Life insurance isn’t complicated, but it is complex,” Paul Craft, a financial planner from Steinbach, Man. tells me. It seems he’s right. You don’t have to like talking about insurance in order to understand how it works and to see where there might be a fit for your farm. Designing the package, however, can take the help of someone who knows how to integrate insurance with your business, personal and succession objectives.
You also need to know the limits. Most important is not to wait too long. Life insurance shouldn’t be a last gasp and costly effort to provide funds required to settle estates and keep peace in the family.
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Also don’t take it for granted that you’re going to be able to buy insurance, says Craft. Today, up to about a quarter of applications for life insurance are rated or declined.
Don McCannell, president of McCannell Financial Group in Saskatoon says before you even talk to an insurance agent, you should write down your business structure, your goals and your current financial position, especially your debt-to-equity position and cash flow.
Also decide if you want to plan for children to take over the farm or not, and tally up all your off-farm investments, including details of current policies.
Every farm and family is different, and not everybody needs the same amount and type of life insurance. It’s better to match your estate strategy with your business needs and structure. “Don’t buy a whack of life insurance, hoping that it’ll fit,” says McCannell.
Exit Strategy
“Know exactly what it’s going to cost you to die,” says McCannell bluntly. “It’s cheaper to pay for insurance now than pay Revenue Canada after.”
When you die, all your capital property is valued at the current fair market value immediately before death. In addition, if the capital property is depreciable, such as buildings and equipment, depreciation claimed in prior years is also added as income in the final return.
Often this results in taxable capital gains that must be included on your final income tax return. Half of capital gains are added to farmer’s income for the year of their death and this can be a huge tax hit.
Farmers do have the capital gains exemption of $750,000, and we can roll farms tax deferred to the next generation or to a spouse. Off-farm investments, like stocks and RRSPs, can also usually roll to a surviving spouse tax deferred, although not to the next generation.
Life insurance can provide a ready source of cash to pay liabilities that exist at the time of death, particularly income tax liabilities. Conversely, life insurance is tax sheltered and proceeds can move from parent to child tax free and can be used by your children to cover tax liability.
“Your tax liability grows as you grow your business and personal wealth,” says McCannell. “And that tax liability flows to the next person.”
Farm Debt
If the idea is to leave the farm to the farming kids without the debt, first figure out how much debt the farm can handle realistically.
“Every generation has an obligation to invest capital into the farm,” says Craft. “How is the next generation going to inject capital into the business if they owe all this money?”
Farmers often have term insurance to cover farm debt. It’s the cheapest insurance but is usually only for a given time period, usually five, 10, or 20 years (although you can buy T-100, i. e. term insurance for 100 years). There’s no investment portion to this type of insurance, so there is no dividend or cash value.
For succession planning, McCannell suggests that you consider a convertible policy to cover your farm debt. Remember though, if they’re not being used for covering debt servicing, premiums cannot be used as an expense.
In multiple-generation farms, you also have to decide for whom you are insuring the debt. Does the spouse have enough off-farm investments to live on, or are the grandchildren going to manage the farm?
Non-farming kids
David Clarke an investment adviser at RBC Dominion Securities and Steve Wiffen an estate planning specialist, both from London, Ont., are often asked by farmers how to make farm estates more fair for non-farming children. “They (farmers) will ask: How can we transfer a farm worth over $2 million to one child, leaving hardly anything else for our other children?” says Clarke.
On top of covering debt, life insurance is commonly used to help make the estate more fair for non-farming children. The insurance proceeds are simply paid as an inheritance to children who are not active in the business. Of course, there are other ways to invest those premiums (like equities or land) but few are guaranteed and have similar end values, especially if you consider the tax implications.
“You don’t have to give anything to anyone,” says McCannell. However, if you want to, the amount should be set when the farm is transferred, not after many years of growth and reinvestment.
Once you have a plan, Wiffen advises families to tell the non-farming children what they will inherit, including life insurance benefits. It’s important to discuss education costs, value any management and labour that the children have committed to the farm, and make sure the non-farming siblings know they’re not to interfere with the farming operation.
Also, you might consider setting up secondary beneficiaries, in case things change between the time you sign up for the policy and your death. “The bottom line is that you want to avoid probate,” says McCannell. “Make sure you ask for a trustee clause so the funds flow directly to the will.”
With some insurance policies, you can split up how much goes where. For example, 40 per cent might go to the bank, 50 per cent to your wife and the remaining 10 per cent to the children.
Joint insurance
Premiums for a joint-and-last-to-die or first-to-die basis are less expensive than if you have two separate policies but you have to pay them longer.
These policies are used to time the payout for needs. For example, a farm may buy joint insurance on the major shareholder or partners, setting the value of the policy high enough to buy out the shares or portion of the farm held by a deceased partner.
If the spouse, shareholder or partner doesn’t need an insurance payout for living expenses or to keep the farm operating, last-to-die might be a good option. Joint and last-to-die life insurance is intended to provide the cash to the estate when the tax liability is ultimately incurred.
Joint insurance can be set up in a criss-cross method. For example, McCannell suggests a joint first-to-die coverage The survivor then has the option of purchasing insurance in an equal amount based on his or her attained age at that time, without evidence of insurability (so you won’t need to go through a medical).
Consider a joint first-to-die coverage when insuring a debt such as a mortgage or for income replacement for surviving family members. McCannell says that with special underwriting, the policy may even provide joint coverage on more than two lives.
Buy-sell agreement — partnership
A buy-sell agreement between business partners sets the terms of their business relationship, including how the assets are to be sold and bought on retirement and on death. “Partnership agreements often have a death clause so that Revenue Canada can’t say that all the taxes are due when one partner dies and you don’t want the spouse as a partner,” says McCannell.
Life insurance is often used as a way to buy out the other party. A criss-cross purchase of insurance means that each shareholder buys a life insurance policy on each other’s life. When the shareholder dies, the survivor uses the insurance proceeds from the policy to buy the estate.
However, the premiums are not likely to be equal, because of things like health, sex or age differences. Plus those premiums are paid out of personal aftertax dollars since the insurance is not covering debt.
The policy should equal the amount to pay off the dead partner’s family. Also consider adding extra for a couple salaries. When a key person dies, the remaining partner may need to hire employees, and there may be a drag in productivity.
Share transfer
“A company never dies, just the shareholders,” says McCannell. Farm estates can roll over the shares to spouses and actively farming children, deferring the capital gains tax.
However, if some of the children prefer cash to shares, they’d be taxed heavily and the farm has to pay for the shares, potentially stressing liquidity and forcing sales of assets.
Life insurance can be a way to get cash out of the corporation without the corporation having to sell assets. However, families have to organize it right to avoid taxes and play within the corporate structure.
Essentially, you bequest shares of a family farm corporation to all of your children and the insurance proceeds are made payable to the corporation. The corporation then uses the proceeds to redeem shares held by non-active family members.
Often corporations own life insurance policies on a key shareholder. If it’s for estate planning only instead of security on a bank loan, the premiums would be an expense on the company’s financial statements for accounting purposes but not a deductible expense for tax purposes, says Brad Gee, certified management accountant at Stewart Gee and Associates in Saskatoon.
Life insurance works well with a corporate estate freeze. The life insurance proceeds become available when taxes arise on assets that aren’t eligible for the farm property rollover with accrued gains. Once you freeze your estate, you buy enough insurance to pay the projected tax liability on the frozen share value.
Your shareholder’s agreement should reflect who the farmers are and not be a standard fill-in-the-blanks form. It should also set out the rules of engagement, including how shares will be dealt with at death. Several vehicles are available for corporations to get the cash value of the shares to the non-farming children without paying the large tax bills.
“Looking at the after-tax returns, the life insurance solution makes sense comparing taxable investments in the corporation to tax-sheltered investments,” says Steve Wiffel.
Capital dividend accounts
A capital dividend account (CDA) is a special tax, notional account used to flow certain corporate capital receipts, tax free, to the shareholders. A credit in the CDA does not mean the company has cash or assets on its books, but rather that it has, at some point, been in receipt of certain specified capital amounts.
When the farm corporation owner and spouse die, the investment funds and life insurance are combined to make up the total death benefit paid to a corporation. The insurance proceeds minus the policy’s adjusted cost basis (which can get down to zero in time) create a credit to a corporation’s capital dividend account.
A capital dividend is tax free to the shareholder. This comes in handy for estate planning when the shares of the farm corporation are willed to family. Instead of cashing out the shares, the children get CDA dividends — and here’s the insurance link — this CDA account has funds from the proceeds of the life insurance policy.
The corporation owns and funds the life insurance policy so the death-benefit proceeds can flow tax free from the private farm corporation to its shareholders via the capital dividend account. These dividends can equal the share value and the insurance generates the cash flow needed for the purchase of the deceased shareholder’s interest.
The insurance tops up the estate value and the surplus funds are passed on tax efficiently. If the inheriting children took it out of the corporation as a taxable dividend, they could have paid about a third of the value in taxes.
The CDA credit simply allows the parties to implement a corporate-owned insurance program with the same net tax implications as if the insurance had been personally owned. No residual benefit goes to the company or the surviving shareholders.
“It’s a way of transacting share value back to the family and the remaining family member doesn’t have to pay income taxes,” says McCannell.
Holding companies
Another option is an estate freeze and incorporating a holding company which owns the shares of the farm corporation. Potentially, the older generation owns the shares of the holding company. The younger generation and the holding company could hold shares of the farm operating company.
The holding company buys two insurance policies, a single one for the father and a joint-last-to-die one. The premiums can be funded with dividends paid to the holding company from the farm, since often there’s no tax on inter-company dividends. Once again, the CDA accounts can be used to convert shares to cash value.
Additionally, after-tax profits of the farm corporation can flow to the holding company as a tax-free inter-company dividend, provided certain other structural requirements are satisfied. It’s also a way to mitigate risk as after-tax equity in the farm operating company can be transferred to the holding company where they’re not available to creditors and may not be as vulnerable to litigation against the farm. The holding company could also give a loan as a secured creditor to the farm corporation.
Family trusts
Similarly, you can transfer farm or holding company shares into family trusts, which can be handy when multiple children are beneficiaries.
The farm corporation insures the parents, so when they die, the corporation can buy the shares from the trust. The money goes into the trust and the family members can take advantage of multiple capital gains exemptions.
Insuring a key person can be a way to reduce risk. The inheriting generation could face having to sell assets for liabilities or estate issues, leaving them in a potentially vulnerable financial position. Or there could be a gap in productivity and knowledge when your business loses a key person.
However, not all family businesses will be in that position. It means weighing your business needs with personal wants, and it has to be consistent with your legal documents and structures.
On many farms, however, life insurance is worth the struggle it takes to figure it out. As we said, Craft seems right. Life insurance can be the tool that keeps everything in balance.CG
