Most business owners build wealth in their corporations and look to pass it to their successors. Succession planning is more volatile than estate planning, as finding the right successor is a challenge. Even if you train your legal heir for succession, they may not want to do the business. Having a Plan B always helps. If there are no legal heirs, management or employees can buy your stake from legal heirs and continue the business. This will ensure the business is in capable hands and give your loved ones financial support after you are gone. No matter how perfect this whole setup may seem, it has its gaps.
The Role of Life Insurance in Estate and Succession Planning
Succession needs long-term planning and is vulnerable to sudden death or incapacitation of the founder. Such an event could leave the business and the estate exposed to heavy taxation and continuity gaps if the business is still dependent on the founder. Transfer of assets to beneficiaries is considered a deemed disposition at fair market value and triggers a capital gains tax in Canada.
Business assets are mostly illiquid or operationally critical, and after the death of the business owner, they might temporarily lose value. Beneficiaries may not have sufficient liquidity to pay tax on the appreciated value of the business. Add to this the limited time to pay tax, and the estate would be forced to sell business assets at a discounted value. At such times, life insurance provides the necessary liquidity and ensures succession goes as planned, preserving the value and integrity of the business.
Life insurance, especially the one owned by the corporation, can be used in multiple ways in estate and succession planning:
- Fund share redemptions under shareholder agreements
- Support ownership transitions
- Provide value to non-business beneficiaries without fragmenting ownership or disrupting operations.
Four Ways Corporate-Owned Life Insurance Can Support Succession Planning
1. Funding Share Redemptions under Shareholder Agreements
Many companies have a mandatory buy/sell clause in the shareholder agreement to protect business ownership. This clause forces the legal heir of the shareholder to sell the shares to the business or other shareholders upon the major shareholder’s death. The value of the founder’s share is significant, and the business may not have that much liquidity to fund the buyout.
The company can take out the owner’s life insurance policy and, upon their death, use the tax-free insurance proceeds to buy back the deceased’s shares from the heirs. Any amount left from the insurance proceeds goes into the Capital Dividend Account (CDA) and can be distributed to shareholders tax-free.
This strategy needs proper planning and execution, which may require professional guidance, as a small glitch can expose the shares to capital gain.
2. Preserving Business Value During Ownership Transition
Corporate-owned life insurance can also be used to provide working capital on the sudden death or disability of the owner. The insurance proceeds can give the business the necessary liquidity during the ownership transition as the successor gets a hang of the business and rebuilds confidence among stakeholders that they can fill the owner’s shoes.
3. Provide Value to Non-Business Beneficiaries
When business owners’ maximum assets are tied to the business, equal distribution of assets becomes difficult. Beneficiaries actively involved in the business can get the ownership interests. As for beneficiaries not actively involved in the business, life insurance proceeds can be used to buy out their share. They get a fair distribution of the estate, and the business is protected from sharing ownership with unqualified shareholders.
4. Supporting Succession Agreements
If the business owner doesn’t have a legal heir to succeed the business or is unsure, they can even pass it on to employees. In this arrangement, interested employees can buy life and disability insurance on the owner. In the event of the death or disability of the owner, employees can use the insurance proceeds to purchase the business from the owner.
Contact MW&CO in Woodstock to Help You with Succession Planning
Talk to a professional accountant to help you make the optimum use of life insurance and other such estate and succession planning tools that can preserve the value of your business and facilitate succession as planned. At MW&CO, our accountants and tax advisors can provide services such as estate and succession planning. To learn more about how MW&CO can provide you with the best accounting and succession planning services, contact us online or by telephone at 519-539-6109 or toll-free at 1-877-539-6109.