CASE STUDY PROTECTING THE BUSINESS OWNER AND THE OWNER S FAMILY KNOWLEDGE EXPECTED OF: CFP Professionals Only Version 1.0.0, Updated 20170907 John, 42, works on contract in the field of computer animation. He earns $140,000 per year in gross revenue ($91,411 after taxes). John s wife, Sandra, 43, owns and operates a home-based, incorporated business in architectural design. She draws an after-tax income of $80,000 per year. Sandra mainly sells her services online and at trade shows. She also has an office in her basement for client meetings. The business has one part-time apprentice and a fulltime architect, Veronica. Sandra sees great potential in Veronica and would like to give her the right of first refusal to purchase the business in the event that Sandra dies prematurely or becomes permanently disabled. Sandra estimates that in the event of her or Veronica s death or disability, the business would lose about $100,000 and $50,000 in revenue, respectively. Currently, the business has $150,000 in the bank, $50,000 of which Sandra needs to maintain as working capital. The remaining balance is earmarked for a down payment on new building space as she considers expanding the business. Sandra estimates that an expansion might double the net income of the business. The couple has a $92,308 mortgage, with five years remaining on the amortization. The couple plans to apply their mortgage payments to their retirement savings. In the event of premature death, they have creditor life insurance. The couple has six-year-old twins, Amanda and Alex. At birth, the couple set up a whole life insurance policy worth $200,000 on John s life, paid up to age 65. According to their insurance agent, it would build up a cash surrender value that could be used for emergency purposes, or to supplement their incomes in retirement. John also obtained a disability insurance policy that would pay a tax-free benefit of $1,500 a month, enough to cover the mortgage payment at the time. The only insurance coverage Sandra has is extended health benefits that she and John have through a personal health plan. Should John or Sandra die prematurely, the survivor would need to maintain the family income to continue funding important plans, such as Registered Education Savings Plans (RESPs) and Registered Retirement Savings Plans (RRSPs). The survivor would also want to consider taking a one-year leave of absence under the circumstances. Such income will be required until John is 65. Any insurance proceeds could be invested in a balanced portfolio (50-50 split between equities and fixed income) at an expected return rate of 3.5 percent after fees. The death of the couple s close friend at age 49 was the catalyst that the couple needed to review their insurance needs. Wendy had been diagnosed with cancer three years before her death, and was not able to return to work during that time. John and Sandra would like to ensure that, if they experience a similar situation, the supporting spouse could take up to two years off to help the other; they would also like to have $100,000 set aside for home renovations, if needed. Based on the care that their friend Wendy received at the local hospice, they would like to donate $25,000 to the charitable foundation that funds that hospice, upon the death of the last spouse. The couple lacks emergency savings. Sandra and John own cars in their personal names, however Sandra utilizes hers mostly for business purposes. They would like to know where their risks lie, and learn about potential solutions. Page 1
Knowledge Expectations Insurance Needs The CFP professional should be able to: Identify that an inflation rate of two percent may be suitable for projections, based on the information provided in the Projection Assumption Guidelines. Estimate the financial needs of the family if John or Sandra should predecease one another, or die concurrently. Life Insurance Needs Analysis John and Sandra If John Dies If Sandra Dies Needs After Death Mortgage $92,308 $92,308 Final expenses (Funeral) $25,000 $25,000 Immediate Needs $117,308 $117,308 Income replacement for deceased spouse 1 $1,427,877 $1,546,469 Income replacement for one year for surviving spouse $80,000 $91,411 On-Going Needs $1,507,877 $1,637,880 Charitable Bequests $25,000 $25,000 Goals $25,000 $25,000 Total Insurance Needs $1,650,185 $1,780,188 Insurance Available Creditor protection for debts $92,308 $92,308 Group insurance coverage $200,000 $- Personal insurance coverage $- $- Insurance Available $292,308 $92,308 Total Insurance Available $292,308 $92,308 Surplus/Shortfall -$1,357,877 -$1,687,880 1 Income Replacement if John Dies: 65-42 = 23 years at $91,411 net income. Insurance required: N = 23; I/Y = 3.5% - 2.0% = 1.5%; PMT = $91,411; FV = $0. CPT PV = $1,427,877 Income Replacement if Sandra Dies: 65-42 = 23 years at $80,000 net income. Insurance required: N = 23; I/Y = 3.5% - 2.0% = 1.5%; PMT = $80,000; FV = $0. CPT PV = $1,546,469 * Projections based on 2016 Projection Assumption Guidelines Surviving spouse could expect to earn gross rate of return = 6.3%(0.50) + 3.9%(0.5) = 5.1% Surviving spouse could expect to earn net rate of return after fees = 5.1% - 1.6% = 3.5% Inflation rate = 2.0% Page 2
Explain to Sandra that she may consider establishing a holding company for ownership of the building she plans to purchase for the business. Doing so will help protect the asset from creditors of her operating company. The holding company may also be used to house investable assets that Sandra may purchase with future income from the business. Sandra should consult with tax and legal specialists to assess the feasibility and suitability of this opportunity. Explain that, should John or Sandra die, the greatest financial strain on their family would be the loss of their respective incomes. Their family would face a shortfall of cash flow, resulting in insufficient resources to maintain their current lifestyle. Their retirement and education goals would also be put in jeopardy. To protect against this risk, they may consider purchasing additional life insurance in the amounts of $1.36 million for John and $1.69 million for Sandra, naming each other as beneficiaries on their respective policies. They may wish to investigate the benefits associated with an insurance trust for their children, should they die together. The couple should consult with an insurance specialist to determine the optimal type of insurance to meet their needs. Explain that the couple has temporary and permanent insurance needs. John and Sandra s education goals for their children, which require funds in 12 years, and income replacement needs for the next 23 years, are considered temporary. The couple may consider the purchase of term insurance approximating the duration of their need. Their permanent need of providing $25,000 as a charitable donation may be achieved using a joint, last-to-die life insurance policy. The couple can choose to name the charity as the beneficiary of the policy, or bequest the policy to them in their will. In both cases, they can elect to have the donation of $25,000 be used on their final tax return. Alternatively, they may choose to assign the policy to the charity, and receive a donation receipt for the amount of their annual premiums each year. The couple should consult with an insurance and tax specialist for appropriate products, premiums and impact on their taxes. Explain that John s whole life policy should be reviewed by a licensed insurance representative. Factors that should be considered include premium cost, guaranteed growth of the cash surrender value, tax impact and impact on their goals, among others. John may consider supplementing his current insurance coverage to ensure he has a total of $1.36 million in life insurance coverage. Explain that Sandra should obtain a life insurance policy, or policies, to take advantage of lower taxation rates available to businesses. She may consider setting up her holding corporation as the policy holder and beneficiary of that policy, or policies. Doing so would lower the revenue required to cover the cost of the premium compared to paying the premiums with her personal after-tax income. Under this option, Sandra should name John, the ultimate beneficiary of the proceeds, as a shareholder of the corporation. This would ensure that, upon her death, the insurance proceeds can flow through the company s capital dividend account to John tax-free. Sandra should consult her legal, tax and insurance specialist(s) before taking steps toward this goal. Explain that the couple may review their creditor insurance with the help of an insurance specialist. A creditor insurance company generally charges level premiums based on the average cost of the insurance throughout the expected lifetime of the mortgage. In many cases, this results in higher premiums than those of the individual term insurance. However, during the latter years of mortgage payments, creditor insurance may be more economical than term insurance. Creditor insurance provides declining coverage over the amortization of the mortgage. Term insurance policies provide constant coverage over the term, and are payable to a named beneficiary, not the mortgage holder as is the case with creditor insurance. This flexibility provides the beneficiary with the opportunity to utilize any excess insurance benefits for their goals, something that John and Sandra could benefit from. Should the couple find that it may be beneficial to replace their creditor insurance with personal insurance, they should ensure that a policy is in place before cancelling their existing overage. They may wish to discuss the appropriate type of insurance with an insurance specialist. Page 3
Explain that John should get disability coverage that will replace his net monthly income if he is unable to work in his job due to disability. This is especially important since he will not qualify for employment insurance or workers compensation benefits. Given the couple s lack of emergency savings, and inability to fund their lifestyles by themselves for long periods of time, John may wish to select policies that have short waiting periods. John should consult his current policy provider to ensure that his current policy is based on an inability to fulfill the duties of his own job. If it is not, he should investigate replacing the policy with one that meets this need. If his current policy does provide a benefit based on his own occupation, then he should supplement it with an additional policy that covers the difference, which amounts to $6,118 tax-free per month, payable to age 65. John should work with an insurance specialist to obtain appropriate coverage. This is important given that his request may be limited by policy maximums, or restricted coordination between plans based on the higher income required. Explain that Sandra should also get disability coverage that will replace her monthly income if she is unable to continue working at her own job due to disability. Similar to John s, a policy payable to 65 would provide her with the greatest protection. Sandra may consider paying for her disability insurance premiums through her corporation. By doing so, she can choose to deduct such expenses and receive any disability-related benefits on a taxable basis. In this case, she would need to ensure her policy provides benefits of $6,667 per month to replace her current income. An additional option is to have the corporation pay the premiums and provide Sandra with a shareholder, taxable benefit to ensure that she receives any benefits tax-free. Sandra should consult her tax specialist to determine which set-up works best for her and her business, including the opportunity to increase her coverage if her income grows with the expansion of the business. Explain that the couple should consider obtaining critical illness insurance to protect them if one of them becomes critically ill. Based on their request, Sandra should obtain $282,822 2 so that John could take time off to be with her should she become ill. John should obtain $260,000 3 for similar reasons. This assumes that their respective disability insurances will cover the critically ill spouse s income. Caution Sandra to avoid paying her critical illness insurance premiums through her business, unless she receives a shareholder taxable benefit. Failure to do so would result in the lump sum benefits becoming fully taxable. The couple should investigate appropriate solutions, including the types and number of illnesses to be covered, with an insurance specialist. Explain that the couple should consider buying long-term care insurance. While disability insurance may provide the couple with enough funds if they are unable to work, the proceeds received from their disability plans will cover expenses related to the family and the household. Should either of the spouses require additional, specialized care, for example in a long-term care facility, because neither they nor the family can take care of them, further coverage would be needed to cover such expenses. If adequate coverage is not in place, the family may not be able to maintain their lifestyle and achieve their goals, as their income and savings may be required to cover the cost of the added care. The couple should investigate appropriate insurance types and coverage with an insurance specialist. Explain that the couple should confirm with their auto and home insurance providers that their coverage is payable if they need to make a claim related to their commercial activities. This is particularly important for liability-related claims, which can have a catastrophic effect on the couple s personal finances if coverage is not in place. Explain that Sandra should locate an insurance specialist familiar with the architecture and design industry to ensure her insurance needs related to the liability for customers, employees and end-users, are met. A specialist will also be able to provide relevant direction on any requirements that Sandra may be responsible for to maintain business-related insurance coverage. 2 2 X John s earnings of $91,411 + $100,000 for renovations = $282,822. 3 2 X Sandra s earnings of $80,000 + $100,000 for renovations = $260,000 Page 4
Explain to Sandra that she should also consult legal and tax specialists to draw up an appropriate buy-sell agreement. Under the agreement, Veronica should be provided the right of first refusal to purchase the business, if Sandra is not able to maintain the business due to death or disability. One method for Sandra to fund the buy-sell agreement is through the use of insurance. Sandra may consider establishing a life insurance policy through the business to fund the agreement, or ask Veronica to establish one where Sandra is the life insurer. Explain that Sandra may consider establishing a key-person insurance in case of her, or Veronica s, incapacity or death. The policies should cover lost revenues to the corporation, $100,000 and $50,000 respectively for each of them. CFP, CERTIFIED FINANCIAL PLANNER and are certification trademarks owned outside the U.S. by Financial Planning Standards Board Ltd. (FPSB). Financial Planning Standards Council is the marks licensing authority for the CFP marks in Canada, through agreement with FPSB. All other are registered trademarks of, unless indicated. 2017 Financial Planning Standards Council. All rights reserved. Page 5