It was at the tender age of six or seven that Dana Mitchell first realized the kind of help her father could provide to people in troubled times.
“My uncle had just died of cancer and I remember one of my biggest concerns was whether he had enough life insurance for my aunt, whom I loved very much,” says Mitchell, a certified financial planner. “I obviously had only a rough understanding of what my dad did at that age, but I did know that he provided money when people died. When I went to business school I always wanted to do something to give back and be helpful.”
Now, Mitchell, along with her father, Ed Postrozny, own Toronto-based Basis Wealth, dedicated to planning for professional families. Currently, Postrozny is in the planning stages of transitioning the business to Mitchell, but both realize the important role insurance plays in all family businesses.
When working with a family, Mitchell begins with an analysis of the client’s objectives, what and when they are planning to transition and to whom.
“With insurance planning you spend probably half your time identifying the problem and only a relatively small amount of time on the solution. That’s especially important with a family business,” says Mitchell. “The more time figuring out what they want to see happen, the better the solution you will implement.”
Insurance has different benefits – everything from providing efficiencies through the generations to estate equalization, says Paul Tompkins, president and founder of Tompkins Insurance Services Ltd. in Toronto.
In fact, the insurance needs could differ depending on whether they are first, second or third generation, said Tompkins. “You have multi-generational needs so we can use insurance at each generational level.”
Life insurance is known to help fund the obligations of a buy-sell agreement, in which surviving shareholders buy the deceased’s shares. Under this scenario, there must be a life insurance policy on each shareholder with a death benefit equal to the value of that person’s shares – or a similar-style arrangement that can be devised, depending on what the client is trying to achieve, says Mitchell.
Sometimes in a family business, not all the children are involved in the company, but the parents still want all their children to benefit equally when they pass away. In this case, the parents can buy joint last-to-die insurance. When they both pass away, there will be enough money to take care of estate taxes with the rest divided equally among all the children, says Mitchell. Let’s say two adult children are in the business and a third is not and would prefer to have the cash rather than shares. The life insurance would provide the other two siblings with enough liquidity to buy out the third sibling.
In this way, the insurance helps to not only fund the tax liability that occurs on death, but also buys out shares from family members and provides equalization to the family member who will not be receiving shares.
Key person insurance
In much the same way, insurance can step in as key person insurance to help keep the company moving should a major player in the business die or if revenue is lost if that person becomes disabled and cannot work, says Mitchell. In this case, disability insurance will look after the needs of the key person without putting pressure on the company to provide an income. “On buy-sell agreements, we see clauses that affect insurance and also those that affect disability and how to finance them.”
In many cases, life insurance that will be required for estate planning needs will be owned in a holding company that owns the operating company, says Tompkins. If the policy has a cash value, then it will be an asset of the holding company. At time of death, all or a significant portion of the tax-free death benefit proceeds will be credited to the capital dividend account of the holding company. The amount credited to the capital dividend can be paid out tax free to the estate. The exact amount of the death benefit proceeds credited to the capital dividend account will be subject to the adjusted cost of the policy at time of death, says Tompkins. Recent Income Tax Act changes relating to life insurance policies issued after January 1, 2017, slightly altered the adjusted cost base calculations, making corporate-owned policies bought before January more attractive.
Some people use the leveraging strategy of an immediate financing arrangement (IFA) in family businesses to acquire their life insurance. IFAs use debt to finance policy premiums and use the cash value of an insurance policy as collateral. The debt is paid off at death with the insurance if financing remains in place.
Immediate financing arrangement
Tompkins says there has been increased use of IFAs lately because of low interest rates. While he says there are some unique places where an IFA can be used, he says they should be used with great care.
“It should not be seen as a panacea or a blanket solution for everyone. It should not be considered free insurance; it should not be considered zero-cost insurance. A great degree of caution should be exercised when undertaking it and advising someone to do it.”
Many people have gravitated to IFAs because of the extremely low interest rate environment, says Tompkins. “So what happens if those interest rates should rise – how would that affect underlying, immediate financing arrangements? If rates increase and the underlying value of the asset decreases you have over-leveraged yourself and problems arise.”
Tompkins, who generally works with the family business’s internal and external advisors, says life insurance is an individual issue based on any number of needs and wants. And because of that, great care needs to be taken on behalf of both families and life insurance advisors to ensure the best possible products are selected.
“For life insurance in a family, private, business setting, it’s best to use someone who has worked in that field,” says Tompkins. “Life insurance is not a clip-on to an investment. There are lots of pieces to it.”