An owner-managed company can use life insurance to better handle costs all through the business’s lifecycle. Corporate owned life insurance can assist with safeguarding the aspirations of an owner-manager or business partners if they are no longer present. There could also be tax advantages.

In light of infinite banking in Canada, a private company’s life insurance can be utilized in two ways: to create wealth or provide liquidity. This article will concentrate on liquidity; a successive article will go over corporate-owned insurance coverage as an instrument for wealth accumulation.

Benefits of liquidity – three scenarios

There are three main scenarios in which corporate-owned insurance can increase liquidity:

• Estate equalization
• Life insurance utilized in financing capital gains taxes on death
• General key-person life insurance

The kind and amount of life insurance required in each scenario will differ based on the requirements of the situation. Furthermore, because the needs of taxpayers are always changing, it is critical to evaluate coverage on a constant basis.

Key-person Life Insurance

An owner-managed business, by its nature, is defined by its owner-manager. In case the owner-manager or another key employee passes away unexpectedly, the company can quickly obtain funds through key-person life insurance. As a result, the life insurance coverage can function as business interruption insurance, giving the surviving owners enough time to implement a succession plan. Furthermore, many lenders or third-party investors demand that the company carry key-person life insurance.

A fraction of the premiums is eligible for deduction if life insurance is needed as a condition of funding. However, the funding must pass a test.

After the test is met, the exact amount of deductible premiums are calculated by employing three factors: the overall sum of life insurance acquired, the year’s average loan balance, and the “net cost of pure insurance.” You may also deduct the percentage of the premiums related to the net cost of pure insurance on the value of corporate owned life insurance required to repay the outstanding loan in case the insured person passes away. With the exception of this component, the premiums paid in the corporate entity for life insurance on the owner-managers life are not subjected to tax deductions.

Life Insurance Utilized in Financing Capital Gains Taxes on Death

When an owner-manager sells their business, they mostly encounter their highest tax bill. When at the time of death, the owner-manager owns the shares, this tax will be due either during the time of death or on the partner’s death, if the shares of the owner-manager were passed to the partner upon the owner’s death. Corporate owned life insurance can not only help pay for those taxes but also enable you for becoming your own banker in Canada.

Single shareholder

Consider the example of Mary White. Mary, who is 62 years old and a single parent with three grown-up children, is the founder of Maryco. Mary is the owner of all of Maryco’s shares, all of which are common shares. The value of the common shares amounts to $5,000,000 and with a cost basis worth $1,000.

If Mary owns these shares at the time of her death, they will be considered disposed of. Supposing that the lifetime capital gains exemption does not apply and that there is no change in the worth of the tax rates or shares, the presumed disposition at death could result in a projected income tax liability of 25 percent of the gain (25 percent of $1,249,750 or $4,999,000). The 25 percent tax rate is a theoretical rate that would apply if the upper personal tax rate were 50 percent.

Mary has the option to buy corporate owned life insurance to cover the taxes in the event of her death. Nevertheless, she will have to withdraw funds from Maryco in the form of taxable dividends or salaries to finance the life insurance premiums. Maryco must pay sufficient dividends or salary to cover the life insurance premiums after taxes.

Maryco could also buy the life insurance policy and name herself as the beneficiary. There will be no deductions on premiums paid for income tax reasons, however, Maryco can finance the insurance premiums.

The proceeds of corporate owned life insurance will be tax-free to the company upon Mary’s death. Any excess proceeds above the corporate owned life insurance policy’s cost basis can be paid as capital dividend tax-free to the company’s shareholder, which we will assume is Mary’s estate for this article’s sake. Mary’s estate could then utilize those monies to fund the tax bill that occurred as a result of Mary having owned the shares at the time of her death.

Several shareholders

In a scenario with multiple shareholders, life insurance can also be beneficial. Canadian-controlled private corporations (CCPCs) frequently have a small set of related shareholders or a group of unrelated shareholders who collaborate as business associates. A shareholder’s death can place a burden on the remaining shareholders.

A shareholders’ agreement is popular in a closely held company with numerous shareholders. The agreement goes far above business law to establish ground rules for how the corporation is controlled as well as how shareholders interact with one another. Among other things, the agreement should foresee probable future scenarios including a shareholder’s death. It could be stipulated in the agreement that shareholders maintain corporate owned life insurance on the remaining shareholders to acquire the shares held by the departed.

Consequently, the agreement may state that the corporation will acquire life insurance on all shareholders’ lives and utilize the proceeds to buy or redeem the deceased shareholder’s shares.

Estate Equalization

In the case of Mary White, she passed away as a single mother of three adult children. Mary could well have passed on shares in the company to any of her children who were involved in the business. This could have been done with succession planning prior to death.

For the children who are not actively involved in the business operations, this could more sensible to pass on cash to them instead of being Maryco shareholders in the event of her death. The company can acquire corporate owned life insurance on the life of Mary to provide finances for the kids who aren’t involved in the business’s activities.

Benefits of Corporate Owned Life Insurance

We have seen how corporate-owned life insurance could perhaps help offer liquidity in the three cases above. We can sum up three major benefits demonstrated in the above scenarios:

• The insurance can be acquired using corporate after-tax dollars because it is less costly than using taxable finances to pay for the insurance using personal after-tax dollars.
• If premiums are required to obtain funding, they may be tax deductible.
• A capital dividend allows life insurance proceeds to be distributed to shareholders tax-free.

Dangers of Corporate-Owned Life Insurance

Any tax planning involving corporate-owned life insurance should take into account the dangers. The following are some of the most serious risks:

• The possibility of capital losses reducing the value of life insurance proceeds that could be paid out tax-free to shareholders.
• Exposed life insurance proceeds to the company’s creditors
• Collaboration with other post-mortem planning efforts

Post-mortem Planning

Estate planning is complicated. Life insurance, particularly corporate-owned insurance, shouldn’t be utilized in isolation, but rather as part of a comprehensive plan. In some cases, paying a capital dividend from life insurance proceeds decreases the efficacy of other post-mortem planning.

Final Word

In light of infinite banking in Canada, life insurance is an efficient tool for managing the business-related and tax-related costs that may arise when the owner-manager passes away. Besides that, it can enable you for becoming your own banker in Canada.  Inquire from your financial adviser about more information on how you can prepare for an untimely death and safeguard both your business and loved ones.