In the business life insurance market, the question of policy ownership is often raised. A business owner may have many reasons for preferring that his company own the policies. However, it’s important to consider all the issues before a decision is made.
Personal need or business need
Before deciding if insurance should be owned by the company or personally, the first question to answer is whether the insurance protection is needed for personal or for business purposes.
Personal need – The cautious and conservative approach is not to mix personal and business affairs. You can’t go wrong personally owning insurance needed for personal protection. Every step is easier, from the completion of the application to the possible future withdrawal of the cash values. Despite this element of ease, many business owners still prefer their company own the policy. Also, it’s often difficult to isolate business needs from personal needs.
Business need – In the case of a business need, it’s more common to have the corporation own the policy. Some situations are straightforward, such as a case where key-person protection is needed as working capital for the company. If a key employee dies, the owner and beneficiary of the policy will likely be the company.
Other situations are not quite as obvious, like the funding of a buy-sell agreement in the case of the death of a shareholder. The purpose of this article is not to cover the different mechanisms of a buy-sell. However, it is important to discuss some general rules.
In the case of policies funding a buy-sell agreement on death, the most important rule is to issue the policies so that they respect the terms of the agreement. If the agreement is already in force, a copy should be examined to ensure the policies conform to the agreement. If the agreement is not written at the time of issue of the policies, they should be issued in anticipation of the desired buy-sell mechanism by the shareholders, and take into account other elements mentioned in this article.
If the agreement is written later and does not correspond to the way the policies were previously issued, it would then only be necessary to make the proper transfer of ownership. If the transfer is made in the first years after the policy is issued, it’s possible that the transfer would not trigger a policy gain.
Can the death benefit be received tax-free?
The company, as owner and beneficiary of a policy, will receive the death benefit tax-free. If the company is a private corporation, most of the amount may be paid to the Canadian resident shareholders by way of a tax-free capital dividend. The maximum capital dividend is dependent on the balance in the cumulative capital dividend account. This balance will increase by an amount equal to the death benefit minus the adjusted cost basis of the policy at the time of death. Every portion of the death benefit that exceeds the capital dividend account may also be paid, but as a taxable dividend to the shareholder.
Sole shareholder or multiple shareholders
Having a company own the policies for personal needs may create a delicate situation if the company is owned by multiple shareholders. The shareholders might find it useful to seek legal advice about control over the policy and, eventually, over the death benefit and potential tensions between shareholders.
In the case of a buy-sell agreement on death, the policies are often issued before the agreement is drafted. A buy-sell agreement should be discussed before the policies are issued. Also, ensuring maximum security to the estate of the deceased is another matter that should be examined before issuing the policies.
In the absence of an agreement, policies issued crisscross (i.e., on the life of one shareholder, and owned by the other shareholders) and do not give much negotiation power to the estate for the sale of its share in the business. The surviving shareholders may continue to operate the company. Also, they could cash in a substantial amount of the death benefit. For corporate-owned policies, the estate would have at least an indirect interest in its share of the death benefit cashed by the company.
The question of creditors
A major obstacle to corporate policy ownership may be company creditors. In the case of bankruptcy, if the company owns the policies the trustee has access to the cash values of the death benefit. Life insurance policies may offer some creditor protection in certain cases, but if the company is owner and beneficiary of the policies, there is no special creditor protection.
Problems may also arise upon death if the company has outstanding debts. It’s common to see clauses in loan agreements that limit the company’s ability to pay dividends. As a result of these clauses, in a buy-sell scenario upon death, the capital dividend – usually paid with the death proceeds – may not be paid at all. All the planning would be short-circuited because the money would not be available to the surviving shareholders when it’s needed most. A way to get around this would be for the client to buy additional protection to cover the loan upon death.
Some companies may also get around creditors by having their holding companies (if they exist) own the policies. While this does not entirely protect the cash from the operating company’s creditors, it provides an additional corporate layer creditors need to access.
Cost of life insurance premiums
The lower, net after-tax cost of life insurance premiums is usually the main reason business owners prefer to have company-owned life insurance policies. It’s worthwhile to emphasize that life insurance premiums are generally not tax-deductible, even if paid by the company. However, there remain some tax advantages to having the company pay for the premiums, namely when the tax rate of the company is lower than the shareholder’s marginal tax rate. The bigger the difference, the bigger the tax benefit.
Client has the last word
Usually, if the company serves as owner, it will be named as beneficiary as well. There may be a personalized ownership structure, but a nonstandard ownership structure may create delays in the issue of the policies. Once the client has analyzed the relevant elements, it is their decision to choose the type of ownership that will best suit their situation and meet their goals.
Dealing with permanent policies
Deciding whether a permanent insurance policy should be issued to an owner or manager’s company or him or her personally is complex for two reasons. First, cash values are an additional asset on the balance sheet and permanent policies are often used to accumulate savings for retirement. Second, shareholders often have personal plans for cash values which, consequently, might be withdrawn from the policy and distributed to the shareholder.
Policies as balance sheet assets
The cash value policy constitutes an asset for the company and may have a significant impact on the balance sheet. The cash value of a policy would normally be shown in the long-term assets section of the balance sheet. In negotiating company credit, long-term assets ratios are sometimes taken into account.
Increase in share value on death
With a corporate-owned policy, cash values are an asset of the company and are included in the valuation of the fair market value (FMV) of the company for purposes of the deemed disposition of the shares upon the death of the shareholder. This will increase the taxable capital gain upon death.
One might argue that the asset would be reflected in another item of the balance sheet, such as investments. In this situation, owning a permanent policy would not create the effect of increasing the value of the shares. This element impacts each business differently and must be examined on a case-by-case basis.
Capital gain exemption on qualified shares
Ownership of permanent policies by a corporation could jeopardize the qualification of the shares for the enhanced capital gains exemption on the death of the owner, and for the surviving shareholders. This may not necessarily be the case, but is a possibility that a policy owner should review with the help of his or her professional advisors. It is possible that the shareholder is not eligible for the exemption either way.
Will the policy eventually be transferred to the shareholder?
Another important question to consider when a permanent policy is involved is the intention of the shareholder to eventually sell the shares. The buyer will not likely be interested in a life insurance policy that insures the life of the previous shareholder. The policy is usually transferred to the life insured, and a potential policy gain may be generated, taxable to the company transferring the policy. The transfer may also generate taxes payable by the transferee life insured as the policy is considered to be transferred at fair market value.
The company will pay the tax related to the policy gain, which may affect the sale price of the shares of the company by decreasing it accordingly. This puts less money into the hands of the former shareholder, just as if he had paid the tax himself. Of course, a corporate term policy won’t create this situation because there’s no cash value in the policy and the policy gain upon the transfer will be deemed to be zero. If the shareholder has become uninsurable, this transfer of a term policy could also give rise to a taxable benefit to the shareholder.
Another item to consider is the tax treatment of a transfer of a policy. In this case, there are several possibilities, including:
- The transfer of the policy may be a reimbursement of an outstanding loan of the shareholder to the company. In this case, there would be no taxable amount to the shareholder following the receipt of the policy.
- The transfer of the policy may be considered as a dividend or a bonus and, consequently, be taxable to the shareholder.
- The company may use the funds from a policy loan to pay a retiring allowance to the retiring owner. The retiring allowance could then be transferred into his or her RRSP (under certain limits), in addition to his usual contributions. This would generate a deduction to the company for the payment of the retiring allowance that would offset the additional policy loan interest. Later, he or she could receive the policy that contains the loan and would then be taxed on the lowered value of the policy, which is diminished by the policy loan.
Seek professional advice
Owning a permanent policy in a private corporation may have other significant tax implications for both the corporation and shareholders. Before deciding to have the company own the policy, the client should always seek independent professional advice.
Bruce Unsal, B.B.A., CHS, CPCA, EPC, FPSC Level 1™ Certificant in Financial Planning is Managing Director and Financial Security Advisor at Milestone Wealth and Estate Planning Group Inc. You can reach Bruce by email or at 416-789-4527, ext. 299.
Disclaimer: The above should not be taken as providing legal, accounting or tax advice. You should obtain independent professional advice from your lawyer and/or accountant that takes into account your particular circumstances.