How Corporate-Owned Life Insurance Can Boost Your Liquidity

June 08, 2018

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Life insurance can help an owner-managed business manage its costs throughout the business lifecycle.  If an owner-manager dies, life insurance can help to protect the interests of their family or business partners. There can also be tax benefits.

Life insurance owned in a private company can be used in two general ways – to provide liquidity and to build wealth. This article will focus on liquidity; a subsequent article will discuss corporate-owned life insurance as a tool to build wealth

Liquidity benefits – three situations

There are three main situations where corporate-owned insurance can boost liquidity:
  • General key-person life insurance
  • Life insurance used to fund capital gains taxes on death
  • Estate equalization

In each situation, the type and amount of life insurance will differ depending on the needs of the situation. Also, as taxpayers’ insurance needs are constantly evolving, it is important to review the coverage on a regular basis.

Key-person life insurance

By its very nature, an owner-managed business is defined by the owner-manager. Key-person life insurance held by the company on the life of the owner-manager, or on certain other key employees, can give the company quick access to funds if the owner-manager or another key employee dies suddenly. In that way, the life insurance policy can act as business interruption insurance to allow the remaining owners time to deploy a succession strategy. In addition, many lenders or arm’s length investors require the company to carry key-person life insurance.

If the life insurance is required as a condition of financing, a portion of the premiums is deductible. However, the financing must satisfy a test.

Once that test has been satisfied, the actual amount of the premiums that can be deducted is determined using three factors: the “net cost of pure insurance,” the average loan balance during the year, and the total amount of life insurance purchased. You can deduct the portion of the premiums that relates to the net cost of pure insurance on the amount of the life insurance that would be needed to cover the loan balance in the event of the death of the insured person. Except for this portion, the premiums paid for life insurance in the corporation on the life of the owner-manager are not a tax-deductible expense.

Life insurance used to fund capital gains taxes on death

An owner-manager often faces their largest tax bill when they divest of their company. If the owner-manager owns the shares at death, this tax will come due either at death or on the death of their spouse, if the owner-manager’s shares passed to the spouse on the death of the owner. Life insurance can provide liquidity to fund those taxes.

Single shareholder

Let’s consider the example of Mary White. Mary at age 62 is the founder of Maryco, and is widowed with three adult children. Mary owns all of the shares of Maryco, and they are all common shares. These common shares are worth $5,000,000, and have a cost basis of $1,000.

If Mary holds these shares at death, there will be a deemed disposition of these shares. Assuming the lifetime capital gains exemption is not applicable, and assuming no change in the value of the shares or tax rates, the deemed disposition at death could create an estimated income tax liability of 25% of the gain (25% of $4,999,000, or $1,249,750). The 25% tax rate is an assumed hypothetical rate, which would apply when the top personal tax rate is 50%.

Mary could purchase life insurance to provide the funds to pay the taxes when she dies. However, in order to fund the life insurance premiums, funds would need to be withdrawn from Maryco in the form of salary or taxable dividends. Maryco will need to pay sufficient salary or dividends to allow enough after-tax proceeds to pay the life insurance premiums.

As an alternative, Maryco could purchase the life insurance policy and be the beneficiary of the life insurance policy. The premium payments will not be deductible for income tax purposes, but Maryco can fund the insurance premiums.

On Mary’s death, the life insurance proceeds will be received by the company tax-free. Any such proceeds over the cost basis of the life insurance policy can be paid as a tax-free capital dividend to the shareholder of the company, which for purposes of this article we will assume to be Mary’s estate. Mary’s estate can then use those funds to pay the tax bill that arose due to Mary owning the shares at death.

Multiple shareholders

Life insurance can also help in a scenario featuring multiple shareholders. Canadian controlled private corporations (CCPCs) often have a small group of shareholders who are related, or a number of unrelated shareholders who work together as business partners. The death of a shareholder can create a strain on the remaining shareholders.

It is common for a closely held company with multiple shareholders to enter into a shareholders’ agreement. The agreement goes beyond corporate law, to set rules on how the corporation is governed and how the shareholders deal with each other. Among its other purposes, the agreement should anticipate likely future events such as the death of a shareholder. It may be specified in the agreement that shareholders hold insurance on the other shareholders’ lives, in order to be able to purchase the shares owned by the deceased.

Alternatively, the agreement may specify that the corporation will hold life insurance on the lives of all of the shareholders in order to use the proceeds of insurance to redeem or purchase for cancellation the shares held by the deceased shareholder.

Estate equalization

In the situation of Mary White above, she died a widow with three adult children. If one or more of her children were active in the business, Mary may have transferred shares in the company to the children who are active in the business. This may have been carried out with succession planning before death.

For the children who are not active in the business, it may make more sense to leave them cash in the event of her death, rather than be shareholders in Maryco. The company can purchase life insurance on Mary’s life, which could be used to provide funds for the children who are not active in the business.

Advantages summarized

In the above three situations, we have shown where corporate-owned life insurance can help to provide liquidity. We can summarize three main benefits shown in the above situations:
  • The insurance can be purchased with corporate after-tax dollars, which is less expensive than paying taxable funds to the shareholder to purchase the insurance with personal after-tax dollars.
  • Premiums might be tax deductible if necessary to secure financing.
  • Life insurance proceeds can be paid out to shareholders without tax through a capital dividend.

Risks of corporate-owned insurance

Any tax planning using corporate-owned life insurance must also consider the risks. Some of the main risks are:
  • Risk of capital losses eroding the amount of life insurance proceeds that can be paid out tax-free to shareholders
  • Exposure of life insurance proceeds to creditors of the company
  • Coordination with other post-mortem planning

Risk of capital losses and exposure to creditors

The key tax attribute of corporate-owned insurance is the tax-free receipt of insurance proceeds, and the ability to pay them tax-free to shareholders by way of a capital dividend.

The overall ability of a corporation to pay a capital dividend depends on the balance in the capital dividend account. In simple terms, this is a tax account of the company that keeps a cumulative tally over the life of the CCPC of the non-taxed portion of capital gains, and the non-deductible portion of capital losses, less the amount of any capital dividends previously paid. The amount that can be paid as a tax-free capital dividend at any point in time depends on the corporate history of capital gains and losses, as well as the timing of the payment of previous capital dividends and other items that can affect the capital dividend account. For this reason, a significant capital loss in the company could reduce the amount that would otherwise be paid as a capital dividend as a result of the receipt of life insurance proceeds.  

Where a corporation owns life insurance policies, there is a risk that the proceeds of insurance may become subject to the claims of creditors. For example, where the policy has been pledged to a financial institution as security for corporate debt, the institution may choose to retain the proceeds of insurance to pay down corporate debt rather than release the funds to allow for the funding of a capital dividend. General creditors may also have a claim, depending on the financial state of the company.

Both of these issues can be mitigated by using a holding company to own the life insurance policy. However, if the holding company is the beneficiary of the policy, it should also be the entity that is making the premium payments.

Post-mortem planning

Many factors go into estate planning. Life insurance and in particular corporate owned- insurance should not be used in isolation, but should be considered as part of the overall plan. There are situations where the payment of a capital dividend from life insurance proceeds will reduce the effectiveness of other post-mortem planning.

Conclusion

Life insurance can be an effective tool to help manage the business and tax costs that will arise on the death of the owner-manager. Contact your BDO advisor to learn more about preparing for an unexpected death, helping to protect both your family and your business.


The information in this publication is current as of May 17, 2018.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it. 

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