, it would result in higher capital gains tax. The inverse is true for younger shareholders - a disposition of the policy would trigger less tax liability, but in the event of death, less of the proceeds may be placed into the CDA.

However, the balance in the CDA belongs to all shareholders in proportion to their ownership. If the corporation were to pay out the CDA dividend, the proceeds would go to living shareholders as well as the deceased's estate. As the goal of insurance is to help the survivor(s) finance the buyout, it is not preferable for the estate to receive the proceeds before the buyout can be completed.

Hence, to bypass this issue, the surviving shareholder(s) buy the shares from the estate using a promissory note (a promise to pay funds) equal to the purchase price. At this point, the estate is no longer a shareholder. Then, when the insurance proceeds are paid out and placed into the CDA, a capital dividend is paid out to the surviving shareholders, who use the funds to pay back the promissory note. If the insurance proceeds do not fully cover the note, the remainder is typically repaid over 3-5 years, with interest.

Separate from the above, a corporation can also use life insurance proceeds to fund a share redemption agreement. Unlike a promissory note arrangement, the corporation is acting to buy back shares (redemption) from the deceased's estate. However, this triggers a deemed dividend, which is attributed to the shareholder's estate. Under §83(2) of the Act, the corporation may be able to elect to pay part of the redemption from the CDA, which would be subsequently received tax free by the estate.

It is also possible for a share buyback to be executed in the event of a shareholder's permanent mental or physical incapacitation - it would advantageous for the shareholder's agreements to consider these possibilities. Usually, disability insurance is used to fund the buyout. However, unlike life insurance, disability insurance proceeds do not benefit from the same tax advantages, such as the CDA treatment.

As a whole, insurance is a powerful tool for business succession and estate planning. By understanding the tax implications and structuring options of corporate-owned and personally-owned policies, the owner-manager can be sure that the business remains protected, heirs are treated fairly, and liquidity is available when it’s needed most.

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