Redemption Agreement Insurance in Canada: The Key to Business Continuity

Business succession planning is vital for privately-held Canadian companies to ensure continuity when a key owner departs or passes away. Redemption agreements funded by life insurance can provide an effective mechanism for ownership transitions. This comprehensive guide dives into how redemption agreements work, associated costs, tax impacts, ideal candidates, and professional considerations to inform Canadian business owners.

What Are Redemption Agreements?

A redemption agreement, also known as an entity purchase agreement, is a legally binding contract between business partners or shareholders of privately held Canadian companies. It outlines the process and terms for transferring a departing or deceased owner’s shares back to the company.

The key components of a redemption agreement are:

• It obligates the departing owner or their estate to sell their shares according to predefined contractual terms.
• It obligates the company to repurchase or redeem the departing owner’s shares, often utilizing life insurance policy proceeds to fund the share acquisition.
• It establishes a formula, process or methodology to determine the valuation of the shares being transferred.
• It delineates clear procedures for executing the share transfer and succession of ownership interests.

Redemption agreements are commonly funded using permanent life insurance policies purchased on the business owners’ lives by the company. This provides cost-effective liquidity when needed to finance the mandatory share buyouts upon an owner’s death, disability, retirement or other exit.

How Do Redemption Agreements Work in Canada?

Redemption agreements are structured as entity purchase agreements from a Canadian tax perspective. The company is both the owner and beneficiary of permanent life insurance policies taken out on each owner’s life. The insured owners must provide their consent to the company purchasing these policies on them.

When an insured owner passes away, becomes disabled, retires or otherwise leaves the company, the business receives the income-tax-free death benefit or surrender value proceeds from the applicable policy. These funds are then utilized to finance the purchase of the departing owner’s shares.

The redemption agreement also clearly delineates the valuation methodology or formula to determine the fair market value of the shares being transferred. Common valuation approaches include:

• Revenue or earnings multiple
• An independent business appraisal by a qualified valuator
• Book value based on financial statement carrying values

Establishing the valuation methodology upfront creates certainty in the transfer process between the existing owner or their estate and the company.

Why Fund Redemption Agreements Using Life Insurance?

Permanent life insurance policies have several advantages that make them well-suited for funding redemption agreements:

• Lifetime coverage – Policies provide coverage during the entire lifetime of the insured owner, paying out a death benefit whenever they pass away.
• Tax-free death benefits – Avoid erosion of company capital and assets compared to using cash reserves to fund share buyouts.
• Cash value accumulation – Cash values accessible via policy loans or withdrawals can supplement retirement savings or provide supplementary business funding.
• Adjustable coverage – Death benefits and premiums can be adapted as business valuations and ownership stakes evolve over time.
• Tax deductible premiums – Premiums are generally deductible business expenses, providing tax savings compared to funding buyouts with after-tax dollars.

Permanent life insurance is a strategic asset that aligns with the long-term funding needs of most redemption agreements.

What Are the Costs of Redemption Agreement Insurance in Canada?

The cost of life insurance utilized to fund redemption agreements depends on several factors:

• Ages of the insured business owners
• Individual health status and family medical history
• Total amount of death benefit coverage purchased

According to insurance industry data, average annual premium costs for permanent life insurance policies range from:

• $500 – $2,000 per $100,000 of coverage for Canadian business owners aged 30-40 years old.
• $2,000 – $5,000 per $100,000 of coverage for owners aged 50-60 years old.

Term life insurance generally offers lower initial premiums but lacks permanent coverage. Consulting an experienced insurance advisor is key for determining appropriate solutions tailored to your situation.

Let’s look at an example to estimate potential costs:

• Canadian private company with 3 owners
• Each owner has a 33% ownership stake
• Company worth $3 million
• Owners aged 35, 55 and 60

In this scenario, the coverage needed for each owner would be:

• Owner 1 (Age 35): $1,000,000
• Owner 2 (Age 55): $1,000,000
• Owner 3 (Age 60): $1,000,000

The estimated annual insurance premiums based on industry averages would be:

• Owner 1 (Age 35): $1,500 – $2,000
• Owner 2 (Age 55): $4,000 – $5,000
• Owner 3 (Age 60): $5,000 – $6,000

Total: Approximately $10,500 – $13,000 annually

Actual costs depend on specific underwriting. Speak with an advisor to review the needs of your business.

The Pros and Cons of Redemption Agreements in Canada

Redemption agreements offer several advantages but also some potential limitations to evaluate:

Pros of Redemption Agreements

• Provide leadership continuity upon an owner’s death or departure
• Avoid forced sales of assets to fund unexpected buyouts
• Ensure heirs receive fair value compensation for inherited shares
• Allow tax-efficient funding structure utilizing insurance proceeds
• Premiums are generally deductible business expenses

Cons of Redemption Agreements

• Ongoing premium costs for life insurance policies
• Surviving owners don’t benefit from a step-up in cost basis
• Complexity coordinating multiple policies as the number of owners grows
• Potential disputes regarding valuation methods for share transfers
• Life insurance death benefits exposed to company creditor claims

Assessing these tradeoffs relative to your specific business structure, goals and needs is key to determining if implementing a redemption agreement is prudent.

What to Consider When Purchasing Redemption Agreement Insurance in Canada

Some key considerations when exploring using life insurance to fund a redemption agreement are:

• Carefully estimate the current and projected future value of ownership shares, consulting professional valuators as needed.
• Weigh permanent versus term life insurance options to balance long-term costs against needed coverage periods.
• Compare premium costs and policy offerings from multiple highly-rated life insurance providers.
• Evaluate optional riders like a waiver of premium to limit costs if an owner becomes disabled.
• Review agreements regularly as the business evolves to confirm adequate death benefit coverage.
• Structure policies to optimize available tax advantages.

Working closely with qualified legal counsel, tax accountants, and insurance advisors helps craft agreements and insurance policies tailored to your situation.

Tax Considerations for Redemption Agreements in Canada

Maximizing available tax advantages associated with redemption agreement insurance is crucial:

Note: As of June 25, 2024, the life time capital gains exemption limit is $1.25 million for qualified small business corporation and farming and fishing property in Canada. (Source).

Carefully structuring the tax aspects of a redemption agreement can provide substantial savings and advantages. Some key tax considerations include:

Payment of Policy Premiums

• Premiums paid by the company are typically deductible as regular business expenses. This provides tax savings compared to buying out owners using after-tax retained earnings.
• However, the deductibility of premiums depends on certain factors like the type of policy and business structure. Consult a tax advisor.
• Premium payments using corporate dollars may be subject to the corporate attribution rules. Proper structuring can minimize attribution.

Insurance Death Benefit Payout

• Death benefit payouts from a corporate-owned policy are generally non-taxable to the company.
• The amount received in excess of the policy’s adjusted cost basis is credited to the company’s Capital Dividend Account.
• This Capital Dividend Account can be used to pay tax-free capital dividends to shareholders. There are specific eligibility rules to qualify for these tax-free corporate distributions.

Read more: Shareholder Insurance in Canada

Share Purchase from Departing Owner

• Redeeming shares from a departing owner triggers a disposition that may generate capital gains or losses for the seller.
• There are tax planning strategies that can maximize the lifetime capital gains exemption on qualified small business shares in Canada.
• Corporate reorganizations may also provide capital gains deferral opportunities in certain cases.

Ongoing Tax Planning

• Tax rules and company valuations change over time. Reassess planning regularly.
• Work closely with tax experts when developing and reviewing agreements to optimize the tax structure.
• Keep meticulous records of adjusted cost bases, policy values, dividends, redemptions and other relevant transactions.

The ideal tax treatment of a redemption agreement requires experienced tax expertise. Always consult a tax professional to minimize liability and leverage available tax advantages.

Ideal Candidates for Redemption Agreements in Canada

Based on their benefits and applications, redemption agreements are best suited for:

Private companies with multiple owners – Provides clear process when any partner, investor or shareholder departs.

Family businesses – Helps maintain company ownership within the family bloodline for intergenerational transition.

Owners nearing retirement – Allows for an exit strategy to execute leadership succession.

The table summarizes situations where redemption agreements effectively support business continuity:

Alternatives to Redemption Agreements

Cross-purchase agreements are another common buy-sell agreement structure businesses should consider. Here, each owner purchases a business life insurance on the other owners. When an insured owner dies, the survivors use the payouts to acquire the deceased’s shares.

While cross-purchase agreements have more complexity with multiple owners, they can provide surviving owners with a step-up in the cost basis of the purchased shares. This can benefit the survivors for tax purposes when they eventually sell their shares.

Hybrid approaches combining aspects of redemption and cross-purchase agreements are also an option. Comparing all structures thoroughly with professional support is advised to find the optimal solution.

Getting Help from Advisors

Properly implementing redemption agreements requires competent legal, tax and insurance expertise. Key advisors to engage include:

• Business lawyers – Draft agreements recommend corporate structure.
• Estate planning lawyers – Ensure consistency with wills and estate plans.
• Tax accountants – Advise on tax optimization deductibility of premiums.
• Insurance advisors – Analyze insurance needs, structure policies, and illustrate costs.
• Financial advisors – Review business valuation methods and succession goals.

Getting personalized guidance from a collaborative expert team is prudent to avoid pitfalls and maximize the benefits of redemption agreements.

Conclusion – Plan Today to Ensure Tomorrow’s Continuity

For Canadian private companies, redemption agreements funded with permanent life insurance can strategically prepare for eventual ownership transitions. However, careful planning and expertise are needed to properly structure agreements and reap the full benefits.

As experienced advisors, we’re we’re here to guide you through this process. Connect with us today to start planning so you can protect your business’s future.

Frequently Asked Questions (FAQs)

Article Sources:

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1. Buy/Sell agreements – The share redemption method – https://tepg.salesstrategies.ca/
2. Entity-Purchase Agreement – https://www.investopedia.com/
3. Mastering Buy-Sell Agreements: A Guide to Ensuring Business Continuity in Canada – https://protectyourwealth.ca/