AMT and life insurance planning

Proposed changes to the alternative minimum tax (AMT) will increase the exposure of certain high-income taxpayers, with planning implications for life insurance.

In a nutshell, all individuals (including most trusts) are currently subject to the federal AMT when their regular Part I tax (calculated under the general rules) is less than the amount of tax calculated under the AMT rules. Draft legislation released in August 2023, expected to take effect in 2024, substantially changes these rules. 

The AMT rate will increase from 15% to 20.5% of an individual’s adjusted taxable income (ATI). ATI is determined by adjusting the individual’s Part I taxable income to account for various types of income or deductions receiving preferential tax treatment (e.g., capital gains, capital gains eligible for the lifetime capital gains exemption, dividends, employee stock options and tax shelter deductions).

For most individuals, ATI is reduced by a basic income exemption that will increase to about $173,000 from the current $40,000. This amount is then reduced by certain non-refundable tax credits available to individuals other than trusts. AMT paid by an individual for a particular year can be carried forward for seven years to offset regular Part I tax (assuming the Part I tax is greater than the AMT payable in that year).

The increased AMT income exemption will result in most individuals not being caught in the AMT net. But for certain high-income taxpayers and trusts, the higher AMT tax rate, combined with increased inclusion rates for capital gains and further reductions in allowable deductions and credits (including the charitable tax credit and financing expenses), will result in greater exposure to AMT, and an increased likelihood that the tax will not be recovered.

Implications for life insurance

The impact of the AMT on life insurance planning is generally a good news story. First of all, the growth in the cash value of an exempt life insurance policy is not included in income under the Part I tax or the AMT. And while the disposition of an exempt insurance policy can result in taxable income, it is taxed like interest income and therefore should not create additional AMT tax liability. Thus, permanent life insurance acquired for estate planning purposes should not be adversely impacted by the revised AMT.

While corporations are not subject to AMT, distributions of taxable dividends to shareholders could increase exposure under the new rules. However, not only is the death benefit under a corporate-owned life insurance policy received tax-free, but also a significant amount of this benefit can be credited to the corporation’s capital dividend account. Capital dividends payable to a shareholder are tax-free under the regular tax system as well as under the existing and revised AMT rules. Thus, the use of corporate-owned insurance for funding estate liabilities, buy-sell funding or key person coverage should not have significant AMT implications. 

As well, certain post-mortem planning strategies involving life insurance, which assist in reducing “double taxes” arising on death, should not be adversely impacted, as the AMT does not apply in the year of death or to the deceased’s graduated rate estate (this is a new exemption from AMT starting in 2024).

Individual taxpayers may also acquire life insurance to fund a large charitable gift on death. This involves the individual donor being the owner and premium payor, with the charity designated as beneficiary of the policy. Under regular tax rules, the value of the charitable donation (the life insurance death benefit) can be used in the deceased’s estate to offset taxes arising on death, or by the deceased’s GRE. As noted, the revised AMT will not apply in the year of the individual’s death or to a GRE, so once again, this type of charitable giving strategy will not be impacted.     

However, another charitable giving strategy involves the donation of an existing life insurance policy. The donor is generally entitled to claim a tax credit equal to the fair market value (FMV) of the policy. In certain cases, the FMV of the policy can be significantly higher than its cash surrender value, making this an attractive option. As with other charitable gifts made while the donor is alive, the value of the charitable tax credit will be reduced by 50% under the new AMT rules. Depending on the individual’s other sources of income, this could result in additional tax under the AMT.  

Finally, it is possible for individuals to use their life insurance policy (or a corporate-owned life insurance policy) to secure a loan for investment or business purposes. For regular tax purposes, the borrower may deduct related interest expenses, guarantee fees and the collateral insurance deduction (where the policy is personally owned) and use those deductions to offset other sources of income. Under the revised AMT, such expenses are reduced by 50%, creating potential exposure to AMT. This result can be avoided by structuring the arrangement through a corporation, with the corporation being the policyholder/borrower, as corporations are not subject to AMT.

In summary, the revised AMT rules will require high-income individuals to reconsider certain planning strategies that otherwise have beneficial tax implications for regular tax purposes.  Fortunately, while there are notable exceptions, most common insurance planning strategies will not be impacted by the revised rules.

Kevin Wark

Insurance

Kevin Wark , LLB, CLU, TEP, is managing partner, Integrated Estate Solutions, and tax consultant, Conference for Advanced Life Underwriting. He’s also the author of The Essential Canadian Guide to Income Splitting.