In the previous article (published Aug 15, 2022) we covered the importance of getting to know your business owner prospects desires, concerns and needs by asking the right questions. In this article will take a deeper dive into the most common insurance opportunities that are present in the development/growth phase of those businesses: Business Loan Protection (Collateral Insurance), Key Person Funding, and Buy Sell Funding.
Business Loan Protection (Collateral Insurance):
Most businesses require financing to expand business operations. In most small business situations, adequate financing is difficult to obtain unless the business owner is willing to personally guarantee the loan. The premature death of a business owner or a key executive may cause creditors to demand immediate repayment of any outstanding loans. This event may cause undue pressure on the business and force it to liquidate (fire sale at depressed prices) essential assets to raise funds. Assuming the owner had personally guaranteed the debt, this may also put added pressure on their estate to repay the loan. Obviously, the timing could not be worse; since it comes at a time when the business results are already under pressure because of the death. Without proper planning, the survival of the business may be a stake.
A solution would be to purchase life insurance on the key individual(s). Proceeds from the life insurance are paid to the corporation tax free and can be used to pay down any or all outstanding debts. In some scenarios, a creditor (i.e. bank) may require the purchase of collateral insurance to protect their interest. This is especially true in small business situations when the value of the business would be severely impaired due to the death of the key individual. In other cases, the business owner may simply want to purchase insurance to minimize the financial risk to their heirs and to permit the continuation of their business free of debt.
Generally, life insurance premiums paid by a corporation are not tax deductible. However, in cases where a restricted lending institutions (i.e. bank, credit union) requires the loan to be insured as part of loan agreement and subsequently requires the policy to be collaterally assigned to them, a portion of the premium may be deductible. Also, the receipt of life insurance proceeds by a private corporation will result in a credit to the corporations capital dividend account.
Collateral life insurance can play a pivotal role in business continuation and estate preservation.
Key Person Funding (Insurance):
Business owners and key executives spend considerable time and effort in acquiring knowledge, experience, judgement, reputation, relationships, and skills that make them valuable to the business. The death of that individual can have a severe financial impact on the success of the business going forward. During that time, creditors may hold back new loans, or worst yet demand repayment of existing loans, debtors may delay payments, and employees and customers may lose confidence.
Although larger companies can withstand the blow by sheer size and numbers, most small business have a tough time coping. It is often necessary for them to look outside of the business to find a replacement, causing delays, disruptions, and reduced efficiency. During this time, profits are affected, further weakening the company. In the absence of proper planning the very survival of the business is a stake.
A solution is for the business to purchase life insurance on the life of the key person. In case of death, the proceeds provide the business with much needed working capital to meet the immediate cash needs and to supply a source of funds for finding, attracting, hiring, and training a replacement for the key person. In addition, these proceeds may serve to temporarily replace loss profits as result of the death, until the business is able to recover.
Life insurance premiums paid by the business for key person protection are not deductible for tax purposes. However, life insurance proceeds received by a private corporation creates a credit to the corporations capital dividend account for any amounts above the policies adjusted cost basis. This credit provides surviving shareholder(s) the opportunity to extract funds from the corporation tax free.
The business interest often accounts for a substantial portion of the wealth the business owner has accumulated. Implementing a plan for the eventual transfer of the business interest will help the business owner realize full value for the business interest and will also help the business, and the surviving (remaining) owners weather the transition. This is particularly true in case of a premature death of one of the business owners.
A shareholder agreement is a key part of the business succession plan. It lays out the terms and conditions for the transfer of share ownership after a retirement, disability, bankruptcy, marital breakdown, shareholder disputes and DEATH. Under the agreement, one or more of the parties agree to purchase the shares of another shareholder at a fixed price, or a price that follows a specified formula if certain events take place.
An integral part of the shareholder agreement is to ensure that funding is in place in case of death to finance the purchase and the sale of the business interest. Life insurance is generally, an efficient means of funding the obligation that occurs on death. Although, there are numerous ways to structure a buy out on death, it should be kept 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 each individual circumstance.
In the corporate context, an important threshold consideration is whether to fund the buy/sell arrangement with corporate owned or personally owned life insurance. The ‘criss-cross’ method is generally owned personally, unless entered in my corporate (holdco) shareholders. The ‘promissory note’, the ‘shareholder redemption’ and the ‘hybrid method’ are funded with corporately owned life insurance. Each structure has differing advantages from a tax perspective and depending on the facts, one structure may be more favourable than the other. The analysis of these differences is beyond the scope of this article.
The advantage of using life insurance to fund this obligation are as follows:
Funds are available to purchase the shares
The estate or heirs are not dependent on the surviving shareholders or financial success of the business for their future income or payment of the shares purchase price
Shareholders aren’t forced to sell viable business assets or take out loans (assuming they even qualify)
Life insurance is often the most cost-effective option available in comparison to a sinking fund, taking out a loan, or selling assets.
As we just explored, there are many instances whereby life insurance can play a pivotal role in the development and growth phase of a business cycle. In the next article, I’ll move through the business cycle and uncover the insurance opportunities that are prevalent in the growth/mature phase. Here, I’ll focus on strategies that generate some of largest premium sales in our industry: Estate Preservation (Capital Gains Funding), Estate Maximization (Corporate Estate Bond), Retirement Funding (Corporate Insured Retirement Program) and Immediate Financing Arrangement (IFA). It’s here that we find the transition from “needing” to “wanting” insurance begins to take hold.
Tony Gallippi, B.A.S (Hons.) CFP CLU
Advanced Case Consultant
This communication reflects the views of Qualified Financial Services Inc. as of the date published. The information in this publication is for general information purposes only and is not to be construed as providing individual legal, tax, financial or other professional advice. Qualified Financial Services Inc. assumes no responsibility for any errors or omissions in the information contained herein nor for any reliance placed on such information. Please seek independent professional advice before making any decisions.