Our latest case study highlights a significant issue faced by many successful business families. Names and other key identifiers have been changed for privacy reasons, but the situation and key issues presented here are real.
Permanent life insurance is more than an estate tax solution for Canada’s business families. It also builds business capital and can be a source of liquidity – in all market conditions, including a global pandemic like the one we’re experiencing. Whether for a financial emergency, or to capture a business opportunity, life insurance can provide access to cash when you need it most.
The Redner family of Toronto had a long history of business success, dating back to the early 1900s. It began as a small metal parts manufacturing operation in the core of the city, and stayed small and profitable for two generations.
Then things started to evolve.
With the third generation in the 1970s, the two Redner brothers, Jim and Ray, saw an emerging opportunity. Ray, the oldest, was conservative by nature – and happy with the status quo. Jim had more of an entrepreneurial mindset, and was captured by the growth in real estate values as Metropolitan Toronto expanded. He saw big potential in real estate development.
Jim knew his brother was more cautious, so he proposed a pilot project. The Redners would continue its manufacturing operation. At the same time, they would test the waters and develop some of the land the family owned on the outskirts of the city.
It was a profitable endeavour – and opened Ray’s eyes to the potential in the future. The two brothers found that they enjoyed working together on the real estate project – the planning, building, and marketing. Within three years, they had an opportunity to sell the manufacturing business. They took the plunge and sold the business, redeploying the sale proceeds to their real estate development company.
THE GROWTH YEARS
By the 1980s, the Redner family had grown its real estate business – Redner Developments – exponentially. As Metro Toronto grew, so did the business. Before long, advisors to Jim and Ray were making them aware of a new ‘silent’ partner in their endeavour – the Canada Revenue Agency. The rapid growth in their business would be taxed as a capital gain when the business eventually changed hands down the road.
Jim and Ray understood the issue. It wasn’t impacting the business yet, but it would eventually. That was certain. As their own children approached adulthood, both brothers saw the potential for the business to remain family-owned and operated for the long term.
They wanted to ensure two specific things:
- First, that their children could continue to benefit from their hard work and success.
- Second, that Redner Developments would have the liquidity needed to cover the capital gains tax bill when it happened. If not, Jim and Ray would likely need to sell some parts – or even all – of the business. And that could lead to the loss of family control. Not good.
The challenge? The business was asset rich and cash poor. So, Jim and Ray needed to plan now to cover their future tax bill.
PUTTING A STRATEGY IN PLACE
The Redners and their advisors explored all of their options. They undertook a full review of the family’s capital to develop an estate planning strategy. As part of that review, they dug into how they could most effectively generate the funds needed to cover future taxes.
Everything was on the table. Jim and Ray looked at selling land and buildings and other assets in order to start a liquidity fund. But the impact to the family capital was significant and would hamper business growth. Plus, they hated the idea of selling off those assets, especially seeing that their best ones were the ones that could be sold at the best price. It was like cutting off their right arm.
But soon another option intrigued them: using life insurance to cover the liability. They learned about the cost-effectiveness of insurance and were pleasantly surprised. They also liked their ability to align the amount of insurance coverage to the specific estate tax need.
In reviewing their insurance options, both term and term-to-100 life policies had lower annual costs and were less expensive on the surface. But neither had any cash value, and Jim and Ray didn’t like that. The annual premium payments would constantly erode their family capital. As with many business families, the most important financial statement for the Redners was the balance sheet. It represented capital – and building capital was the brothers’ primary business focus.
Jim and Ray then examined one other insurance option – whole life insurance – and liked what they saw. The policy’s cash value sat on the family balance sheet as a capital asset. In fact, after the second year of ownership, the cash value life insurance had less impact on capital than the cheaper ‘no cash’ permanent plans. And it continued to improve as the cash value grew over time, with safe and consistent tax-sheltered investment returns.
As long-term planners, Ray and Jim had no hesitation in putting this whole life strategy in place.
THE FINANCIAL CRISIS – PUTTING CASH VALUE TO USE
Fast forward a couple of decades. Through their annual family capital reviews, the Redners continued to make regular insurance premium payments – and their business continued to thrive. Jim and Ray (and, by this time, their children) were now secure in the knowledge that they had covered any capital gains tax exposure.
What they didn’t know (or fully appreciate) was how valuable the cash value of their policies would prove to be.
In 2007, Redner Developments embarked on a major expansion plan. Using cash on hand and lines of credit, Jim and Ray doubled their land holdings for development. The GTA was burgeoning in development and the Redners wanted to capitalize.
Then came the 2008 financial crisis.
Banks quickly began to reduce their exposure to many industries – including real estate. Redner Developments was no exception. With a single phone call in September 2008, Jim and Ray’s long-term bank of 30 years reduced their business credit line and wanted them to pay it down with their cash flow. Boom.
Now the Redners had a problem. They had already committed to their expansion plans and land purchases. They had invested in the planning and infrastructure and expended a lot of capital. They couldn’t just stop now. But their bank had cut their access to the cash they needed in half. While the bank said they could restore most of the lost credit in the business, it would be at a significantly higher – and unaffordable – mezzanine financing rate.
From their annual family capital review meetings, the Redners knew they had built capital inside their life insurance policies and they knew it wasn’t ‘dead’ capital. So they contacted their insurance advisors with a single question. Could they use the cash value of their life insurance to get through this sudden cash crunch?
Yes, they could.
The Redners had insurance with tens of millions of dollars in cash value. Cashing in the policies and withdrawing these funds from the policy would lose their capital gains tax protection. And once withdrawn, tax rules prohibited them from putting the money back in. But borrowing against the cash value was easy to arrange.
The insurance advisors approached a rival bank on behalf of the Redners. Within days, the bank agreed to set up a $10 million line of credit at preferred rates. This allowed Jim and Ray to continue with their plans uninhibited. The Redners had the low-cost capital they needed to continue their expansion – even as the financial world was melting down around them.
THE NEED STRIKE AGAIN
Jim and Ray paid off the line of credit by 2010 as their land development plans moved forward successfully. And they had a renewed appreciation for the value of their rainy-day fund, should a future need or opportunity arise again.
And eventually it did.
When the global pandemic of 2020 hit, Redner Developments slowed considerably. Jim and Ray soon deployed the same strategy as 2008, using some of their ‘rainy-day cash’ to help maintain operations. But they used the bulk of it to take advantage of the business opportunities that arose. Less liquid developers were selling off assets to raise cash as the pandemic raged on. The Redners would soon buy these assets at reduced prices.
Thanks to this strong liquidity, Redner Developments – and the Redner family – would be well-positioned for continued growth when the economy recovered.
A LITTLE FORESIGHT BRINGS BIG BENEFITS
Looking back, the Redners hadn’t foreseen the financial crisis of 2008. Nor did they (or anyone) predict the pandemic of 2020.
But they did foresee the value of a growing capital asset on their balance sheet. While their primary focus was covering future capital gains tax liabilities, Jim and Ray’s secondary focus on capital was a key advantage. With the growing cash value of permanent insurance in place, they had provided their business with a source of liquidity for years to come, even amidst challenging market conditions all around them.
Paul Russell is a Freelance writer based in Toronto.