Living Value in Life Insurance

The primary value of a life insurance policy is in the benefit that arises upon death. The death benefit creates capital for the insured’s beneficiary, or helps pay taxes and expenses that arise upon death. In addition, value can be generated during the insured’s life time. Using a life insurance policy to accumulate funds for future use such as retirement income has been a long-standing financial planning strategy. As financial products have evolved, planning with a life insurance policy has transitioned to a broader array of ideas with increased complexity.

While there is no income tax relief on deposits into a life insurance policy, generally the investment earnings on the cash value that accumulates within the policy do not attract annual taxation. When the policyholder wants to access the cash that has accumulated, a partial withdrawal may be possible. This may trigger a policy gain if the amount withdrawn (proceeds of the disposition) is greater than the adjusted cost basis allocated to the withdrawal.

Accessing cash within a policy has been facilitated through a strategy that utilizes a collateral loan to access the build-up of cash value. The proceeds of the loan are acquired without triggering immediate tax consequences, while the loan is secured by the cash value in the policy. Upon the death of the life insured, the loan is repaid with the proceeds of the policy. In this way, funds have accumulated on a tax-sheltered basis, and have been accessed tax free, and any residual death benefit is paid to the beneficiary on a tax-free basis. Interest paid on such a loan is not deductible for income tax purposes.

A further refinement of this strategy involves the accumulation of surplus corporate funds inside a corporate-owned life insurance policy. An individual may decide to accumulate funds in his or her private company because the corporation pays tax at a lower rate, thus making after-tax life insurance premiums cheaper to the corporation. For example, $100,000 of income earned personally generally results in an immediate tax cost of about $45,000, while this same amount of active business income at a corporate level will trigger a tax-cost of about $15,000 to $18,000, depending on the province of residence. The lower cost of corporate funds thus makes this strategy attractive. When funds have accumulated inside the corporate-owned life insurance policy, the shareholder could, eventually upon retirement, cause the company to borrow against the policy and use the funds to pay out a
dividend to the shareholder.

Alternatively, the shareholder may decide to borrow directly from the bank and ask the company to secure the loan by collaterally assigning the corporate owned life insurance policy. This arrangement has to be carefully constructed and certain protocols observed in order to avoid any unexpected income tax implications. The following points should be considered:

• CRA has indicated that it will assess a taxable benefit equal to the amount of the entire loan if the corporation is guaranteeing a loan that the shareholder is unable to repay.
• Another taxable benefit will arise equal to the value of the guarantee being offered by the company by collaterally assigning the corporate owned life insurance as security for the loan to the shareholder.
• Another taxable benefit may arise if the company is called upon to repay the loan under the terms of the guarantee for the shareholder.
• Finally, a taxable benefit may arise upon the death of the life insured if the lending institution claims against the payment of life insurance proceeds before the payment is made to the company.

The shareholder should pay a fee to the company for guaranteeing his or her loan. The value of the guarantee could be determined as the difference between the bank loan rates with and without the guarantee. Alternatively, the value of the guarantee could be determined by the open market and the interest rate a financial institution would charge the shareholder under similar circumstances.

The guarantee offered by the company to the shareholder for the loan should be documented in an agreement. The agreement should include specifics as to the fee to be charged and the frequency of its payment. As well, the agreement should deal with the results if the company were called upon to pay towards the shareholder’s loan. In that case, the guarantee agreement should make the company the creditor, which avoids an immediate shareholder benefit. It should be noted, however, that the shareholder has to repay the loan before the second following year-end of the company; otherwise, the entire amount owing becomes a taxable benefit.

Planning with life insurance can offer interesting opportunities. However, some of these alternative plans can be very complex and may attract the attention of the Canada Revenue Agency if they are not set up and carefully maintained over the life of the structure. It is crucial to demonstrate that the alternative chosen is the best given the policyholder’s specific circumstances.

E.O. & E.

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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.

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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.