Don’t Take CDA For Granted

Employees Beware! I recently saw the film by Michael Moore entitled “Capitalism: A Love Story”. In it was a pretty gruesome segment about how some large corporations like Walmart take out life insurance on their employees, essentially placing “bets” on their lives, and cashing in on their deaths, with all of the insurance proceeds going to their bottom lines, and nothing to the families of their employees. Pretty cold.

I can’t really comment on whether that story was embellished or slanted in any way, but I can comment on a Canadian case that recently caught my eye, and it’s a cautionary tale about proper planning and not taking anything for granted.

Mr. A entered into an employment agreement, whereby life insurance was taken out on him by his employer. Mr. A was also a shareholder of the company, and in the case of his death, the insurance proceeds would be used to purchase his shares. The agreement did not go any further.

Life insurance proceeds are tax-free to the beneficiary. In this case, the beneficiary was the company. In many cases, the tax-free nature of the life insurance is passed on to benefit the deceased’s estate through the use of a capital dividend (CDA) election. If not, the repurchase of shares by a company are taxable.

A CDA election is a choice that is made by the company, who is not legally required to make it, unless obliged to do so by contract.

In the case of Mr. A, the CDA benefit was not passed on to him, costing his estate to be liable for $250,000 in taxes. It may be that in this case, the intent was never to use the CDA for the share repurchase. In my experience, though, the omission is usually an oversight. The question of using the CDA to repurchase shares must always be addressed and resolved at the time the agreement is drafted.

The CDA was used by the remaining shareholders of the company which I’m guessing turned out to be a windfall for them. Mr. A’s estate attempted to sue for damages, but again, without a clearly defined obligation in the shareholders’ agreement, the company was not held responsible for the deceased’s tax liability.

What’s the moral of this story? Well, I can’t really comment on the character of the parties involved in this case (I’m sure they all have some good in them), but I can say this: Never sign a shareholder’s agreement without the help of a tax professional!