455 Avenue Road, Suite 100, Toronto, Ontario, M4V 2J2
Tel: (416) 966-9675 Fax: (416) 966-9677
With proper structuring, corporate-owned life insurance can still be a very cost and tax effective way of funding corporate redemption or promissory note buy-sell arrangements. Insurance can be used to fund the entire share value, or only a portion of it. In this article, CALU Member Gail Grobe, points out that It is important to consider all the implications of a particular strategy including the effective use of the capital dividend account, the insurance costs, the estate's need for cash and the tax impact on the surviving shareholder - and not just the current tax bill to the deceased shareholder.
Table of Contents
In the days before the "stop-loss rules," share redemption with corporate-owned life insurance was the method for funding buy-sell agreements on death. However, when the stop-loss rules were expanded to apply to estates, the advantages of redemption with corporate-owned life insurance seemed to fade away. Then came the 25% solution and the 33-1/3% solution, which at least partially restored the benefits of using corporate-owned life insurance to fund redemption buy-sell arrangements. Now that the capital gains inclusion rate has been reduced to 50% does a life insured redemption strategy still make sense? This article will take the reader step by step through the corporate redemption method of structuring buy-sell arrangements. It will explain how the stop-loss rules have impacted the use of life insurance in these arrangements, illustrate the former 25% solution, and compare this to the results under a regime with a 50% capital gains inclusion rate.
The corporate redemption method of structuring a buy-sell agreement obligates the corporation to repurchase, or redeem, the shares of a deceased shareholder.
The sequence of events for tax purposes is:
The net result of all of this is typically that there is little or no capital gain on the terminal return since the gain is offset by the loss generated in the estate as a result of the redemption. Instead, the estate will report a dividend approximately equal to what the capital gain would have been. The effect of the redemption to the surviving shareholder(s) is that they now own all the shares of the company since the shares that the deceased shareholder owned no longer exist. Note that the characteristics of the remaining shares have not been affected as a result of these transactions - they have the same adjusted cost base and paid up capital as before.
If the financing for the redemption of the deceased shareholder's shares will be provided by corporate-owned life insurance, generally the corporation is designated as the beneficiary under a life insurance policy on each shareholder's life. Often, the corporation will also pay the premiums and be the owner of the policy. When the shareholder dies, the death benefit is paid to the corporation tax-free, and the corporation receives a credit to its capital dividend account equal to the excess of the life insurance proceeds over the corporation's adjusted cost basis (ACB) in the policy. The corporation uses the insurance proceeds to pay the redemption amount to the estate of the deceased shareholder. As noted above, typically the result of the redemption is that the estate is deemed to receive a dividend. Since the corporation has a balance in its capital dividend account (CDA), the corporation can elect the dividend to be a capital dividend to the extent of the CDA available and the estate can receive the dividend tax-free. This seems to be the perfect solution - no gain was realized on the deceased shareholder's return (because the gain was offset by the loss carried back from the estate), and the dividend to the estate is tax-free. In fact, this used to be exactly what happened until the so-called stop-loss rules became applicable to trusts (i.e., estates).
On April 26, 1995, stop-loss provisions were introduced which reduced the benefits of using insurance to fund a share redemption at death. The rules limit the amount of the loss (i.e., stop the loss) that can be carried back from the estate of a deceased taxpayer to the terminal return when a capital dividend has been paid to the estate. Grandfathering provisions were included so that redemption buy-sell arrangements may fall under the old rules if certain conditions were met on April 26, 1995.
The loss that is "stopped" is calculated as
the lesser of
i. the capital dividend received by the estate, and ii.the capital loss minus any taxable dividends received by the estateminus
25% of the lesser of:
1. the deceased's capital gain from the deemed disposition on death, 2. the estate's capital loss.
Consider the following example. Mr. A and Mr. B each own 50% of the shares of Opco. The shares have an adjusted cost base and a paid-up capital of $200,000 ($100,000 for each shareholder). The shareholders have a "corporate share redemption" buy-sell agreement. Mr. A dies and the fair market value of his shares immediately before his death is $1 million. The shares are not grandfathered for purposes of the stop-loss rules. Assume that the combined federal/provincial top marginal tax rate is 46%, which translates into a tax rate of 23% on capital gains (assuming a 50% inclusion rate) and approximately 31% on dividends.
Now lets compare the results under three different circumstances:
A. The share redemption will be done by issuing a promissory note to Mr. A's estate - there is no corporate owned life insurance to fund the redemption. B. Opco owns a life insurance policy on Mr. A for $1 million with NIL ACB. The proceeds are used to fund the redemption, and any resulting deemed dividend is elected to be entirely a capital dividend. C. The "50% Solution": Opco owns a life insurance policy on Mr. A for $1 million with NIL ACB. The proceeds are used to fund the redemption, but only $450,000 of the resulting deemed dividend is elected to be a capital dividend.
Comparison of the results:
Scenario A has the highest tax liability - approximately $175,000 and $140,000 higher than in Scenario B and C respectively. Assuming the corporation does not currently have the cash to fund the redemption (since there is no life insurance), the corporation must issue a promissory note to the estate and pay it out of future cash flow. As a result, the estate must fund the tax liability from other estate assets. However, the corporation has not had to pay the insurance costs associated with the life insurance on its shareholders.
In scenarios B and C, when Mr. A dies Opco receives life insurance proceeds of $1 million and a corresponding credit to its capital dividend account. The proceeds of the life insurance are used to redeem the shares from the estate, so the estate receives the redemption proceeds in cash, which it can use to pay the tax liability. However, during the life of the shareholder, the corporation has paid the insurance costs associated with the life insurance on its shareholders.
In scenario B the full dividend triggered on the redemption is elected to be a capital dividend. This minimizes the tax payable by A's estate, but $450,000 of the CDA is essentially wasted because of the stop loss rules. The corporation only has $100,000 of CDA remaining, and the shareholder is still being taxed on $450,000 of gains.
In scenario C the "50% solution" results in a $450,000 taxable dividend instead of a $450,000 capital gain. In this scenario there is a taxable dividend of $450,000 because only $450,000 of the $900,000 dividend is a capital dividend, and there is no capital gain to Mr. A because none of the loss generated in the estate on the redemption was "stopped." The tax liability is higher than in B by $30,000 (29%), but it preserves an extra $450,000 of CDA to the corporation which the surviving shareholder can use to draw funds out of the corporation on a tax-free basis in the future. The higher tax results from the now significantly higher tax rate on dividends than the tax on capital gains. In choosing the best alternative, the key question is: Would $450,000 of CDA be worth $30,000? The answer to this question must be evaluated on a case-by-case basis. If Mr. B plans to pull money out of the corporation in the fairly near future, the $450,000 of CDA is quite valuable. Based on a dividend tax rate of 31%, arguably the CDA could be worth as much as $139,500 (31% x $450,000). If we look at Mr. A and Mr. B together, then a $30,000 tax cost for a $140,000 tax savings is a pretty good deal. However, if it will be a very long time until Mr. B realizes these tax savings, the time value of money must be factored in, and the tax cost to Mr. A may not be as worthwhile.
Under the "old" rules (i.e., before the reduction in the capital gains inclusion rate and the corresponding change to the stop-loss rules) the results were quite different. Below is a summary of the results under the old rules versus the new rules based on the fact situation outlined in the above example. All of the columns assume that sufficient insurance is purchased to fund the entire redemption (i.e., $1 million). The insured redemption column shows the results if the resulting dividend is treated entirely as a capital dividend. The 50% and 25% solution columns show the results if the dividend is treated only partially as a capital dividend. (For a detailed calculation under the old rules please refer to the Appendix).
As can be seen from the analysis above, the change in the inclusion rate and the anticipated corresponding change to the stop-loss rules results in a lower amount of tax under the 50% solution than was previously possible under the 25% solution. In addition, there is now a fairly significant "cost" to using the 50% solution versus electing capital dividend treatment for the entire amount of the gain under the insured redemption strategy. In this example, it costs $30,000 to preserve an extra $450,000 of CDA. In contrast, under the old rules, there was actually a tax savings to using the 25% solution and preserving $675,000 of CDA. This shift from a tax savings to a tax cost has resulted because of the reduction in the capital gains inclusion rate such that the tax rate on capital gains is now significantly less than the tax rate on dividends in all provinces.
As illustrated in the above example (scenario C), the premise behind the 50% solution is to elect capital dividend treatment for an amount equal to 50% of the gain to the deceased shareholder. If anything greater than this is elected as a capital dividend, that amount of the loss to the estate will not be permitted to be carried back to the return of the deceased shareholder, and a corresponding capital gain will be reported on the terminal return. Thus the 50% solution results in the maximum amount of capital dividend possible without causing the stop loss rules to reduce the estate's loss on redemption.
In the example above, it was assumed that sufficient insurance was purchased to fully fund the redemption of Mr. A's shares. Another variation is to fund only part of the redemption amount with life insurance. For example, assume the life insurance was $450,000 rather than $1 million in Scenario C above. When Mr. A dies, the redemption proceeds are paid with the $450,000 in life insurance proceeds and a promissory note for the remaining $550,000. In this case the tax liability to the estate is still $139,500, and the cash received on the redemption will be sufficient to pay the taxes. The main differences from Scenario C are: 1) there is no remaining CDA credit, and 2) the net cash to the estate is only $310,500 after paying the taxes. However, this alternative minimizes the insurance costs to provide the same tax result as in Scenario C. However, the estate now has a promissory note for $550,000 rather than cash, and the corporation has a liability of $550,000 to the estate which it must fund out of future cash flows. Under the former "25% Solution" when insurance was purchased only to cover the 25% gain, there was even less cash to the estate since this amount of insurance was usually just enough to cover the tax liability.
Another version of the 50% solution is to insure Mr. A for $1 million, but only use $450,000 of the proceeds to redeem the shares from the estate as a tax-free capital dividend. The remaining $550,000 of the redemption amount is satisfied by issuing new shares or a demand note to the estate much like in the previous example. Then the remaining insurance proceeds can be distributed to Mr. B as a tax-free capital dividend that he can use to purchase the newly issued shares or demand note from the estate. The tax result is the same as previously outlined, and Mr. B has additional cost base in Opco (in the form of the newly issued shares) or a demand note he can easily convert into cash at some point in the future. Essentially, this process converts the unused CDA of $550,000 into cost base in the shares or a promissory note for Mr. B.
All of this analysis has focused on comparing various corporate redemption strategies to one another. In general we have seen that corporate owned life insurance reduces the tax liability which arises on death when it is used to fund a corporate redemption buy-sell arrangement. We have also seen that the benefit of using the 50% solution as compared to a 100% capital dividend on redemption is less than it used to be under the 25% solution. The question remains, how does a life insured corporate redemption compare to a promissory note buy-sell arrangement which results in capital gains treatment at death?
In a promissory note buy-sell arrangement, when a shareholder dies, the surviving shareholder(s) is obligated to purchase the shares of a deceased shareholder in exchange for a promissory note issued to the estate of the deceased. If the agreement is funded with life insurance, the corporation must be the beneficiary of a life insurance policy on each shareholder's life. When a shareholder dies, the life insurance proceeds are paid to the corporation tax-free, and the corporation receives a credit to the capital dividend account equal to the excess of the life insurance proceeds over the corporation's adjusted cost basis in the policy. The corporation uses the insurance proceeds to pay a capital dividend to the surviving shareholder(s) to enable them to repay the promissory note to the deceased's estate.
Using the fact situation outlined in the previous example, for tax purposes, when Mr. A dies he would have a deemed disposition of his shares at death at fair market value ($1 million). Mr. A's estate would acquire the shares with a cost base of $1 million, and then would sell them to Mr. B for a $1 million promissory note. The estate would have no gain or loss on the sale since the proceeds and adjusted cost base are equal. The tax owing by Mr. A is simply the tax on the capital gain that results from the deemed disposition at death - $207,000 (calculated as 23% tax on a $900,000 gain). Mr. B now has all the shares of Opco with a total adjusted cost basis of $1.1 million ($100,000 from his shares, and $1 million from the shares he acquired from Mr. A's estate.) If we assume that Opco owns a life insurance policy on the life of Mr. A for $1 million with NIL ACB for the purpose of funding the buy-sell arrangement, then on Mr. A's death Opco would receive insurance proceeds and a CDA credit of $1 million. Next Opco would pay a capital dividend of $1 million to Mr. B using the CDA, and Mr. B would use the insurance proceeds to repay the promissory note owed to Mr. A's estate.
So how does this compare to the life insured corporate redemption method? Looking at it purely from Mr. A's point of view, the insured redemption strategy results in a lower tax burden ($139,500 under the 50% solution vs. $207,000 under a promissory note strategy). However, the factor which must also be considered, is the increase to Mr. B's future tax liability under a redemption strategy because of the lack of step up in the adjusted cost basis of his shares. The following table compares the tax liability to Mr. A and Mr. B on the assumption that Mr. B will sell his shares after Mr. A dies. Note that this analysis assumes that before Mr. B sells his shares he receives a capital dividend from Opco equal to any available CDA generated from the insurance proceeds.
If you consider the total tax liability of both Mr. A and Mr. B, under the new capital gains inclusion rate, there is an overall tax cost to the redemption strategy over the promissory note strategy. The 50% solution costs $36,000 more in total tax than the promissory note method. Before the changes to the capital gains inclusion rate (i.e., under the 25% solution), there was an overall tax savings to the 25% solution redemption strategy over the promissory note method. This is illustrated in the table below:
Although the total tax burden to Mr. A and Mr. B is now higher using the 50% solution, this still may be a preferable structure if Mr. B will not be realizing his capital gain for a long time into the future.
With proper structuring, corporate-owned life insurance can still be a very cost and tax effective way of funding corporate redemption or promissory note buy-sell arrangements. Insurance can be used to fund the entire share value, or only a portion of it. It is important to always consider all the implications of a particular strategy including the effective use of the capital dividend account, the insurance costs, the estate's need for cash and the tax impact on the surviving shareholder - and not just the current tax bill to the deceased shareholder.
Example under the 'old' rules (75%capital gains rate, 25%solution)Consider the same fact situation as outlined above except that the capital gains inclusion rate is 75% and the stop-loss rules refer to 25% rather than 50%. Scenario 'C' illustrates the 25% solution where the insurance proceeds are used to fund the redemption, but only $225,000 of the resulting deemed dividend is elected to be a capital dividend. Assume that the combined federal/provincial top marginal tax rate is 46% which translates into a tax rate of 35% on capital gains and approximately 31% on dividends.