Benefits of Corporate Owned Life Insurance

Holding a life insurance policy through a small business corporation can provide several advantages that business owners might find compelling. In this blog post, I will outline the key benefits that make this strategy a valuable consideration for both financial and estate planning purposes.

Ways a Small Business Owner Can Buy Life Insurance:

Generally, life insurance premiums are not tax deductible as the premium payment is not considered an expense for generating income from a business or property.

Therefore, premiums must be paid with after-tax dollars. This means that an owner has two options:

1. Pay themselves an increased salary or a dividend, incur personal tax, and purchase the life insurance personally. Premiums will be paid with personal after-tax dollars.

2. Have the small business corporation purchase the life insurance policy. In this scenario, premiums will be paid with corporate after-tax dollars, the corporation will be the beneficiary of the policy, and upon death, the corporation will receive the insurance proceeds tax-free.

   
   

In most cases, the second option is significantly cheaper, given that the small business corporate tax rate in Manitoba is 9% on first $ 500,000 of active business income as of the writing of this blog post.

Leveraging the Capital Dividend Account (CDA)

To receive the insurance proceeds tax-free, the corporation must be both the owner and beneficiary of the policy. When the corporation receives the death benefit, the proceeds are credited to the Capital Dividend Account (CDA), net of the adjusted cost basis. The CDA is a notional account that tracks tax-free amounts accumulated within the corporation. The corporation can then distribute these funds to shareholders as tax-free capital dividends, either immediately or at a future date, providing flexibility in timing.

Instances Where Life Insurance Premiums Are Deductible

One of the key instances where life insurance premiums are deductible is when the policy is used as collateral for a corporate loan. In such cases, part of the premiums may be deductible, which can help reduce the taxable income for the business. However, it is important to note that strict conditions must be met for the premiums to be deductible: the policy must be assigned for a loan from a "restricted financial institution" (e.g., a bank, trust company, insurance company, or credit union). The loan interest must be deductible, the collateral assignment must be a requirement from the lender, and the policyholder must also be the borrower. If these criteria are met, the deductible amount is the lesser of the policy premiums or the net cost of pure insurance (NCPI), proportionate to the loan amount for the year.

Types of Life Insurance

• Term life insurance provides coverage for a specific period (typically 10, 20, or 30 years) and pays out only if the insured (usually a key person or shareholder) dies during the term. It is a cost-effective solution for temporary needs like debt repayment or key person protection.

• Permanent life insurance offers lifelong coverage and accumulates cash value that grows tax-free within the corporation, which can be accessed or borrowed against. This is advantageous, as investment income within a corporate-owned permanent life insurance policy does not count towards the corporation's passive income. Consequently, it does not reduce the small business deduction when passive income exceeds $ 50,000. It is more expensive as it has both an insurance and investment component.

Estate Planning Flexibility

Corporate-owned life insurance is an useful estate planning tool for small business owners, offering multiple benefits. It facilitates tax-efficient estate transfer when a large part of an owner's estate is tied up in company shares, a small business owner can choose to do a preference share freeze and purchase permanent life insurance equivalent to the tax that will be payable on the capital gain realized upon death, ensuring beneficiaries of the estate receive the actual value of the shares. Additionally, it supports the business if a key person passes away, providing necessary working capital to maintain operations. In cases where family members are uninterested in inheriting shares, the policy proceeds can fund a buyout by the remaining shareholders. These uses should be documented in the shareholder agreement to ensure clarity and proper execution.

Conclusion

Holding a life insurance policy through a small business corporation can be a smart move that provides tax efficiencies, estate planning benefits, and additional security for the continuity of the business. As with any tax strategy, it is important to consider individual circumstances and seek professional advice to ensure the approach fits well with your overall financial goals.

This blog has been prepared to provide general guidance and should not be considered specific advice. It may not address individual situations, and the information contained should not be used as a basis for action or inaction without seeking professional advice tailored to your circumstances. For personalized assistance, please contact Jenkyns Smith CPA's LLP.