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Many business owners find themselves in a position where they have identified one or more employees or family members to take over the business when they retire. Unfortunately, these potential successors may have difficulty obtaining the funds required to effect a buy out. CALU thanks author Virginia Mawer, CA, CLU, TEP, for providing the following response to the question: "Is there a way for business owners to plan for their retirement and business succession by creating a source of funding for a living buyout?"
Paul McKay, CAE
Table of Contents
One method commonly used for living buyouts involves bank financing for the purchaser. The arm´s-length purchaser incorporates a holding company, which borrows the funds to purchase shares. Following the purchase of the shares, the two companies are amalgamated, allowing the interest expense to be offset against taxable income of the amalgamated company. The benefits of this strategy include the fact that the vendor receives capital gains treatment and may be able to claim the $500,000 capital gains exemption for qualifying small business shares. However, the purchaser seldom has the collateral and the assets to satisfy the bank's requirements. In fact, it may not be possible to obtain bank financing when the current owner is retiring. The bank may not be willing to depend on the continued success of the company to support interest and principal payments.
The vendor, having more confidence in the ability of his successors than the bank, may be willing to take a promissory note for the purchase price. The advantages of capital gains treatment are maintained and the company's assets can be used to secure the promissory note. Because many business owners have a significant portion of their assets invested in their business, they depend on the sale proceeds for retirement income so the level of risk assumed with this option may not be acceptable.
Another strategy involves an estate freeze of the current value of the shares by exchanging them for fixed-value preference shares with new owners subscribing for new common shares with nominal value. During retirement, the preferred freeze shares can be redeemed to provide income to the vendor. In the current tax environment, this is generally not as efficient as the alternatives. The redemption of shares results in deemed dividends to the vendor to the extent that the proceeds exceed the paid-up capital of the shares. The vendor does not have access to the capital gains exemption and may pay taxes on the deemed dividends at a rate that is much higher than the current rate that applies to capital gains. This strategy also depends heavily on the continued success of the company to provide the funds required to redeem the shares. Unfortunately, the preferred shares cannot be secured so there is no guarantee that the preferred shares will be redeemed according to the plan and the vendor will have no recourse if they are not.
Because life insurance is a natural solution for funding a buyout at death and also has an investment component with tax-deferred growth, it would make sense to consider whether the living buyout solution could involve life insurance. Accumulated cash values in a corporate-owned policy could be accessed at the time of retirement directly by way of withdrawal or by using them as collateral for a loan to redeem shares or fund an employee purchase. However, there are a number of obstacles with this method. If the vendor wants to utilize the $500,000 capital gains exemption, accumulating non-active assets (e.g., life insurance cash values) within the corporation may disqualify the shares. In addition, the company would have to pay bonuses to the employee-purchaser from the policy withdrawals or loan proceeds, which would be taxed at marginal personal rates leaving only the after-tax bonus amount available to purchase the shares. Finally, it may not be possible to justify the amount of insurance required to support the level of funds required or there may not be enough time to accumulate the funds before the retirement of the vendor. What we really need is a way for the life insurance values to accumulate outside of the company in a way that the employee-purchaser could use the funds as collateral for a future purchase.
It's possible that a Leveraged Retirement Compensation Arrangement (RCA) may be the solution we are looking for. In order to describe how this might work, let's look at a typical situation. The owner of the company (Opco) is currently 52 years old, wants to retire in 10 years and has identified a 38-year-old employee to whom he or she would like to sell the business at that time. The current value of the business is $2,000,000 and the employee is already an important part of the operation. Consequently, Opco requires key-person life insurance coverage on both the owner and the employee, and the owner is looking for ways to provide an incentive to the employee to keep him or her from leaving the company.
An RCA is set up to provide benefits to the both the owner and the employee at each of their retirements. Life insurance is then acquired on a shared-ownership basis. The RCA invests in the investment component of a universal life insurance policy with Opco owning the death benefits to cover its key person needs of $2,000,000 on the owner's life and $1,200,000 on the employee's life. Opco pays $30,000 a year for this coverage and also contributes $190,000 a year for 10 years to the RCA. One half of the contributions to the RCA ($95,000 per year) is paid to the Refundable Tax Account and the other half is deposited to the life insurance policy. At an assumed growth rate of 6% per annum, the cash value of the life insurance grows to approximately $1,350,000 and the balance in the RTA is $950,000 at the end of the 10-year funding period.
When the owner retires at age 62, the employee incorporates a company (Finance) to purchase the shares of Opco from the owner. The RCA trust negotiates a $2,000,000 bank loan, providing its assets as security and loaning the borrowed funds to Finance to fund Finance's purchase of the shares of Opco. Finance and Opco are then amalgamated to form Amalco. While the loan is outstanding, the RCA would not be able to pay retirement benefits that would impair the assets held as security. However, as the loan is repaid and the life insurance values continue to grow, the bank may allow retirement benefits to be paid from the excess assets. In our example, we assumed an 8% loan interest rate and repayment of the loan over 12 years in equal annual payments with the vendor receiving a pension during that time. Once the loan is completely repaid, the RCA could continue to make retirement payments to the vendor and eventually fund the retirement of the new owner. Amalco would have the option of continuing to pay the annual premium for the key person life insurance on each of the vendor and the employee-purchaser. As in any strategy, the effectiveness will depend on the specific circumstances, but it does appear that this strategy may have potential in some living buyout situations.
How does this strategy measure up against the alternatives? From a tax perspective, the clients would want to ensure that the contributions to the RCA are reasonable to fund the retirement benefits and that the RCA status would not be jeopardized by the provision of a loan to Finance in the future. It would also be important to be comfortable with the RCA as an independent strategy in case the future buyout does not materialize for some reason. The RCA assets used to secure the funding for the buyout would be outside of Opco and would not impact the eligibility of the shares for the Capital Gains Exemption. Since the shares will be sold to Finance (not redeemed), the owner will be taxed on capital gains and may be able to claim the exemption. Under current rules, interest on the loan from the RCA trust should be deductible as the proceeds are used to purchase the shares of Opco. Note, however, that there would be no deduction for the net cost of pure insurance because the loan to Finance is from the RCA trust, not a registered financial institution. Finally, loan interest and principal payments will be made by Amalco which is a tax-efficient method to the extent that the corporate tax rate is lower than the personal tax rate of the employee.
There are also a number of financial issues that should be addressed. The illustrated rates for growth inside the insurance policy and the bank loan interest would not be guaranteed or linked in any way. Additional funding of the RCA may be required to provide the promised retirement benefits if the rate of growth inside the insurance policy is lower than projected. The company must have sufficient cash flow to make the contributions to the RCA as well as to make interest and capital payments on the loan. There is no guarantee that a bank will loan funds to the RCA at the point in time that the owner wishes to sell his shares or that the bank loan rate will be acceptable to the employee-purchaser. This is a complex strategy and it is extremely important that clients understand the strategy and the financial risks involved before proceeding with such a plan.
On the other hand, there are many benefits of this strategy that should not be overlooked. First of all, it provides life insurance protection for the company in case of the premature death of either individual at the same time that it provides creditor-protected funds accumulating on a tax-deferred basis. Secondly, the RCA assets may be able to be used as collateral for a bank loan to purchase shares where an employee lacks sufficient other collateral. Note, however, that the assets would not be creditor-protected during the time that they are provided as collateral security. The tax-efficiency of the strategy is enhanced because there is no impact on the $500,000 Capital Gains Exemption, the vendor can take advantage of lower capital gains rates, the purchaser can structure the loan to have deductible interest and there is a provision for supplemental retirement income for both the vendor and the purchaser.
Finally, this strategy provides maximum flexibility. For example, if this strategy were used in combination with a partial estate freeze involving the issuance of some common shares to the employee-purchaser, $2,000,000 of death benefit at the owner's premature death could be used to fund a promissory note purchase. If, instead, the employee dies prematurely, $1,200,000 will be available to the company to help attract and retain a new employee or to offset the costs of the RCA strategy. Even if there is no premature death, circumstances may be such that the employee is unable or unwilling to purchase the shares. In this case, the owner would not have to postpone his retirement. He would simply use the RCA pension to support his retirement needs while he made alternate arrangements for the sale of the shares. The RCA benefits would still be available to the employee even if a third party purchased the shares.
In spite of the complexity and risks involved in this strategy, these benefits may make it an excellent solution to the living buyout problem in certain circumstances.
This article is based on a presentation given by the author, Virginia Mawer, CA, CLU, TEP, at the 2004 CALU Associate Members Meeting.
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