Life Insurance and the Family Farm

Using Life Insurance for Estate Planning

Many farm families have recognized the advantages of using life insurance to help with their estate planning objectives, ensuring the future viability of the family farm. This article reviews these advantages and looks at the different insurance products that are available in the market and appropriate for this type of planning.

Life insurance is used for a variety of reasons. It may be used to provide a source of capital for the ongoing income needs of a family where the major breadwinner has passed away. This need often disappears as individuals get closer to retirement and have adequate resources to provide for retirement income.

Another way life insurance is used for estate planning is to provide a ready source of cash to pay liabilities that exist at the time of death, particularly income tax liabilities.

Income Taxes Arising on Death

When an individual dies there is a deemed disposition of all capital property at its fair market value immediately before death. This results in taxable capital gains that must be included in the final income tax return. In addition, if the capital property is depreciable property, such as buildings and equipment, depreciation claimed in prior years is also added as income in the final return.

There is also a requirement to include in the terminal return the value of all amounts in registered accounts such as registered retirement savings plans (RRSPs) and registered retirement income funds (RRIFs), etc.

There are two basic tax deferrals available. They are:

• where any property has been transferred to a spouse or spousal trust
• where qualified farm property has been transferred to a child.

A common form of life insurance is based on the lives of both spouses, with the death benefit paid on the death of the last spouse. Joint and last to die life insurance is intended to provide the cash to the estate when the tax liability is ultimately incurred.

Transfer of the Family Farm

For most farm families the major asset is the farm, including the land, buildings, equipment and inventory. If the farm is incorporated, the major assets are the shares of the family farm company.

The rules relating to the transfer of farm property to a child are extensive and beyond the scope of this article. However, if properly planned and structured, the farm rollover to a child should always be available for an active farming operation.

The result is the tax liability on death should be deferred for many years, as long as the farm property is left to a child.

People should take advantage of using life insurance because in most cases it is the cheapest method of ensuring that the non-farming children receive a fair share of the estate, without encumbering the farm assets for the farming child. The following example illustrates the use and the advantages of life insurance.

The Simpson Family

Homer and Marge operate a successful family farm. They have three children, Bart, Lisa and Maggie.

Bart has been working on the family farm since graduating from high school and has always dreamed of taking over its operation. Lisa is in medical school and Maggie is traveling with a theatrical group. Neither Lisa nor Maggie has expressed any interest in the family farm.

Homer and Marge have been saving for retirement and have some RRSP money set aside. However, the balance of their assets all relate to the farm. They have a total asset value of $3,000,000. Their RRSPs represent a very small portion of the total.

Their wills are over 20 years old and were prepared at a time when their children were very young. They simply provide that all property will be left to the surviving spouse and divided equally between the three children on the last to die.

Their neighbour, Ned Flanders, passed away four years ago and left the farm to both of his children, Rod and Todd. Rod actively farmed with his dad for a number of years. Todd has never been involved, but has now decided that he wants cash for his share of the farm. He's convinced he can make more in the stock market than the rental income he's getting from Rod. Unfortunately, Rod isn't able to borrow the money required to buy Todd out. They've had to put the farm up for sale.

Both Homer and Marge are very concerned and don't want this to happen in their family. They think it would be okay for Lisa and Maggie to get part of the farm, but Maggie's current boyfriend is a little different, and he and Bart just don't see eye to eye on anything.

Homer and Marge want to make new wills and have decided to leave the farm to Bart. They also want to make sure that Lisa and Maggie get a fair bequest. So they've decided that in order for Bart to get the farm, he will have to borrow so that Lisa and Maggie will each receive $500,000.

Their lawyer has suggested that they review their intentions with Bart so he has a full understanding of the estate situation, and the requirement to find bank financing so that he can provide a bequest to his two sisters.

Homer, Marge and Bart meet with the lawyer and their tax and financial advisors. The tax advisor has cautioned that the borrowing of funds may not be for an eligible purpose, resulting in non-deductible interest to Bart. This adds significant costs to the financing arrangement.

The financial advisor suggests they look at purchasing $1,000,000 worth of joint and last to die insurance on Homer and Marge to provide the necessary cash to make a bequest to Lisa and Maggie.

Both Homer and Marge are very concerned about the cost of the insurance, so the financial advisor does some cost comparisons. Life expectancy is 25 years and the advisor looks at the following two options available to Bart:

• Option number one is the present value of the premium payments required for the life insurance for the next 25 years.
• Option number two is the present value of the cost of borrowing $1,000,000 in 25 years time.

Bart looks at this and decides that he would rather take his chances on the bank loan in the future because the present value of the loan option isn't that much different than the life insurance, but he doesn't have to spend any cash today.

But let's have a look at the ultimate estate distribution under both alternatives. The following assumes that the only asset at the date of Homer and Marge's death is the farm worth $3,000,000.

	Bank Loan	Insurance
Bart: Inherits farm	$3,000,000	$3,000,000
Bart: Takes out bank loan	$(1,000,000)
Lisa: Receives cash	$500,000	$500,000
Maggie: Receives cash	$500,000	$500,000
Total Estate	$3,000,000	$4,000,000

Not only is the present value of the cost of insurance cheaper, it adds $1,000,000 of tax-free proceeds to the estate and leaves the farm to Bart without the necessity of encumbering it with any debt.

Some Basics About Life Insurance

What kind of insurance should be purchased for this type of estate planning need?

All life insurance products fall into one of two categories, term insurance or permanent insurance.

Term insurance is the cheapest form of insurance and is usually purchased for short-term cash needs. Its cost rises significantly over time, and as a result it would not be used to cover a need that is permanent, such as the funding of an estate bequest or liability. These types of term products often expire at a certain age, for example at 75 years.

There is another product that is often called term, but is really a permanent product. Term-life, sometimes referred to as Term 100, is a permanent form of insurance as it lasts for the lifetime of the insured.

Most other permanent products in the market place fall into two categories, Universal Life (UL) and Whole Life (Participating or PAR). There are a number of differences between these two basic forms of permanent products, but in both cases they provide for an investment component inside the life insurance contract.

These permanent products allow for additional funds to be paid into the contract over and above the cost of insurance. These funds are then allowed to grow tax-deferred within the life insurance contract and within certain maximums that are provided under the Income Tax Act. Some contracts provide that this investment amount is paid out on death as part of the death benefit proceeds. In that case, the full amount is received tax-free.

One of the major differences between UL and PAR is the ability to choose how these additional funds are invested. UL produces allow the investor to make the investment decisions, whereas the life insurance company on behalf of the investor invests the funds inside a PAR product.

There is no rule of thumb as to which is better. This is dependent on the investor and his or her investment style. However, not all life insurance companies have both products available in the market.

What About the Kids that Farm Together?

An ever-increasing number of Canadian family farms have already gone through transfers to the next generation, and in some cases, several generations. Farm corporations or partnerships hold many of these multi-generational farm businesses. In some cases, several family members are involved in the farming business. There is increasing pressure to keep these farming units together in order to protect their economic viability.

These family units have gone beyond mom, dad and the kids. Now it isn't unusual to see cousins owning the shares of a family farm company together. This change in the farm family can create some challenges as time progresses and succession to the next generation is contemplated.

Many farm corporations are looking at the need to provide a mechanism to allow this transition to take place in the most efficient manner. This usually requires a written agreement amongst the shareholders or partners, which is often referred to as a "buy-sell agreement."

Buy-sell Agreements

A buy-sell agreement is a written agreement that sets out the steps to be taken with the shares of the company or the interest in the partnership when certain events happen. Possible events include death, permanent disability, divorce and bankruptcy. In addition to this, the agreement often provides a structure for a shareholder who wishes to sell their shares. The parties to the agreement include all of the shareholders or partners, as well as the corporation or the partnership.

The agreement usually provides guidance as to how the shares of the corporation or the interest in the partnership are to be valued, as well as who should prepare this valuation. It also sets out the payment period if the shares or interest are to be purchased by any of the parties to the agreement.

The balance of this article focuses on the need for a buy-sell agreement on the death of a shareholder of a family farm corporation. Many of the comments are also applicable to a family farm partnership that is owned by individual partners.

Buy-sell Agreements for the Family Farm

Without a buy-sell agreement, there is no mechanism in place for dealing with the shares when a shareholder dies. The shareholder's will, may leave the shares to a surviving spouse or child, and that individual becomes the shareholder of the farm corporation, when the shares are distributed from the estate.

In many cases, the family farm corporation shares are a major asset to the estate. In fact, the income of the deceased shareholder's family may be dependent upon the farm operation. The surviving spouse or child may have no active involvement in the corporation and unless they have a controlling interest, may find it very difficult to deal with the other shareholders to get cash from the company for their living requirements.

The buy-sell agreement provides a market for the shares, allowing the estate to receive cash (or partial payment). In addition, the surviving shareholders are able to acquire the shares from non-active family members.

Let's look at an example
Let's assume in our previous example that Lisa was interested in farming as well, and that Homer and Marge left the shares of Simpson Farms Ltd. (the family farm company) equally to Bart and Lisa.

Lisa and Bart have farmed together successfully for a number of years and Simpson Farms is worth approximately $5,000,000.

Lisa has one child; Homer Jr. He is a successful nuclear physicist and has no interest in the farm. Bart has two children, Seymour and Monty, both of who have returned to the farm after university and have expressed an interest in the family farm business. They are both turning out to be excellent employees.

Bart has been discussing the transfer of his shares to Seymour and Monty and both have expressed concern over the shares owned by their Aunt Lisa. They do not want to be involved as shareholders in Simpson Farms with Homer Jr. as they see this may cause a number of problems.

Buy-sell Agreement for Simpson Farms and Bart and Lisa

Bart and Lisa have spent time with their advisors and it has been suggested that they enter into a buy-sell agreement that provides a mechanism to purchase the shares from Lisa's estate on her death.

The agreement specifies that either Simpson Farms or its surviving shareholders have the right to purchase the shares from Lisa's estate at the time of her death. Should they exercise this right, the purchase price will be paid in equal instalments over a five-year period. The agreement also sets out the valuation procedures to be used in determining the share value.

Funding the Agreement
Lisa is concerned about the company being able to make the cash payments of $500,000 per year, (assuming today's current value for the shares). Although the company is very sound financially, the additional cash required will definitely put a strain on the cashflow.

In addition, she is aware of the tax liability that will result when the shares are purchased. A tax advisor has estimated that the current amount of this liability is $750,000, and noted that her estate will not have sufficient cash to pay the tax immediately.

It has been suggested that Simpson Farms purchase sufficient life insurance on Lisa's life so that the full value of the shares can be paid immediately. In addition, the tax advisor has indicated that there is a substantial tax saving if life insurance is used to fund the purchase of shares.

For example, if Lisa's shares are transferred to Homer Jr. on a tax-deferred basis, and then repurchased by the company using life insurance, Homer Jr. will be able to realize the full value of the shares without any income tax, a tax saving of $750,000!

Conclusion

Buy-sell agreements are an important tool when dealing with family farm corporations and the transition of ownership to the next generation. The critical issue of funding the agreement should be reviewed. In many instances life insurance is the most efficient funding mechanism from a cost perspective that ensures the viability of the farm business when a death occurs. In addition, corporate-owned life insurance may substantially reduce or even eliminate the tax liability when the shares are repurchased.

Prepared by:
Dereka Thibault, CA, CFP
Manulife Financial
Calgary, Alberta

For More Information:
Visit Alberta Agriculture and Rural Development's website at: http://www1.agric.gov.ab.ca.
Contact Alberta Agriculture and Food's Ag-Info Centre (toll-free) at 310-FARM (3276).

Source: Agdex 812-19. July 2003.