There are many reasons why the owner of a life insurance policy might want to transfer ownership of the contract. As time evolves, the initial ownership of the policy may no longer make sense. The need for a change in ownership could be triggered by an event such as a corporate reorganization, a change in personal circumstances such as a marriage or divorce or, perhaps, the availability of a more efficient ownership structure for funding the life insurance premiums.
In looking at the transfer of a life insurance policy, it is important to understand whether it will be viewed as a disposition of the policy because of the resulting tax consequences. The term “disposition” is defined within the Income Tax Act and is both inclusive and exclusive in nature. A disposition includes a surrender of the policy, taking a policy loan, maturity of the contract or a change by operation of law. The definition goes further and defines activities that are not considered a disposition. A disposition does not include the collateral assignment of a policy, a lapse if the policy is reinstated within 60 days of the end of the year, a payment of a disability benefit, an annuity payment, or a death benefit payment from an exempt life insurance policy.
Where a disposition occurs, a gain on the policy may be triggered. The amount to be included in income is generally equal to the proceeds of the disposition of the interest in the policy, minus the policyholder’s adjusted cost basis of that interest. This is not a capital gain, but is fully taxed like interest income. The wording of the provision contemplates that a policyholder could dispose of only a portion of a policy (i.e., an
‘interest’ in the contract). This could arise, for example, because of joint ownership or a split dollar arrangement, or more commonly, because of a partial cash withdrawal from a contract. It should be noted that a loss cannot occur on the disposition of a policy because of the wording of the income tax provision.
When it comes to the tax consequences of the disposition, the general rule is subject to a number of exceptions. For example, some exceptions allow a tax-deferred rollover while others use a deeming rule to establish the proceeds of the disposition.
The rollover and deeming rules apply depending on the relationship between the transferor (i.e., the current owner) and the transferee (i.e., the new owner). When a rollover of the policy is permitted, the policy transfer takes place at its adjusted cost basis, resulting in no policy gain and therefore no immediate tax consequences. When the deeming rule applies, the proceeds can be deemed to be the policy’s cash surrender value, which would trigger a policy gain if that amount is greater than the policy’s adjusted cost basis.
Spouses can transfer a life insurance policy between them on a rollover basis during their lifetime, or upon death if both spouses are resident of Canada at the time of the transfer. The rollover between spouses is automatic unless the transferor elects out of the rollover. The transaction will be deemed to have occurred at the transferor’s adjusted cost basis, and the transferee will be deemed to have paid the same amount.
A parent can transfer a policy on his or her child’s life to a child, on a rollover basis. The provision is broadly worded such that:
- the life insured under the policy must be a child of the transferor; and,
- the transferee must be a child of the transferor.
The child whose life is insured under the policy does not have to be the transferee (i.e., the same in (a) and (b)). Additionally, by definition the “child” can include a grandchild. This means that a grandfather could insure his son and transfer the policy to his adult grandchild. In order to complete a transfer on death, the parent would have to name the child as the contingent owner under the contract; otherwise, the title of the policy would first transfer to the parent’s estate, and there is no rollover provision from the parent to the parent’s estate nor from the parent’s estate to the child. If the child is a minor, consideration should be given to transferring the policy to the surviving spouse, who could in turn transfer the policy to the child at the appropriate time.
Where the transfer is between non-arm’s length individuals (other than a transfer to a spouse or child), a special deeming rule will apply to deem the transfer price to be the cash surrender value of the policy irrespective of the actual transfer price agreed upon between the parties. It should be noted that when a company is transferring a policy to its shareholder, the transaction should be completed at fair market value; otherwise, the shareholder benefit rule will apply a taxable benefit equal to the excess of the fair market value over the actual transaction price. Note that determining fair market value can be complex since such a determination must take into account numerous factors, including the insured’s state of health.
A life insurance policy does not fall within the rollover rules of section 85 of the Income Tax Act, which allow an individual to roll over certain capital and other properties to a corporation. However, a life insurance policy is eligible for rollover treatment during the course of a corporate wind-up or amalgamation.
There are many reasons why the ownership of an insurance policy might be changed, and it is important to know the income tax implications before any such transfer occurs. While this article provides a brief summary of some of those rules, the ITA provisions can be complex and one may require professional guidance in order to be prepared for the financial consequences.
E.O. & E.
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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.