The pros and cons of corporate-owned life insurance

Business-owner clients can be strong candidates for corporate-owned life insurance, but the tax complexities mean insurance advisors must be prepared to collaborate with the clients’ accountants to ensure such policies are suitable.

Corporate-owned life insurance typically involves the corporation as policy owner and beneficiary, and the business owner (or another key person) as the insured.

Having such a policy in place is often a way to ensure the enterprise will have enough funds to continue operating if the owner dies, while also providing tax-free distributions to the business owner’s estate from the corporation’s capital dividend account (CDA). The CDA tracks tax-free surpluses accumulated within the corporation, and can issue tax-free capital dividends to shareholders.

Jeff Bernstein, managing partner with Seligman Insurance in Toronto, said there are even more reasons for a business owner to hold life insurance inside their corporation.

“We also see corporate-owned life insurance used as [a] vehicle for the owner or shareholder to accumulate money inside the corporation that is not needed for current consumption, but that they hope to shelter before eventually making use of the asset,” Bernstein said. “That’s one of the key ways corporate-owned life insurance works, because of the tax attributes.”

Steve Meldrum, a corporate insurance specialist with Swell Private Wealth in Medicine Hat, Alta., said one of the key advantages of holding life insurance via a corporation rather than personally is the savings achieved from the lower corporate tax rate.

Since insurance premiums are generally not tax-deductible, they’re paid with after-tax dollars. A corporation will need to earn much less money to generate the same amount of after-tax dollars as a wealthy business owner paying tax at the highest personal marginal rate.

In addition, Meldrum said corporate-held life insurance may appeal to business owners looking to put excess funds to use in a tax-advantaged manner, especially if they’ve already maxed out their RRSPs and TFSAs. Income from investments in certain life insurance policies is exempt from the federal $50,000 passive-income limit that could reduce the company’s access to the small-business deduction.

“With an eligible life insurance policy, all that growth happens inside. You could have millions of dollars and it wouldn’t impact that small-business tax rate calculation,” Meldrum said.

But it’s not all good news on the corporate side of the life insurance ledger. Since a corporate-owned life insurance policy is not an active business asset, Meldrum said owners should also consider whether the policy will put their business offside of the Income Tax Act’s “small business corporation” test, which determines an individual’s ability to claim the lifetime capital gains exemption on a share sale. To pass the test, “all or substantially all” of the corporation’s assets must be used “principally in an active business.”

And while family-member beneficiaries of personally held policies are usually entitled to receive the proceeds regardless of any creditor claims, the corporate-owned versions do not receive the same kind of creditor protection, meaning they could be seized to satisfy company debts, said Justin Manning, a life-licensed financial advisor based in Vancouver.

Manning added that older business owners may have less to gain from a corporate-owned policy because of the way the tax-free portion of the payment from the CDA is calculated, which is equal to the full amount of the death benefit minus the adjusted cost basis (ACB) of the policy at the time of death.

“It takes time for the ACB to grind down and make the entire death benefit eligible for the CDA, which can be a disadvantage,” he said. “Another potential downside is the loss of financial flexibility and ongoing payment responsibilities if the company experiences difficulty with cash flow resulting in trouble paying the premiums.”

Entrepreneurs considering a reorganization or exit in the near term should also think carefully before taking out a corporate-owned life insurance policy.

“If someone is buying your business, they may not want to buy the policy for whatever reason. And if you try to take it out of the corporation, there could be tax consequences,” Meldrum said, noting that business owners may opt to place their insurance policies in a holding company, which is less likely to be sold than an operating company.

Once a client has decided to purchase a corporate-owned insurance policy, lines of communication should remain open between their professionals so no planning opportunities are missed, said Jamie Herman, a CPA and partner with Fruitman Kates LLP in Toronto.

After all, the extra planning opportunities bring with them an additional layer of complexity that requires cooperation from the client’s professional team, Manning said.

He said accountants must be involved in all discussions around corporate-owned life insurance, because of their knowledge of the client’s broader financial status and any potentially competing strategies already in place.

“Otherwise, certain information or needs may be missed and it can easily unfold as a biased insurance sale, instead of sound financial planning,” Manning said. “Corporate clients deserve their team of professionals to be unified to increase efficiencies throughout the entire planning process.”

Herman agreed: “There are things that can be done with the cash surrender value (CSV) of a corporate owned policy, but a lot of the time, I find [the CSV is] not recorded anywhere — not even by the person who sold the policy. They should be following up.”

Those things may include using the CSV as loan collateral or withdrawing funds from the cash value account. (The former is not generally considered a taxable disposition, but the latter generally is.)

Meldrum said including a corporate-owned life insurance policy’s CSV on a company’s balance sheet can make the company more attractive to prospective investors.

“Policies can have a stabilizing effect when the business owner wants to expand or is having trouble with other assets,” he said.

Meldrum said his team aims to report to a client’s accountants at least once a year on the status of policies.

“Insurance is something that evolves and builds over time. If you had a really good year, you may have room to put more inside the policy — or maybe not, if things didn’t go as well as you hoped,” he added. “But the accountant should be involved at every stage.”