The insured annuity or “back-to-back” strategy is a popular concept to provide retirement income or to enhance the rate of return on the fixed-income portion of a portfolio. The basic strategy involves the purchase of an annuity to provide a lifetime stream of income, and a life insurance policy to replace the capital used to fund the annuity upon death.
When the insured annuity is personally owned, the annuity can qualify for prescribed tax treatment, which levelizes the annual taxable portion of the annuity. However, sometimes the capital to be used for the annuity is corporate-owned. Setting up an insured annuity under corporate ownership has some drawbacks but also some interesting additional features.
The first drawback is that the annuity will not qualify for prescribed tax treatment when it is owned by a corporation. This means that the annuity is taxed much like a mortgage; the first payment is mostly interest and little principal while a payment twenty years later is mostly principal and very little interest. As much as this is a drawback, there is a silver lining to the disadvantage – the after-tax cash flow from a non-prescribed annuity increases every year, creating an element of inflation protection.
An advantage created by corporate ownership of the insured annuity is the lowering of income taxes realized in the estate. Upon death, a person is deemed to have disposed of all of his or her capital assets, which would include the shares of the corporation. The value of those shares would reflect the assets in the company, which would include the life annuity and the insurance policy on the life of the shareholder who just passed away.
The Income Tax Act contains a special deeming rule for purposes of valuing the corporation’s shares upon the death of a shareholder. This rule provides that the value of a life insurance policy on the life of the deceased shareholder is its cash surrender value, irrespective of any other valuation technique.
The value of a life annuity might be determined by the same deeming rule, because by definition a life annuity is considered to be a life insurance policy under the Income Tax Act. However, a life annuity would not usually have a cash surrender value. The CRA has previously stated that a life annuity is not a life insurance policy for purposes of the deemed value of shares held upon death. In that case, valuing the life annuity is problematic. A valuator would likely take into account the criteria listed by the CRA in Information Circular 89-3 for valuing life insurance policies, including such items as state of health, replacement value, etc. For example, one would generally not buy a life annuity on an individual with a short life expectancy because the capital investment may never be fully returned in the form of annuity payments. Needless to say, the value of a life annuity would probably decline in value very sharply within a few years of issue.
If the value of the life insurance and life annuity are both low, it will reduce the value of the shares of the corporation. The lower share value means a lower accrued capital gain resulting in a lower tax consequence pursuant to the deemed disposition rules at death.
The second advantage of a corporate-owned insured annuity is the credit to the company’s capital dividend account arising because of the receipt of life insurance proceeds. The credit would allow the executor or beneficiaries to draw out tax-free capital dividends or structure postmortem planning to further lower the income tax liability of the estate.
Consider the following example of a corporate-owned insured annuity in the amount of $500,000 on a male aged 70, in good health.
|Annuity payment (annual)||$39,992||$39,992||$39,992||$39,992|
|Taxable portion of payment||Zero||$6,219||$4,652||$3,431|
|Corporate tax (net of RDTOH)||Zero||$1,244||$930||$686|
|Insurance premium (annual)||$18,944||$18,944||$18,944||$18,944|
|Dividend to shareholder||$21,048||$19,804||$20,117||$20,361|
|Equivalent rate of return||5.3%||5.0%||5.0%||5.1%|
The above table shows the tax liability associated with the annuity payment net of refundable dividend tax on hand (RDTOH). The company’s income tax liability is calculated taking into account taxable dividends paid in the year which would generate a refund of the refundable portion of corporate income taxes. This means that dividends associated with the corporateowned insured annuity must be paid in the tax year in which the taxable income arises.
The equivalent rate of return is much higher than that available in the market place today for conservative interest-bearing investments. However, the individual should be aware that the investment is locked-in and does not have any liquidity.
Additionally, as discussed above, the insured annuity adds little or no value to the tax value of the corporate shares, which could be worth $500,000 less from an income tax point of view. This could save the estate between $100,000 and $125,000 in taxes depending on provincial residence. The company has the same economic value, because the life insurance is designed to replace the amount of capital invested in the life annuity.
Planning involves taking into account the facts of the situation and using new strategies to rearrange the taxpayer’s current situation to better accomplish the specific objectives. Sometimes this means reviewing strategies typically designed for individuals and testing them in corporate scenarios. Of course, as with most planning strategies, there are numerous other details to be considered in implementing any plan, and the advice of a professional tax and estate planning advisor is crucial.
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.