Insurance planning for business owners

Small businesses are uniquely vulnerable to key-person risk. Management teams that consist of one, or a small number of, senior leaders can be devastated by the loss of an executive, particularly if that leader passes unexpectedly.

Hemal Balsara, head of tax, retirement, estate planning and individual insurance at Manulife says he’s “heard of horror stories where there’s been businesses that have just gone under … over a short period of time.” Indeed, if your client’s business partner and key decision maker suddenly dies, and the surviving business partners don’t have the funds to buy shares from the deceased’s family, the business might not recover, he said.

The surviving partner of a closely held small business may not want a third party or the deceased’s family members to step in, said Faran Umar-Khitab, a partner at Gowling WLG who specializes in corporate law. Using life insurance proceeds to buy out the shares often makes sense.

Advisors can work with legal and accounting specialists to ensure clients have the right corporate structure in place, consider the right insurance coverage from the time of incorporation and a setup that minimizes tax impact.

Advisors should find out if their clients have a shareholder agreement in the works when discussing life insurance on their business partners, Balsara said. “Surprisingly, there’re many business owners that don’t have shareholders agreements.”

The agreement should clearly state what happens to a partner’s shares when one of them dies, the allocation of the capital dividend account and clarify managerial responsibilities, Balsara added.

Advisors shouldn’t wait for the shareholder agreement to be finalized before starting the insurance application process. Shareholders need to ensure they are insurable first or they must find alternative funding sources for the buy-sell agreement, Balsara said.

The agreement should consider the spouses’ level of financial literacy, too. While a share redemption plan would require less involvement from the surviving family, having business-owned insurance pay the deceased’s family through a capital dividend account will require some financial sophistication, Umar-Khitab said.

He recently had a conversation with an owner of a nine-figure business who planned to have his wife deal with his company when he dies.

“My response was, ‘So you, in your 40s, pass away and your spouse is in her 40s. Who’s looking after your three not-even-teenage kids? Who is going to step up to settle your estate. Is this really fair to her?’” Umar-Khitab said.

Have insurance even while a deal is in the works

Business owners with employees who intend to buy a portion of the company should also have insurance on the employees.

Catherine Metzger-Silver, a financial advisor with Edward Jones in Kentville, N.S., had an electrician client who was about to buy into his boss’s business, but died of pancreatic cancer before the deal was signed.

“It really left the business owner in a little bit of a lurch,” she said.

In addition, clients should consider buying critical illness and disability insurance on their business partners in case they become temporarily incapacitated, Metzger-Silver said. The buy-sell agreement should clarify how long a business partner needs to be incapacitated before they’re forced to sell their shares.

Mind the tax treatment

Corporations typically hold key person insurance and life insurance as they are usually taxed at a lower rate than the owners. But there can be a conflict between the tax interests of the surviving business partner and the deceased shareholder’s estate when choosing a buyout method, Balsara said.

When one business partner dies, the corporation may be able to distribute the funds to surviving partners on a tax-free basis with the buyout from a corporate-owned policy through a capital dividend account (CDA) if the corporation has the right tax attributes, Umar-Khitab said.

This way, the deceased’s estate can take advantage of any remaining lifetime capital gains exemption and maximize the CDA for the corporation, Balsara said.

However, if the corporation redeems shares from the deceased’s estate and the redemption dividend is designated as a full capital dividend, the deceased’s estate can carry back the capital losses to the terminal tax return, providing for the lowest effective tax rate for the deceased, Balsara said.

Any available lifetime capital gains exemption (LCGE) can shelter a lot of the capital gain with the promissory note method. Without available LCGE, and with a sufficient corporate capital dividend account, the shareholder would choose the corporate redemption method with a capital dividend, Balsara said.

To resolve the conflict between the tax optimization for the deceased’s estate and the surviving shareholders, the buy-sell agreement could be structured as a hybrid where part of it uses the promissory note method and another part uses the corporate redemption method, Balsara said.

The agreement won’t specify the ratio between the two methods to maintain flexibility, so if a future government decides to increase the capital gains inclusion rate, the business partners can agree to a corporate redemption, Balsara said.

More insurance needed as business value increases

Some buy-sell agreements have a share-price formula where the share value increases as the business grows.

Clients can buy a universal life policy with a fund indexed to grow at a specific rate, or buy a whole life policy with paid-up additions that increase the death benefit over time, Metzger-Silver said.

Alternatively, the client can ladder multiple term insurance policies to cover short- to medium-term growth with guaranteed insurability riders to buy more coverage in the future, she added.

And as always, the advisor should check in with the client to review their business’s insurance needs regularly to make sure they are adequately covered.