Corporate-Owned Life Insurance
For every decision in life, there is often a set of pros and cons that motivate us to carefully consider all aspects of the choice at hand. In reaching the final decision, it is not unusual to feel that you had to make a trade-off, whereby you gained a significant benefit while simultaneously foregoing something else. Corporate-owned life insurance is an example of one of these decisions. The shareholder will achieve certain benefits by causing his or her corporation to own the life insurance on his or her life, but the decision involves trade-offs that are worth noting.
The primary advantage of corporate-owned life insurance is that the premiums are funded from after-tax cash flow that has generally been taxed at a much lower level than the individual shareholder’s tax rate. The corporate tax rate applicable to the lower level of active business income is somewhere between 11% and 19%, depending on the province of residence. The top individual marginal tax rate is somewhere between 39% and 50%, also depending on the province of residence.
The primary disadvantage of corporate-owned life insurance is the loss of protection from creditors. When an individual owns his or her own life insurance policy and names a beneficiary within a prescribed class, the policy may be exempt from seizure by the individual’s creditors. Corporate-owned life insurance does not offer similar protection, and often a corporation could have a broader range of creditors. (This can sometimes be mitigated by having insurance owned by a holding company.)
The above two points are of importance during the lifetime of the person whose life is insured. Upon death, corporate-owned life insurance creates a credit to the company’s capital dividend account (CDA). This credit can be used in several post-mortem planning strategies that could reduce the overall income tax liability triggered by death. However, corporate-owned life insurance can also increase the income tax liability upon death. The cash value of a life insurance policy will add to the value of the shares of the company, and could impact eligibility of the shares for the capital gains exemption. If the sole shareholder passes away when the company owns a life insurance policy on his or her life, the deeming rules of the Income Tax Act will set the value of the policy at its cash surrender value. The same deeming rule would apply to all corporate-owned life insurance policies on the lives of individuals related to the sole shareholder. The deeming rule is not effective for any other insurance policies, which would be valued at their fair market value, taking into account such items as the health of the insured life.
The issue that needs to be recognized is that the cash value of the life insurance policy will increase the value of the shares and, therefore, the income tax liability triggered by death. At the same time, corporate-owned life insurance will create a CDA credit that can be used to reduce the income tax liability triggered by death. Consider the following example of two corporations, both with a $1,000,000 investment portfolio and a $1,500,000 life insurance policy. The corporations differ in the amount of cash value associated with the corporate-owned policy.
| Situation A | Situation B | |
|---|---|---|
| Investment Portfolio | $1,000,000 | $1,000,000 |
| Life Insurance | $1,500,000 | $1,500,000 |
| Cash value | 0 | $500,000 |
| Accrued income taxes | $230,000 | $345,000 |
| Taxes after planning | $115,000 | $230,000 |
The above analysis assumes a personal effective tax rate of 46% on ordinary income and 32% on dividend income.
In the above example, the ”extra” cash value attracted an extra $115,000 of income taxes. Cash value can be important to the policyholder as a liquidation value or as collateral security. The issue to bear in mind is the added cost of carrying cash value on the books of the company.
Corporate-owned life insurance can be a good decision for many reasons, but it is important to constantly be aware that other issues will arise as a result of the decision.
E.O. & E.
Disclaimer:
This commentary is published by the Institute in consultation with an editorial board comprised of recognized authorities in the fields of law, life insurance and estate administration.
The Institute is the professional organization that administers and promotes the CLU and the CHS designations in Canada.
The articles and comments are not intended to provide legal, accounting or other device in individual circumstances. Seek professional assistance before acting upon information included in this publication.
Advocis*, the Institute for advanced financial education.
(The Institue”), CLU, CHS, FHF.C and APA are trademarks of the financial advisors Association of Canada (TFAAC).
The institute is a wholly-owned subsidiary of Advocis. Copywrite TFAAC. All rights reserved. Unauthorized reproduction of any images or content without permission is prohibited.
Copywrite ISSN 0382-7038
Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.
