Sharing interests in a life insurance policy

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1 Sharing interests in a life insurance policy Important considerations All comments related to taxation are general in nature and are based on current Canadian tax legislation for Canadian residents, which is subject to change. For individual circumstances, consult with a tax professional. An exempt life insurance policy -- i.e. the savings element is exempt from annual accrual taxation -- is defined in regulations 306 and 307 of the Income Tax Act (ITA). The ITA provides that if a policy is to be exempt, the conditions set out in the regulations must be met. The regulations determine the maximum premiums that can be paid while still keeping a policy exempt. Any premium for a Millennium universal life insurance policy that would exceed the maximum premium is put in an account outside the policy (Millennium Account) and credited with interest. Canada Life will report the income to the policyowner each year. The information in this presentation is current as of October 2005.

2 What is sharing interests in a life insurance policy? Sharing interests recognizes that separate interests can be identified within a single policy. The interests can be matched to the parties requiring the benefit provided by the interest. Sharing interests in a life insurance policy How is this done? Multiple methods: - Shared ownership - Shared benefits What are the benefits? The ability to share life insurance costs and benefits between two parties to their mutual advantage.

3 Marketing opportunities - shared interests Executive benefits Key-person protection Buy-sell agreement funding Retirement compensation agreements (RCAs) Individual life insurance policies Family life insurance policies Marketing opportunity executive benefits Employee retention strategy One party (employee) has a long-term objective for retirement and the other party (employer) has an interest in the insurance or death benefit portion. One party (employer) receives tax-advantaged savings from the interest in the cash values and the other party (employee) has an interest in the insurance or the death benefit.

4 Marketing opportunity key person Key-person protection is issued on the life of a key employee or shareholder. In the event of the key-person s death the policy s proceeds are used to compensate the corporation for resulting losses and assist in replacing the key-person. Term insurance is often purchased. A way to attract and retain key personnel. Supplementary retirement income and estate planning for employee. Taxable benefits may apply. Clients must seek advice from their tax advisor to discuss this option. Marketing opportunity buy-sell agreements An agreement for the purchase or sale of the shareholder s interest in the company in the event of a shareholder s death. Enables the surviving shareholders to purchase the deceased s share in the company and pay the estate of the deceased in cash. Owned by the corporation or individual shareholders. Permanent cash value life insurance and the shared interests arrangement reduces the after-tax premium expense for all shareholders and provides tax-advantaged cash values.

5 Marketing opportunity retirement compensation arrangements (RCAs) Shared interests arrangement can fund RCAs. The sponsoring corporation (or an employee of the corporation) has an interest in the death benefit, while the trustees of the RCA trust have an interest in the cash values. The death benefit maintains its tax-free status. In some situations, the death benefit can also provide a credit to the corporation s capital dividend account (CDA). Marketing opportunity individual life Cost advantages for sole owners of incorporated companies when funding permanent life insurance. Net savings can be achieved by sharing the interests in a life insurance policy with the company. The corporation has an interest in the death benefit and the employee (shareholder) has an interest in the cash values. OR The corporation has an interest in the cash values and the employee (shareholder) has an interest in the death benefit.

6 Marketing opportunity family life plans Inter-generational transfer of wealth - Child is generally the insured, although the parent can be the insured - Child has a need for insurance and the parent has a need for tax-advantaged savings - Child would own the death benefit, the parent would own the cash values When the child is able to pay the entire premiums, at that time, parents have two options: - Keep their interest in the cash value. - Transfer the interest in the cash value to the young family, thereby providing a permanent life insurance policy at an affordable premium. How to share interests in a life insurance policy Most common method of sharing interests: One party who has an interest in the life insurance protection (or death benefit) who pays for this portion. The other party who has an interest in the savings portion (or the cash values) of the life insurance policy and pays for this portion. Shared ownership or shared benefits can result in lower costs for each party for their portion of the coverage, new investment opportunities or both. This depends on the client s personal situation.

7 Shared ownership Typically involves: Two or more owners of one insurance policy with the life insurance company (the insurer) through joint ownership. A separate legal agreement specifying the ownership of the separate interests, the sharing of benefits, the allocation of premium and also discusses the terms and conditions of the arrangement. How traditional shared ownership works Named beneficiaries Employee Holding company Cash value Death benefits Life insurance policy Legal agreement Tax-free dividend Operating company

8 Shared ownership considerations The policy s versatility - More than two parties can be involved and be on record with the insurer as a single contract for all purposes. Although the policy has two components, the insurer will report on a per policy basis. The insurer calculates one adjusted cost basis (ACB) for the life of the policy. Clients should be advised that this arrangement requires additional administration and record keeping. Their legal and tax advisors are also responsible for calculating the ACB for each party s interests. Shared benefits One policy owner on record with the insurer. The other party is an irrevocable beneficiary of the life insurance policy. Legal agreement is set up outside of the policy that sets out the terms and conditions.

9 How shared benefits strategy works Employer Employee Face amount Accumulation fund Key-person protection Funds for retirement Shared benefits This strategy is simple compared to other arrangements used for supplemental income planning (i.e. RCAs, reverse shared ownership life insurance) - Achieves same objectives as other arrangements - Provides for a funded plan

10 Shared benefits considerations Using a shared benefits rather than a shared ownership arrangement - The shared benefits strategy involves a personally owned policy with an irrevocable beneficiary so that the policy ownership isn t split. The parties which often includes employee and employer, enter into a separate agreement that allocates the sharing of the policy s benefit costs and the beneficiary designation. - The employee can purchase the life insurance policy from the insurer and the employer is named the irrevocable beneficiary. Shared benefits considerations Irrevocable beneficiary: - Does not have ownership rights in the insurance policy, but has veto power. - The policy can t be assigned, surrendered, sold or otherwise dealt with without their consent. - The beneficiary designation can t be altered or revoked without their consent. - Can agree to change the designation, but this may incur tax consequences. Clients are encouraged to discuss their circumstances with professional tax and legal advisors.

11 Shared benefits considerations The CRA may view the shared benefits arrangement as a lease agreement. Clients entering in this agreement must carefully consider: - which name they wish to use on the life insurance policy - possible future interest transfers - in the event that the shared interest arrangement is no longer in effect, who should keep the life insurance policy Shared benefits key questions for employers How can employers update employee retention strategy? What funding is available for supplemental income planning? How can it be set up on a tax-effective basis? How can employers protect themselves financially in the event of the death of a key employee?

12 Shared benefits corporate context A corporate structure with an employee and employer scenario: Individual (employee) is the owner of the policy. Corporation is designated the irrevocable beneficiary of the face amount. Similar to shared ownership, shared benefits focuses on the two portions of a life insurance policy, i.e. death benefit and savings element. The benefits of the policy and premium payments are shared, not the ownership. For example: employee/employer scenario Tom, 45, controller of Stamping Ltd. for over 10 years. Tom has helped Stamping Ltd. become a national firm and the company doesn t want to lose Tom. Stamping Ltd. currently doesn t have any key-person insurance on Tom. Tom is accumulating some funds which he will not need until retirement. Tom is looking for tax-advantaged savings.

13 Which structure is best for my client? To determine which structure may be more suitable for your client s needs, ask these questions: What is the intent of buying the life insurance? - What need does it fill? Key-person, permanent long-term protection, retirement funding? Will the insurance interest and the savings component belong to one party in the future? - If so, which party? Do any of the parties require any rights? When? - I.e. access to cash values, paying premiums for a specified time How much administration is the client prepared for? Methods of sharing costs Market approach: - The market approach estimates an equivalent term coverage payment in the open market. - Examples of the types of products available: - Term 10 policies - Term to 65 policies - Term to 100 policies - Annually increasing (AI) cost of insurance (COI) under a Millennium universal life insurance policy. Remainder approach: - Once the cost of the policy s life insurance portion has been determined, the cost of the remaining elements in the policy, for example, the cash value, must be determined. - The total premium minus the cost of the death benefit equals the cost of the cash value portion.

14 Methods of sharing costs Net Cost of pure insurance (NCPI): - Is referred to in the Income Tax Act (ITA) reg. 308 and in paragraph 20(1)(e.2)(ii) and subsection 148(9). These provisions cover the ACB calculation of a life insurance policy. - Under this method, NCPI is used to estimate the cost of the insurance or death benefit portion. Actuarial approach: - The pure cost of insurance protection is grossed up to reflect other costs associated with the policy. For example, administration, taxes, overhead, commissions, distribution costs, etc. - Once the costs have been determined, the cost for the insurance portion can be used as the basis for the shared interest arrangement. Shared interests income tax considerations Shared benefits: No definitive position exists regarding tax consequences, particularly employee and employer situations. Shared ownership: The CRA indicates a taxable benefit may be assessed as a result of arrangements between employees and employers or a corporation and shareholders.

15 Shared interests income tax considerations CRA considerations: Each party must pay a reasonable amount of premium for the benefit the party receives. Non-arm s-length situation: a taxable benefit may be assessed for one of the parties to the agreement, unless all parties pay a cost equal to the fair market value (FMV) of the benefit received. The determination of a reasonable premium amount for each party depends on each client s situation and is a question of fact. Shared interests income tax considerations Pre-payment of life insurance portion: - Occurs when premiums are paid quickly - A taxable benefit may arise for the party with the interest in the cash value component - May access the other party s interest Transferring an interest in a life insurance policy - When an interest in a life insurance policy is transferred from a corporation to an employee or shareholder while the insured is alive, a taxable benefit will likely arise at the time of transfer. - At the time of the transfer, the benefit amount is equal to the amount the policy s FMV exceeds the amount paid by the transferee of the policy.

16 Legal documentation Shared ownership and shared benefits agreements will likely be worded differently. Shared benefits agreement can be separate or provisions incorporated into another agreement, i.e. employment agreement. Both need to address what happens upon: - Death - Early termination of employment (if applicable) - Who has access to what and when - The terms and conditions that apply to the arrangement Shared interests arrangement - structure 1) Life insurance application 2) Ownership and beneficiary structure - Shared ownership - Shared benefits 3) Legal agreement

17 Comparing shared ownership versus shared benefits Number of owners on insurers records Multiple beneficiaries Deemed disposition Legal agreement language Marketing Opportunities: Executive benefits Key-person protection Buy-sell agreement RCAs Individual life insurance Family life insurance Shared ownership 2 or more ownership Shared benefits 1 possibly N/A interests Sharing interests in a life insurance policy Offers a tax-effective, flexible way to fund permanent life insurance. Is a complex arrangement and requires the participation of legal and tax advisors. Requires ongoing review to ensure that the agreement continues to meet clients changing needs.

18 Why Canada Life? Canada Life s wide range of permanent life insurance products allow clients to customize their insurance coverage to match their estate planning needs. Permanent products - Participating life - Universal life Term products Why Canada Life (continued )? Estate planning strategies Preserve your wealth Real estate, real solutions Planned giving using life insurance Insured inheritance Retirement income enhancer Insured RRIF Insured annuity Estate planning client material Estate planning checklist Annual review If you die without a will summary Tax worksheet calculator Preserve your wealth calculator Personal records organizer For your family For your executor

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