A Primer on Corporate-Owned Insurance What You Need to Know Now to Protect Your Family s Future. by Shafik Hirani

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1 What You Need to Know Now to Protect Your Family s Future by Shafik Hirani

2 Business Owners need life insurance like anyone else, but many don t understand how to properly structure their Policies to take advantage of CRA provisions... A PRImer on corporate-owned life insurance Individuals who seek their livelihood in a self-employed business are often motivated by a desire not to place their fate in other peoples hands (i.e. CRA, the Stock Markets, Creditors, etc.). Of course, the desire to make money for themselves and their families is not the least of their drives, so investment and insurance products must be adapted to meet the needs and desires of this special class of person - the Owner-Manager of a Canadian Small Business. shafik hirani has been in the financial services industry since During this time, Shafik has won some of the company s most prestigious awards. He has consistently been the top Division Director at Investors Group since 2006² Shafik has also received the President s Elite Award (Top 1% of Investors Group Consultants) from ¹ With an education in Neuropsychology and a Finance Degree from the University of Calgary, Shafik speaks across Canada delivering seminars on investment and tax strategies for the affluent. Since graduating, he has completed his CSC, CFP, CLU, and is a CFA Level 2 candidate. Many owners choose to incorporate their business. Corporations issue shares and the shareholders own the business. The shareholders may also work for the corporation and, as employees, they are paid salaries and other benefits just the same as the corporation can provide to its other employees. Most of these shareholders would prefer to see, in the event of death, their shares pass on either to family members or fellow shareholders, and the latter may be required pursuant to an existing buy-sell arrangement. The major concern is to ensure that there is sufficient money upon disposition of the shares at death so the family may maintain the kind of lifestyle to which it has become accustomed. If family members are not able to assume control of the business, a practical solution to this problem is to enter into a buy-sell plan amongst the other shareholders which obligates one or more of the surviving shareholders to acquire the shares of the deceased shareholder. As a funding means, corporate-owned insurance is an attractive option. This is insurance obtained by the corporation upon the lives of its shareholders, with the premiums paid by the corporation, and usually having the proceeds paid to the corporation. However, it should be recognized that buy-sell funding is not the only reason why business owners should consider having their corporation purchase life insurance. For more information, please visit PAGE 1

3 WHY buy corporate-owned life insurance? Life insurance provides for the payment of cash at death, a financial benefit that is unique and incomparable. Business people need life insurance for these key reasons: To provide funds for the family to pay estate debts and taxes on capital gains and to give the family a sum of money independent of the risks and hazards of their business. To provide funds to fulfill the terms of a buy-sell agreement amongst shareholders. To pay the debts of the corporation so that creditors claims are satisfied and the business can either continue on a profitable basis or can be sold at a maximum price. To provide funds to help offset the economic loss of the death of the key employee. Life insurance may allow time to hire, promote and train new key people. To provide funds to the corporation to be used to pay a death benefit as defined in the Income Tax Act (the Act) to the deceased shareholderemployee s surviving spouse, common law partner or other beneficiary. The amount paid is deductible to the corporation. The amount received by the beneficiary is tax-free up to $10,000, so long as no other death benefits have been paid. Where the policy has cash values, these appear as an asset on the corporate balance sheet. The cash values can be utilized as additional collateral or emergency funds during the insured shareholder s lifetime. During the policy s accumulation period, the increases in cash values are tax sheltered. PAGE 2

4 advantages OF CORPORATE-OWNED LIFE INSURANCE 1. In Alberta, where the corporation is eligible for the small business deduction (on the first $500,000 income) and other corporate tax credits, there is a significant reduction in the before-tax earnings required to pay premiums. FOR EXAMPLE: PERSONAL Assume an individual is paying taxes at the marginal rate of 39%, the corporation is paying at the 14% business tax rate, and the annual premium is $10,000. The individual shareholder must earn $1 to net $0.61 after taxes. Therefore, because the shareholder needs $10,000 after taxes to pay the premium, he must earn: $10,000 (1-39%MTB) = $16,393 CORPORATE In contrast, a corporation must earn $1 to net $0.86 after taxes. Therefore, because the corporation needs $10,000 after taxes to pay the premium it must earn: $10,000 (1-14%MTB) = $11,628 Cash Flow Saving ($16,393 - $11,628) $4, These savings become quite substantial as premiums are paid year after year. (Depending on the amount and type of insurance required, the annual premium could potentially far exceed $10,000.) * 2013 rates have been used in this example 2. Corporate-owned life insurance can utilize the capital dividend account (CDA) as a route to pay the proceeds without tax at the death of an insured shareholder. At death, the proceeds received by the corporation less the adjusted cost basis (ACB) of the policy will be eligible to be credited to the CDA. A non-taxable dividend can then be paid to the estate of the deceased shareholder and/or the other shareholders to the extent there is a balance in the CDA. The use of the CDA may be especially advantageous for purposes of funding a buy-sell agreement. PAGE 3

5 In a situation where the insurance is required to fund a buy-sell agreement, there will be policies insuring each shareholder. The shareholders will probably be different ages and subject to unequal premium rates. There may also be cost differences among shareholders due to underwriting premium ratings. By having the corporation pay the premiums, corporate-owned policies help to equalize the resulting premium differences. Where insurance is being used to fund a buy-sell agreement, the surviving insured shareholders do not have to purchase the policies owned by the deceased shareholder on each of their lives as would be the case if they owned the insurance individually. The corporate-owned policies simply remain in force on the surviving shareholders. From a psychological standpoint, there may be a preference among shareholders to spend corporate dollars rather than personal dollars. An expenditure on life insurance premiums is more favourably regarded when the disbursement is made from the corporation s surplus rather than the shareholder s personal wallet. A corporation with only one shareholder may be in the favourable position of having considerable investment assets, some of which could be sold over time in order to pay the premiums on the life insurance policy on the life of the shareholder. One of the benefits of such an arrangement is that the proceeds received by the corporation can be used, on the insured s death, to make a tax-free distribution of assets as a capital dividend to the estate of the deceased shareholder, to the extent there is a CDA balance. The use of this strategy will result in a larger amount that can be passed to the estate compared with using taxable investments for this purpose DISaDVANTAGES OF CORPORATE-OWNED LIFE INSURANCE As the corporation is the beneficiary of the insurance policy, the proceeds may be subject to the claims of any corporate creditors. Creditor protection under provincial insurance legislation does not extend to corporations. If creditor claims are a problem, then business loan insurance should be purchased insuring the shareholderemployees. The premiums in this case may qualify for a deduction, in whole or in part, provided the policy is given as collateral to the lending institution and certain criteria under the the Act are satisfied. The ACB of a corporate-owned life insurance policy increases as more premiums are paid in. This will, in turn, reduce the amount of life insurance proceeds at death that may be paid out to the surviving shareholder(s) as a capital dividend. This effect is offset in whole or in part by the deduction to the ACB of the Net Cost of Pure Insurance (NCPI) each year. The NCPI is applicable to life insurance policies issued after December 1, It is basically equivalent to the cost for annual renewable term insurance. Generally the NCPI will be greater than the premiums at advanced ages so the ACB will be reduced to zero over time. For policies acquired prior to December 2, 1982 the NCPI will not apply to the ACB calculation. PAGE 4

6 3. For purposes of the deceased shareholder s tax return and the taxation of capital gains upon the deemed disposition at death, the calculation must take into account the fair market value of life insurance policies owned by the corporation on the lives of anyone other than the deceased. In a nonarm s length sale, the receipt of life insurance proceeds by a corporation potentially can increase the value of the shares as the proceeds become an asset of the corporation before the payment of the dividend from the CDA. Cash surrender value of the policy or policies on the life of the deceased shareholder is used in this calculation. 4. Corporate-owned insurance can potentially affect the status of shares as qualified small business shares for purposes of the capital gains exemption. The definition requires that substantially all (90% or more in the view of the Canada Revenue Agency (CRA)) of the assets be used in an active business. The CRA takes the position that generally an insurance policy is not considered to be used in an active business nor do life insurance proceeds qualify as active assets. So, if the amount of proceeds received by the corporation causes the active business assets to fall below the 90% threshold, the shares will no longer qualify for the exemption. Upon the deemed disposition at death, in determining whether the corporation qualifies as a small business corporation at the time of death, the value of the life insurance policies owned by the corporation on the life of the deceased shareholder is determined immediately before death and is limited to the cash surrender value. This latter provision addresses the holding period asset test under the Act applicable to the shares which requires that throughout the two-year period preceding the disposition, more than 50 per cent of the fair market value of the corporation s assets must have been used in an active business carried on in Canada. However, the CRA may argue that insurance policies on shareholders who have not died may also have an impact on the share valuation at death and, presumably, the status of the company as a small business corporation. In essence, if a small business has several policies in place insuring the lives of its shareholders, the cash surrender values of these policies are not considered to be active business assets. In some cases, this could jeopardize the availability of the capital gains exemption if the corporation s active business assets fall below 90 percent. With respect to these other policies, consideration would be given PAGE 5

7 to a number of other factors including the life expectancy of the life insured, mortality tables and the state of health of the insured as it is known to others If the policy is corporate-owned, it may give rise to a tax problem in the event there is a need or desire to transfer ownership of the policy to the shareholder. The transfer will be considered a disposition for tax purposes and, therefore, the corporation will be required to report any policy gains. If it is anticipated that the shares of the operating company may be sold to an outside party in the future, it may be recommended at the outset to set up the ownership of the policy in a holding company owned by the shareholder so as to avoid any concern regarding the transfer of ownership. Ownership of the policy would continue in the holding company after the shares of the operating company are sold. It is important to note, however, that the impact of such an ownership structure may have other consequences that should be considered when evaluating such an arrangement. If a corporate-owned life insurance policy is intended to address the estate planning objectives of the shareholder, care must be taken in arranging the beneficiary designation of the policy. If the beneficiary is anyone other than the corporation such as the spouse, estate or child of the shareholder, the premiums will give rise to a taxable benefit which will not be deductible to the corporation. The stop-loss rules will need to be addressed where the corporate-owned life insurance is being used to fund the purchase of the shares of the deceased shareholder by the corporation at the death of the shareholder. As a result of the stop-loss rules, the capital loss that otherwise would occur on the redemption in the hands of the estate may be impacted where a capital dividend has been paid in respect of the shares. Therefore, it could result in the surviving shareholder(s) eventually paying income tax on capital gains previously taxed in the hands of the estate. The stop-loss rules may also apply if the corporation is wound-up by the executor of the estate and a capital dividend funded by life insurance has been paid to the estate. There are a number of planning strategies available to avoid or mitigate the tax consequences arising from the stop-loss rules. CONCLUSION Despite some of the concerns raised above, the many significant advantages of corporate-owned insurance means that this type of ownership should be seriously considered by all business people and their professional advisors. PAGE 6

8 About the Author Since joining Investors Group in 1996, Shafik has been honored to have received some prestigious awards: A warded Presidents Elite (Top 1% of Investors Group Consultants): 2005, ¹ C onsistently the top Division Director at Investors Group since 2006² A warded Presidents Club (Top 3% of Investors Group Consultants): 2004¹ A ppointed to National Division Director Advisory Council: ³ Chosen as Calgary s Top 40 under 40: Avenue Magazine Logging more than 100 speaking engagements per year, Shafik delivers presentations on the Psychology of Wealth to many Alberta-based corporations, associations, and conferences. He has also delivered presentations to advisors nationally as well as internationally (speaking at Investors Group conferences in St. Petersburg, Russia; Shanghai, China; Tokyo, Japan; Bora Bora; Edinburgh, Scotland; and Venice, Italy.) In his spare time, Shafik teaches the Certified Financial Planning (CFP) Course to students at Mount Royal University. He is a regular panelist on CTV s Alberta Primetime News, Global TV s Energy TV, and CBC s alberta@noon. After taking Neuropsychology at the University of Calgary, Shafik returned to complete a Post-Secondary Degree in Finance. Since then, he has also attained a Chartered Financial Planning designation and is a Chartered Life Underwriter (CLU) and Certified Financial Planner (CFP). He also holds his CFA Level 2 Charter. Shafik is responsible for the active private asset management of over $250M in investments and through his region office, has access to a team of specialists in the areas of mortgage, insurance and securities. Shafik is happily married to Beth and has one beautiful boy, Avery. Shafik is also the Founder of Hirani Foundation for Charitable Giving. For more information about this strategy, or to book Shafik for a speaking engagement please feel free to Shafik at shafik.hirani@investorsgroup.com Disclaimer This article is written and published by Shafik Hirani. It is provided as a general source of information and shouldn t be construed as legal or tax advice. It is not intended to provide investment advice or as an endorsement of any investment or company. Every effort has been made to ensure that the material contained in the commentary is accurate at the time of publication; however, we cannot guarantee the accuracy or the completeness of such material and accept no responsibility for any loss arising from any use of or reliance on the information contained herein. This material is not intended to be a recommendation or opinion as to the approach you should take, but rather to form a basis for further discussion between you and your financial security advisor. You should obtain independent legal, tax, and accounting advice regarding your particular circumstances. Investors Group is a registered trademark owned by IGM Financial Inc. and licensed to its subsidiary corporations. Insurance products and services distributed through I.G. Insurance Services Inc. Insurance license sponsored by The Great-West Life Assurance Company. Investors Group Trust Co. Ltd. is a federally regulated trust company and the mortgagee. Mortgages are offered through I.G. Investment Management, Ltd. Inquiries will be referred to a Mortgage Planning (Agent) Specialist. Brokerage offered through Investors Group Securities Inc. ¹ Based on Investors Group New Business ² Investors Group National TOP Leader ( , ) and National Division Director of the Year award winner ( ,2012) based on performance, recruiting, coaching and mentoring of Consultants. ³ Based on Investors Group TOP points SHAFIK HIRANI S PRIVATE WEALTH MANAGEMENT PRACTICE Dome Tower: Suite 800, 333 7th Avenue SW Calgary, AB T2P 2Z1 TOLL FREE (800) PHONE (403) FAX (403) shafik.hirani@investorsgroup.com WEB