The Use of Life Insurance Policies to Fund Business Exits│Canada

The use of life insurance policies as a financial tool to fund business exits is a common strategy employed by business owners and partners. In the case of a business owner or partner’s death, a life insurance policy for that partner can help ensure the smooth transition of either ownership or the necessary funds for surviving business partners. The specific method for using life insurance to fund an exit for a business will depend on the particular scenario, as well the specific aims of the business owner or partner. Some common scenarios where life insurance is used to fund business exits include business succession planning, estate planning, and key person insurance.

A business exit strategy is essentially a plan that a founder or owner puts in place to enable the sale of their ownership or share in a business. The rationale for a life insurance policy being used as a strategy to fund a business exit is as follows. First, as businesses grow, capital gains accrue. Second, as the heads of businesses are thinking about succession, it should be noted that transitioning shares will – in most instances – trigger the classification of these share transitions as taxable events. As a result of the transition of these shares being classified as a taxable event, the business will then have to come up with cash to pay the resulting tax, even though it may not necessarily want to take on the debt or financial obligation.

In light of the above, the question then arises: how does a business create the opportunity to avoid the share transitions being classified as a taxable event? The answer is through succession or death. By way of an example, when a business founder passes and the surviving business partners want the shares conveyed to family members of the deceased founder, then that conveyance will usually be a taxable event – unless it is going to a spouse. However, by having life insurance as an asset, this will create the liquidity and the cash to facilitate such transaction because it creates an asset of either the corporation or the estate (depending on who owns it) that enables the paydown on the tax bill that is generated.

Moreover, even when business owners may be relatively advanced in age or potentially unhealthy, there are a lot of alternatives in the insurance space. A last-to-die policy can be created between two spouses or, alternatively, a life insurance policy with different creative features. Also, if the business is the beneficiary, then this life insurance could be deemed a business expense.

In other words, the business can own a policy on the business owner’s life and, if it has the cash flow, then opportunities can be created for smooth business exits. This is really the essence of the strategy: using corporate pre-tax dollars to buy an asset – namely, the life insurance (of which the company is a beneficiary) on the life of the founder – will create these opportunities.

As business owners or partners start thinking about succession or the passing of founders, then a tax deferral from spouse to spouse can be obtained. However, if shares in the business are being passed to the children of a deceased business owner, then the relevant tax will actually be recognised and will need to be paid – even if no money is changing hands in the passing of these shares. For the estate to give the shares to a child, the estate is essentially deemed to have sold these shares and therefore has to pay tax on these shares, even though the estate may not have the necessary cash to pay this tax.

Life insurance can be used to fund the buyout of a deceased business owner’s share in a business, thus ensuring a smooth transition of ownership. Notably, life insurance is often used to fund buy-sell agreements (also known as business continuity agreements) in the context of such business succession planning. A buy-sell agreement is a legally binding contract that basically stipulates what happens to a business if a business owner or partner passes away, becomes disabled, or wants to leave the business.

How a buy-sell agreement typically works is that each business owner or partner in the business will purchase a life insurance policy on their own life. If one of the owners or partners subsequently passes away, then the death benefit from their policy will be used to buy their share of the business from their estate at a pre-determined price. This will ensure that the surviving owners or partners can keep control of the business while, at the same time, the deceased owner’s family will receive fair compensation.

In some situations, a business might rely heavily on the expertise or contributions of a so-called “key person”, who is usually the business owner (or, alternatively, an employee who is critical to the business). If such a key individual were to die unexpectedly, then this could have a serious financial impact on the business in terms of its operations or value. For such scenarios, the business can take out key person insurance on the life of the individual in question.

Key person insurance is a form of life insurance that will enable any death benefit (ie, insurance payout) to be used to cover any losses arising from the death of the key individual, as well as any outstanding debts or loans. Key person insurance can facilitate the continuation of the business by preventing it from going under due to financial strain upon the death of the key individual. It can also enable the hiring of a replacement.

Where a business owner has an estate of significant size, then life insurance can be used as part of estate planning. Specifically, the death benefit from a life insurance policy can assist in the payment of any estate taxes, thereby ensuring that the businesses can be passed on to any heirs without the burden of a large tax bill.

In other words, life insurance can provide liquidity to cover any tax liabilities. As a result of the business owner having a life insurance policy, the family or heirs of the business owner will not need to sell the business or liquidate any other assets to pay the estate taxes.

When a business is considering using life insurance policies for business exits, it is essential to collaborate closely with attorneys, financial advisors and insurance professionals, in order to set up policies and associated agreements that will suit the particular requirements of the business. As regards the specifics of how life insurance is structured and used for business exits, this will depend on the nature of the business, the aims of the business owners or partners, and the legal and tax considerations in the relevant jurisdiction.

Lastly, it is important that such arrangements are regularly reviewed and updated as the business evolves or as any changes take place among the owners or partners. Doing this will ensure that the arrangements continue to be properly implemented and aligned with the business’s objectives.