Succession planning can be especially difficult if more than one person owns the business. Planning for the possible death of an owner is one of the most difficult tasks business people will confront. There are various aspects to this, so let’s look at the financial planning options.

Imagine a simply structured company in which two owners each own half of a firm worth $2 million. Their shareholders’ agreement has a “buy-sell” clause: meaning that if either owner died, the other would be required to buy the rest of the company.

Here are four possible ways for the surviving owner to come up with the funds required to buy out the deceased owner’s share.

Where does the buy-out money come from?	Cost if one shareholder dies	Cost if both shareholders live	Balance at end of 10 years if both shareholders live
1. Borrowing	$1,333,255	nil	nil
2. Selling company assets	1 million	nil	nil
3. Saving (creating a sinking fund)	Amount in sinking fund + borrowing or sale of assets to total $1,000,000	nil	$1 million
4. Buying life insurance	Cost of insurance premiums paid until the date of death	$3,200 yearly cost of two $1 million life insurance policies	nil

The Four Options

Borrowing

This is probably the most commonly chosen course. If an owner dies, the company (or the surviving owner) borrows the money needed to buy the deceased owner’s shares in the company from the estate. Let’s quickly do the math: assume the company could borrow the $1 million at 6%, the buyout is to occur over 10 years, and payments would be monthly. A loan calculator shows the total amount expended is $1,333,225 — and the $1 million in principal will be paid in after-tax dollars.

Main advantage: if no-one dies, the loan doesn’t happen so there is no cost.

Main disadvantage: this is the most expensive option if one of the owners dies.

Selling assets

How about just selling an asset or two to raise the funds? If the company wanted to liquidate some assets, the cost may only be $1 million (assuming no gains are being realized on selling off an asset or two), but the company may want or need those assets for the business. As well, the company loses the ability to time the sale of the assets, so may be selling them at a disadvantage (such as a forced sale during bad economic times). On the other hand, this may force the company to re-evaluate which assets it really needs, and focus on liquidating its least productive assets.

Main advantage: if no-one dies, no assets need be sold.

Main disadvantage: forced asset sale could come at a really bad time for the company.

Saving

The vehicle for saving for events like the death of an owner is called a sinking fund. The company would be required to set aside the money regularly, and the owners would need the necessary discipline to keep saving and not take money out of the fund. Also, if an owner dies before the 10-year saving period, the surviving owner would have to borrow or sell assets to make up the shortfall in the savings.

Main advantage: if no-one dies, the company has $1 million at the end of 10 years (which would eventually be used to buy out one owner or the other).

Main disadvantage: siphons off cash that the company will likely want for other purposes.

Insurance

In many situations, the least expensive option is life insurance. If both owners are, say 50 years of age, non-smokers, and in good health, $1 million policies that are good for a 10-year term could be taken out on each of their lives for an approximate cost of $32,000 over that 10-year period. In addition, the deceased owner’s estate could have a lower tax bill as the insurance, if received by the company, will result in a special tax account called the capital dividend account. This account can be used as part of the planning for the repurchase of the owner’s shares and, depending on the circumstances can reduce the estate’s tax bill to not greater than half of the bill if there was no insurance, and possibly to zero.

Main advantage: by far the cheapest option if one owner dies during the period covered by the insurance.

Main disadvantage: this is the only option that costs money if no-one dies.

Chris Ireland is Vice-President, Planning Services, PPI Financial Group in Vancouver.