Owning a business can be rewarding, but the challenges most business owners face today can be daunting. Whether it is handling changing business conditions or managing employee expectations, the tasks at hand often push growth plans to the side.
One of the difficult challenges in a competitive business market is retaining the organization’s valuable key people. Losing one of these employees could be financially crippling to the future success of the business. The loss may not only be a drop in business revenues and net profit but also the costs associated with finding a replacement.
A financial strategy to protect against this risk to the business can work for both the owner and the valued employee. Let’s focus on an example that is typical of small business owners.
Jim and Pete own an environmental technology company (ABC Tech) that is growing rapidly in sales and net income. They attribute a lot of the success to the efforts and expertise of their vice-president in marketing and sales, Kevin Cash. To retain Kevin, the company needs to find a solution that reduces the risks of losing him due to illness, death, or disability. At the same time, it should be a benefit that increases his desire to stay with their company.
CRITICAL ILLNESS POLICY
We are going to focus on what would happen if Kevin suffered a life-threatening illness or disability. ABC Tech currently provides Kevin with the tax advantages of an RRSP and IPP to create a pension plan for him. By adding a critical illness insurance policy with a return of premium benefit with a shared ownership agreement, the company reduces the loss of a key employee and simultaneously provides Kevin with additional tax-free deferred savings.
Critical illness policies with a return or premium benefit typically have a 15-year duration. There are two components to this type of plan. First is the cost of the critical illness portion paid by the company, and there is a return of premium cost that is borne by the key employee. If a claim is made due to the loss of Kevin’s ability to work, the company receives a tax-free lump sum payment to cover the loss of revenue and new hiring costs associated with replacing Kevin and can protect the company by reducing debt during any transition period.
If there is no claim, then the insurance company returns all premiums paid over the 15 years to Kevin as a tax-free benefit upon cancellation or expiry of the plan. The incentive for Kevin to stay on as a key member of the company is encouraged by the fact that the benefit only pays out if the 15-year period is reached. This helps ABC Tech retain their key employee.
It is important to note that only one benefit can be paid out. If Kevin suffers a critical illness, then the company receives the benefit and Kevin will not receive the return of premium benefit. If no critical illness is incurred and the 15-year period or beyond is reached and the policy is cancelled, then both portions of the premium are paid to the key employee.
If Kevin decides to leave the company before the 15-year expiry period, he has a choice to carry the policy with him by assuming the premiums beyond that point. He may incur a taxable benefit if he acquires the policy for less than its fair market value. The details would be outlined in the shared ownership agreement.
The shared ownership agreement between the parties involved is a private contract and a legal one that should be reviewed or designed by independent legal representatives for both the company and the employee. Both parties should be required to sign for the cancellation of the policy to take effect, thereby protecting both the company and the key employee.
Present laws surrounding the tax-free benefits of critical illness are clearly defined but must meet the provincial definition of an accident and sickness insurance benefit. There is always a possibility that this could change in the future. So it is very important that these agreements be reviewed by both independent legal advisors and independent tax advisors.
At the time of writing this article, ABC Tech has determined that it needs $250,000 of coverage to protect against losses they may incur should Kevin suffer a critical illness. The company’s portion of the premium that covers the cost of the critical illness benefit for Kevin (a 45-year-old male nonsmoker) would be $3,350 annually. (We are using a level premium method of payment for illustration purposes.) The return of premium benefit portion, which would be paid by Kevin, is $1,667.50 annually.*
If a claim is made due to an illness defined under the plan, then ABC Tech receives a $250,000 tax-free payout that represents an average 20.42 per cent internal rate of return (IRR) on the premiums paid at age 60. The IRR is higher in earlier years and lower in
ABC Tech would use all of the $250,000 benefit to find a replacement employee, covering losses incurred from reduced business revenues and/or to fund a buyout of their key employee. Kevin could receive a portion of this benefit if the company agrees to this in the shared agreement. The benefit would be a taxable benefit to the key employee.
If there is no critical illness and the policy survives for the minimum 15-year period, Kevin receives $76,387.50 tax-free payout provided it is outlined in the shared ownership agreement and the contract details of the policy. Kevin would have to earn a 13.03 per cent guaranteed rate of return on the premiums he paid for this benefit to achieve a similar outcome. Kevin can use these funds for his personal use to supplement his long-term savings or to add to a tax-free savings account or to top up pension or RRSP contributions.
There are various permutations and combinations that can be used with critical illness policies to the benefit of both employer and employee and, in this difficult business environment, both parties should encourage the inclusion of such strategies for the future success of the business.
*At the time this article was written, the cost of the insurance and internal rate of return were guaranteed but may change in the future.
Steve Bokor is an insurance advisor and Ian David Clark is a certified financial planner and insurance advisor with PI Financial Services.