Life insurance sounds boring and straightforward right? Not so fast! When you have corporate owned life insurance, it gets a lot more interesting. Why? Because it directly involves reducing and eliminating tax. Now that I have peaked your interest let’s do a deeper dive into the ins and outs of corporate owned life insurance.
I did mention tax so let’s cover that first with some background info. Tax integration is the idea that a person earning income as an employee should pay the same amount of overall tax as someone that earns income from his/her business first and then pays himself/herself dividends. A company that is a Canadian Controlled Private Corporation (CCPC) pays a low rate of tax on the first $500,000 of active income. It is only when those retained earnings are paid to the shareholder that the second layer of personal tax is paid. Due to this two-step nature of tax when a corporation is involved, there is an advantage of paying for your life insurance corporately. For example, in order to pay for a $10,000/year policy, a CCPC in Alberta would only need to earn $11,236 before tax versus an individual in the top tax bracket earning $19,231 before tax. Therefore, the cash flow required to cover your life insurance premium is less. Said another way, using the same cash flow, you can buy more insurance with corporate dollars than you can with personal dollars.
For a corporation to receive the insurance proceeds tax free, it should be both the owner and beneficiary. Oftentimes, the shareholders have purchased the corporate policy to also cover personal needs. Fortunately, there is a mechanism to flow a portion, and potentially all of the insurance proceeds, to the shareholder’s estate tax free. When the insurance payout comes into the corporation there is also a credit to a notional account called the CDA, or capital dividend account. The CDA is calculated as the death benefit minus the ACB-adjusted costs basis. The CDA is important because it can be paid tax free out of the corporation immediately or at any time in the future.
Although I mentioned tax savings on premiums and tax-free payments from the capital dividend account, there is yet another tax advantage while the corporate life insurance is in place. That is, premium deposits into a life policy are able to grow tax sheltered. It’s important to know that many insurance policies support extra deposits into them, thereby becoming preferred tools for the accumulation of corporate assets. These assets do in fact show up on the corporate balance sheet and may provide future opportunities for the corporation or the shareholder(s). Accountants usually understand this, but sometimes lack experience on how to properly record it. I regularly train accountants on how to record policies on the financial statements during quarterly counsel sessions that my firm provides. Proper documentation is beneficial for the business and shareholders, now and into the future when opportunities arise.
Since the corporate life insurance can be an asset on the balance sheet, it directly strengthens your banking relationship and capacity for additional lending. Over time, there is often a yield enhancement over traditional investments while the insured is alive. Depending on the insurance structure you can chose to control the investment decisions within the insurance policy or you can have the insurance company make them for you. Either way, you can throttle the level of risk to your desired level, reduce it, or even eliminate it.
Recent changes to the tax rules have increased the popularity of corporate owned life insurance. Previously, many corporations would retain earnings and invest them to avoid or delay personal taxes. However, since 2018, the small business limit is reduced by $5 for every $1 of passive investment over $50,000 in any given year. Losing the small business rate radically increases the company’s tax bill. Fortunately, assets within an insurance policy do not form part of the calculation, which is technically called the AAII, or Adjusted Aggregate Investment Income. An offset to this win is that cash value of the policy also contributes to the value of the shares upon death, which can contribute to overall taxable gain.
You can do some creative planning like the use of life insurance tracking shares. This topic itself would require another article but suffice it to say, there is a way to reduce or eliminate the tax effect of the Cash Surrender Value (CSV) on the death of the insured. Another approach may be to structure a shared ownership, also known as split dollar life insurance policy, where the corporation owns the death benefit and the shareholder or Holdco owns the CSV. Special attention is required to ensure that the portion that each party pays is considered reasonable and it’s a good idea to have a written agreement to outline those details. Alternatively, if a policy was structured with no cash value, there would not be an increase to share value and an ancillary perk is that the overall share value of the corporation would be lowered immediately as those assets are put towards premiums. This can both retain the small business rate and restore the funds tax free upon death.
It is also important to understand some cautions with corporate owned life insurance.
Firstly, I will point out that the corporate owner needs to be the same as the beneficiary; otherwise, you can trigger a shareholder benefit – which accountants know as a 15(1) tax issue. This attracts the highest level of tax with no offsetting deductions.
Secondly, many corporations evolve and change over time. They may expand, get sold or collapse from market or personal causes. So, longevity of the corporation is relevant to all of the tax benefits we have previously discussed. This is why corporate life insurance is often held within a holding company as opposed to an operating company. Holding companies tend to remain in place, without being sold or transferred, thereby not triggering taxable dispositions.
Thirdly, corporate owned policies are generally not creditor proof, which is different than personally held policies.
Fourthly, and less commonly, residency of the corporation can be important. That is, if you become a non-resident, it can form part of your Eligible Capital Property (ECP) and result in you needing to pay tax on it when you do taxes in the other country, or it may call for more reporting.
Fifthly, the policy contributes to the calculation of taxable capital for the federal small business deduction, which starts to phase out after 10M of capital and is eliminated once there is 15M of capital.
If you plan on selling or winding up your corporation, there can be tax consequences of doing so. Worth noting again is that if you sell, the cash value of the insurance policy may add value to the shares of the corporation and therefore cause the sale price to be higher.
The potential purchaser may not be willing to pay for a policy on another person’s life or have the financial capacity for the higher price. It is not cut and dry when transferring an insurance policy out of or between corporations in order to purify and prepare for a sale, as it is considered a disposition and may attract tax. Additional factors, like the health of the person and replacement options to the policy contribute to the actual valuation of the policy.
I recommend that this be done by a proper actuarial firm and not just by the advisor or accountant. Remember, the valuation here is a combination of the product attributes and the individual’s health. Proper guidance on transferring policies is required to reduce or avoid tax and shareholder benefit issues. One unique method to not trigger tax is to transfer the policy via a dividend in kind. Again, the accountant needs to be involved to determine if there is sufficient safe income to do so. It is a best practice to work in tandem with the accountant whenever doing transfers, as there are nuances.
For whatever reason, the corporation may decide to cancel or redeem the policy. As a corporate asset, a potential tax trigger is calculated when the CSV is greater than the ACB. Unfortunately, these gains are treated as ordinary income. I advise people to understand this calculation prior to taking action as there may be new cash flow required to pay those taxes. Your insurance advisor can obtain all of these numbers for you or the accountant beforehand. Accountants regularly bring me into corporate life insurance cases to navigate through these factors. Rather than cancelling the policy when it’s no longer needed, you can donate it to a charity and receive immediate or deferred tax benefits.
Another important consideration is a company’s capital gains exemption. Corporate insurance is not considered to be an active asset, but rather a passive asset. The value of this passive asset is generally considered the CSV of the policy. In order to retain the capital exemption, the policy may want to be held within a holding company instead of the operating company.
Corporate life insurance can be used for a variety of reasons. Commonly it is used for buy-sell agreements, a sinking fund to buy out a partner, a growth asset or even personally as retirement income stream. Life insurance proceeds are key to liquidity for buying out deceased shareholders shares. Depending on the shareholders agreement, the company may buy out or redeem shares or flow capital dividends to the shareholders.
There are also multiple ways to access the value of a corporate life insurance policy while the insured is alive. The most popular option is to use the policy as collateral for a bank loan. This way, there is no tax triggered and generally the interest rates are around prime. It does require financial underwriting, so this may not work for every company. If the corporation uses the loan to reinvest in the business or another business or investment, the interest becomes tax deductible. Additionally, there is another deduction called the NCPI-Net Cost of Pure Insurance available. In a general sense the NCPI is considered the annual mortality charge for insurance. It’s important to note that you may deduct the lesser of premiums and NCPI.
There is also potential for the shareholder to use the corporate policy as collateral for a personal loan. In such scenarios, it is common for the corporation to charge the shareholder a guarantee fee to counter shareholder benefit issues for the use of the corporate asset. A streamlined alternative to a bank loan is a policy loan direct from the insurance company itself, although the interest rate is higher rate than bank loans. Note that the policy loan does become taxable when the amount of the loan is greater than the ACB.
Another way to access value is to receive yearly dividends from the policy. This attracts some level of tax, but it is spread out over time.
You can also do partial redemptions of the policy itself. This also unlocks the value over time but again is taxable if the CSV is above ACB. Plus, the coverage amount itself is reduced so caution is required not to undermine the core insurance need. You could also redeem the entire policy; however, this usually triggers the greatest amount of tax.
If the insured person becomes totally disabled, the corporation can access the cash values tax free. Note that accessing the cash value in this way may impair the eventual total death benefit coverage.
A lot of business owners are happy to learn about corporate life insurance but need to be prepared to provide additional information to the insurance company. Gathering documents such as financials, the certificate of incorporation, the business number, the articles of incorporation etc. can take additional time and coordination with the business owner, the accountant and lawyer.
If a death claim occurs, these professionals may also require additional time to properly calculate, record and facilitate the insurance payout from the corporation to the shareholder. In some circumstances you may want to bridge that gap in time with a small personally held insurance policy.
If there are multiple shareholders, it is critical to have clear directions within the shareholders agreement indicating that a buyout is done via the capital dividend, otherwise it could be a taxable dividend to the estate.
There are a lot of interesting elements of corporate owned life insurance policies. Related to them are nuances and special provisions that require specialized insurance knowledge. With proper counsel and collaboration between the client, accountant, lawyer and insurance advisor, you can experience the game changing benefits of corporate owned life insurance. Now that is exciting!
Author’s Background:Steve Meldrum is a contrarian by nature. He is the corporate insurance specialist at Swell Private Wealth, a boutique firm specializing in corporate tax strategies for medical and dental professionals. His advisory practice also supports quarterly training for national and regional accounting firms, lawyers, and private bankers on advanced insurance strategies. Established as a thought leader for the dual advisor approach, he consults other financial advisors in collaborative planning. He loves the challenge of solving complex problems in creative ways with a mantra that simplicity brings clarity.
