Selling the Company, and the Contract Inside It

Most sales of a private company reach a point at which somebody asks what happens to the life insurance contract the corporation owns. The question usually surfaces during diligence, a few weeks from a closing, raised by the buyer's accountant and not by the vendor. By then the contract has accumulated value, the price has been discussed, and the calendar is full. The same question was cheap to settle years earlier.

This page sets out the forks that decide the answer and names who decides each one. It recommends no transaction structure, because the shape of a sale belongs to the parties and to their own professionals on facts this page does not hold. Every tax consequence named below is priced by the vendor's CPA. Every document that gives effect to one is drafted by the vendor's lawyer or the vendor's notary. What follows is the material those two conversations need.

Why does this question arrive so late?

It arrives late because nothing forces it earlier. A contract owned by a corporation asks nothing of anyone while the premiums are paid and the statements are filed, so it sits on the balance sheet unexamined until a buyer's advisor reads that balance sheet and asks whose asset it is.

Two things make the delay expensive. The first is that the tax consequence of moving a contract is measured on figures that change every year, so a decision deferred is usually a decision that costs more when it is finally taken. The second is that the professionals who must answer the question keep their own timetables. An accountant asked in January can model three routes and give a considered opinion. The same accountant asked in the last week of diligence can be quick or careful.

The question belongs at the beginning, when the corporation first applies for the contract. An owner who has already written down what happens to the contract on a sale, on a wind up and on a reorganisation has taken this problem out of the transaction entirely. That note costs nothing at the application stage. It is the cheapest page in the file, and most owners do not have it, which is why the question keeps surfacing where it does.

Is the sale a share sale or an asset sale?

That is the first fork and it governs everything after it. In a share sale the buyer acquires the corporation itself, so the contract travels with the company unless it is moved out beforehand. In an asset sale the buyer acquires assets, the corporation usually stays with the vendor, and the contract usually stays inside the corporation.

On a share sale the contract is part of what changes hands, because it sits inside the company whose shares are being bought. The parties then have to decide whether the buyer wants it. If the buyer does not, the contract has to leave the corporation before closing, and leaving is a taxable event described further down this page. If the buyer does want it, the accumulated value forms part of what the price is measured against, and the vendor is selling an asset it had been holding.

On an asset sale the operating assets move and the corporation remains behind with the vendor, often holding the proceeds and the contract together. The contract may need nothing done to it at all on the closing date. What has changed is the character of the company that owns it, because a corporation holding cash and a policy is no longer carrying on the business it once carried on, and that has consequences of its own for the shares. Which form a transaction takes is settled by the vendor's CPA and the vendor's lawyer or notary across the whole file, and nothing here recommends either one.

What does a buyer actually want from the contract?

Rarely the contract itself. A buyer is purchasing a business and a management transition, and a contract insuring a person who is leaving does a job the buyer has no use for. The common buyer position is that the contract should go out with the vendor and the price should account for it.

There are exceptions and they are worth naming. Where the contract insures a manager who is staying with the business, the coverage may still serve the buyer and the arrangement can continue with a change of beneficiary. Where the accumulated value is large, a buyer may be willing to take the contract as an asset and pay for it, on a number their own accountant produces. Buyers frequently discount that number, on the view that an insurance contract on a departing founder is worth less to them than the statement suggests.

The vendor's position on this should exist before an offer does. A vendor who has decided in advance that the contract leaves with them can price the transfer, plan for the tax and put a clean proposition in front of the buyer. A vendor who has decided nothing will be asked the question in a room full of people who are all waiting for an answer. The figure that settles it comes from the vendor's CPA, working on the insurer's statement and the company's books.

How does the contract leave the corporation?

By a transfer of ownership of the policy from the corporation to the shareholder, or to another corporation such as a holding company. The insurer records the change on its own forms. The tax consequence is nowhere in those forms, because a transfer of this kind is a disposition of an interest in a life insurance policy.

Income Tax Act s.148(7) sets the rule for these transfers. It applies where an interest in a policy is disposed of by way of gift, by a distribution from a corporation, or by any transfer to a person with whom the policyholder was not dealing at arm's length. Where it applies, the policyholder is deemed to become entitled to proceeds of disposition equal to the greatest of three amounts: the value of the interest at that time, the fair market value of any consideration given for the interest, and the adjusted cost basis of the interest immediately before the transfer. That is the provision in outline, and the outline is where this page stops.

What those deemed proceeds produce in the hands of the policyholder is a calculation, and it belongs to the vendor's CPA under the same provision. The figure turns on the two numbers described in the next section, and it is an ordinary income inclusion and not a capital gain, which matters to the rate applied and to the accounts of whoever is reporting it. Nobody should carry an estimate of it into a negotiation. Ask for the calculation in writing, on the insurer's own figures, before the transfer is made.

Why do the adjusted cost basis and the accumulated value both matter?

Because the deemed proceeds are measured against the first and are often set by the second. The adjusted cost basis is defined at Income Tax Act s.148(9), and it moves in both directions across the life of a contract. The accumulated value is what the contract holds. The distance between the two is where the tax sits.

The basis generally rises with premiums paid and falls by the net cost of pure insurance, an amount that grows as the life insured ages. Early in a contract the basis often sits close to the accumulated value, so a transfer produces little. Later the basis can fall well below that value, and in the later years of a long contract it can approach nothing at all. A contract transferred in year five and the same contract transferred in year twenty five are two different tax events, and only an accountant holding the insurer's figures can say by how much.

Neither figure appears on an annual statement in the form the calculation needs. The accumulated value is usually visible. The adjusted cost basis usually is not, and it has to be requested from the insurer in writing, as at a stated date. Ask for both at the same time, give them to the CPA together, and keep the insurer's reply in the file, because that reply is the evidence the calculation rests on.

When is the amount measured, and does the agreement date matter?

The amount is measured on the day the transfer takes effect. A letter of intent, a purchase agreement and a closing schedule fix commercial terms between the parties, and they do not fix the tax figures. Income Tax Act s.148(7) measures at the time of the disposition, so the figures used must be the figures of that day.

The gap between signing and closing is where this becomes a live problem. A contract continues to accumulate value through that period and the adjusted cost basis continues to move, so a figure produced in March is no longer the figure in September. Where a purchase agreement obliges the vendor to remove the contract before closing, the obligation and any adjustment to the price should be drafted to reference the figures as at the transfer, which is a drafting question for the lawyer or the notary and never for an advisor.

A second date matters as much. The insurer takes time to process an ownership change, and the transfer is effective when the insurer records it and confirms it, on the insurer's own timetable. A closing that assumes an instant change of ownership is assuming something no insurer has agreed to. Ask the insurer, early, what it requires and how long it takes, and put the answer in the closing schedule where everyone can see it.

What does a shareholder benefit assessment look like here?

It looks like an assessment raised against the shareholder for the difference between what the contract was worth and what the shareholder gave for it. Where a corporation allows an asset to leave for less than its value, the Canada Revenue Agency can treat the shortfall as a benefit conferred on a shareholder under Income Tax Act s.15(1).

The difficulty is that the worth of a life insurance contract is a valuation question and never a reading taken from a statement. The cash surrender value is one input. The health of the life insured, the guarantees written into the contract and the cost of obtaining the same coverage again can all bear on what an arm's length party would pay for it. Where the amount is material, a valuation is obtained and never assumed, and the assumption is the part that gets assessed.

Two separate consequences can therefore follow one transfer. The income inclusion on the deemed proceeds under s.148(7) is the first. A benefit under s.15(1) on any shortfall in consideration is the second, and it is assessed in the shareholder's hands. Both are sized by the vendor's CPA before the transfer is made, and the consideration actually given is documented by the vendor's lawyer or notary at the time, because a defensible file is built while the facts are fresh.

What does the accumulated value do to the price and to the shares?

Two things at once. It adds to what the corporation is worth, which a buyer prices and a vendor negotiates. It also sits on the balance sheet as an asset that may not be used in an active business, which is the measurement deciding whether the shares qualify for the lifetime capital gains exemption at Income Tax Act s.110.6.

Qualification under s.110.6 depends on what proportion of the company's assets are used in an active business, tested over a period before a sale, and a contract that has accumulated value for years inside an operating company can count on the wrong side of that test. Purification is the planned removal of assets that are not used in the business, undertaken to restore qualification. A contract is one of the assets such an exercise may have to address, and it is usually the least convenient one, because moving it is the disposition set out above.

None of that is a verdict on corporate ownership and nothing here says an owner chose wrongly. It says the measurement exists, that it looks backwards over a period that has already begun, and that it is run by an accountant holding the company's real figures. Take no conclusion about qualification from this page. Ask for the test to be run under s.110.6 on the actual balance sheet, and ask for it well before a buyer is in the room.

Why is a letter of intent too late to begin?

Because a purifying transaction and a transfer of the contract both take time a transaction calendar does not contain. A letter of intent commonly leaves a matter of weeks before closing. The qualification test looks back across a period preceding the sale, and an insurer's ownership change runs on its own processing schedule. The two clocks do not agree.

Consider what has to happen inside that window. The accountant has to establish the adjusted cost basis and the value of the contract. A valuation may have to be obtained from somebody qualified to give one. The lawyer or the notary has to draft the resolutions and the transfer documents and record the consideration given. The insurer has to process the ownership change and confirm it in writing. Every step is ordinary, none of them is instant, and they run one after another.

The harder constraint is the one nobody can compress. Where qualification of the shares is tested across a period that has already run, a step taken after a buyer appears cannot change what the balance sheet held during that period. That is why accountants ask owners to test qualification periodically and years ahead of any offer. The sequence a sale actually follows is set out on the succession planning process.

What happens to a contract that funds a buy-sell agreement?

The agreement it funds may be superseded by the sale, and the contract is then funding an obligation that no longer exists. A buy-sell arrangement governs what happens among shareholders on a death, a departure or a dispute. A purchase of the whole company by an outside buyer usually brings that arrangement to an end.

Ending the agreement does nothing to the contracts themselves. They remain assets owned by whoever owned them, which may be the corporation under a promissory arrangement or each shareholder under a cross purchase. A contract sized against a shareholder's interest in the company now insures a person whose interest has been sold, and the question of what it is for has to be asked again. That is a question for the shareholders and their lawyer or notary, working from the agreement as written.

Surrendering a contract because the agreement behind it ended is a decision that deserves its own analysis. A surrender is itself a disposition measured against the adjusted cost basis under s.148(9), with a tax consequence for the CPA to calculate. The coverage may also still be wanted, for an estate or for a new obligation the vendor is about to take on. Establish what the contract is for now, and then establish what to do with it.

What should the vendor establish before the process begins?

Four figures and one decision, all of them before a buyer is spoken to. The adjusted cost basis of the contract, the accumulated value, an estimate of the tax on a transfer out of the corporation, and the current answer on qualification of the shares. The decision is whether the contract stays or leaves.

Each of the four has an owner. The insurer supplies the first two on a written request, as at a stated date. The CPA produces the third under s.148(7) and the fourth under s.110.6, on the company's own balance sheet. The lawyer or the notary reads the shareholders agreement and says what it requires when shares change hands. An advisor's part is to gather the contract mechanics and the insurer's requirements, and to put the question in front of the other three in a form they can answer.

A vendor who arrives at a first meeting already holding those four answers negotiates about price. A vendor who arrives without them negotiates about surprises, and surprises are expensive once a closing date has been set. The work takes a few weeks when nobody is waiting and it takes longer when everybody is. The wider set of questions an incorporated owner settles before any of this begins is laid out across the business owners section.

Who this suits, and who it does not

This page suits an incorporated owner whose corporation holds a life insurance contract and who can imagine selling the company inside the next ten years. It suits the owner who was told the answer once and has not checked it since the company was reorganised. It applies with most force where the contract carries real accumulated value.

It applies with less force where the coverage is small and temporary, because the accumulated value that drives most of the analysis above barely exists in a term life insurance contract. It applies with less force again to an owner heading toward a wind up and not a sale, since the questions raised there are different ones. Those owners can settle the coverage question first and come back to this page if a buyer ever appears.

It does not suit a reader who came for a rule about which sale structure to use. No rule is given here, and none could be. Participating whole life insurance is an insurance product and it is not an investment, and every figure in this subject belongs to one company's balance sheet, one contract's history, and one set of professionals reading both. Nothing on this page is tax advice or legal advice, and this practice holds an insurance licence and gives neither.

Settle the smaller question before the larger one. What is the contract for now that the company is changing hands, and where does the money it holds need to arrive. An owner who can answer both can evaluate any structure a buyer or an accountant puts in front of them. An owner who cannot will accept whichever structure the transaction defaulted to, and will read about the tax consequence afterwards.