Life insurance loophole closed for biz owners

Budget 2016 wasn’t kind to business owners.

Not only did the small business tax rate get frozen, but a popular life insurance strategy is no longer tax-advantaged.

A loophole in the tax act allowed business owners to transfer their life insurance policies to their corporations in return for tax-free proceeds of the policy’s fair market value (FMV), usually in the form of a note. Then, when the business owner died, the corporation would receive the proceeds of the death benefit – again, essentially tax-free. Private corporations can add the value of the benefit, less the adjusted cost basis, to their capital dividend accounts, and then pay out capital dividends, which aren’t taxable in the hands of shareholders.

Read: Harness the Capital Dividend Acount

“This [strategy] was marketed for the last 20 years, and prolifically, I would say, for the last five to 10 years” to older business owners, says Kim Moody, director, Canadian Tax Advisory at Moodys Gartner Tax Law.

This double-dip has finally caught the ire of the Department of Finance.

The 2016 budget proposes to tax the initial transfer from the policyholder to the corporation as full income*, says Moody.

Now, for instance, if a business owner has an insurance policy with a FMV of $800,000 and a death benefit of $1 million, he would be taxed on the $800,000 value of the note he receives back from the corporation.

“Is it a good fix? In my view it is, because those plans were inappropriate,” Moody says. “There’s no way the Income Tax Act should [have] allowed [this].”

Read: Pros and cons of new life insurance rules

Moody says if there are compelling reasons to transfer policies to a corporation, policyholders should be aware of these new tax rules.

Corporations and partnerships will be required to report information on policies where they aren’t policyholders but would still receive policy benefits.

More to come.

*The original version of this article stated that the transfer would be taxed in a capital gains-like fashion. The source has since determined the transfer will be taxed as income. Return to the corrected sentence.

Melissa Shin

Melissa is the editorial director of Advisor.ca and leads Newcom Media Inc.’s group of financial publications. She has been with the team since 2011 and been recognized by PMAC and CFA Society Toronto for her reporting. Reach her at mshin@newcom.ca. You may also call or text 416-847-8038 to provide a confidential tip.