Corporately Owned Life Insurance
Every small business owner knows some of the tax advantages of having a small business. Borrowing money, deducting certain expenses, and having limited liability protection are all great reasons to incorporate. I talked about all considerations for incorporating in my last blog post.
Most business owners however do not know about the advantages of having Corporately Owned Life Insurance. If you have a shareholder structure that’s favourable, and many small businesses do, having a corporately owned life insurance policy can be an excellent way to take advantage of current tax rules.
What are the main advantages of corporate ownership of a life insurance policy?
- Reduced tax-cost of life insurance premiums: Paying premiums through a business allows for the use of after-tax dollars generated by the business. Since corporations have a favourable (i.e. a lower tax rate than individuals) it is advantageous for a corporation to own a life insurance policy rather than a shareholder. For the same amount of premium dollars, a corporation can own a much larger policy on the shareholder, than if the shareholder was using their own income to pay for the policy. As life insurance premiums are payable for several years, including over the entire lifetime of the insured individual, such savings can become quite substantial over time.
- Tax-free death benefit: Should the insured person pass away, proceeds of corporate-owned life insurance received by the corporation can be paid through to the deceased’s individual’s estate or any other beneficiary with little or no tax through the capital dividend account. Even though the premiums are being paid by the corporation, the policy is owned by the corporation, and the beneficiary is the corporation, the remaining shareholders can get the proceeds of the insurance out of the corporation tax free. This is a very favourable ‘loophole’ for shareholders, one that should be taken advantage of by every business owner. The amount of the tax-free payment is equal to the death benefit amount minus the adjusted cost basis (ACB) of the policy at the time of death. Typically, a policy held to life expectancy will result in nearly all or a very high proportion of the death benefit available for tax-free dividends.
- Equitable distribution of premiums: A corporation can pay for premiums for several shareholders / key persons regardless of the cost of premiums that may vary across the various individuals, due to their age or personal health situation. Each shareholder therefore proportionately assumes the cost of the premiums paid for by the corporation and the potential benefit therein. This allows for a more equitable distribution of premiums rather than each shareholder individually paying for a policy.
- Easier management: Policies owned by a corporation on multiple individuals or shareholders can be easily managed centrally by the corporation including in making premium payments or in utilizing the cash values, validating the status of the policies or even in filing claims.
- Creditor protection: Policies owned by a corporation on an individual shareholder generally allow them to be shielded from creditors of an individual shareholder. Certain structures could be created where any death benefit proceeds received may also be shielded from the creditors of the business.
- Tax-preferred cash value accumulation: The cash surrender values on corporate-owned permanent insurance policies are treated as an asset of the corporation. Any unrealized gain in the cash surrender values would be exempt from taxes unless the policy is cashed in, or the cash values are withdrawn. This allows the corporation to diversify its asset mix and avoid having to pay taxes otherwise payable on regular investment income.
How can a life insurance policy be used for your business?
If you are a business owner, you may be worried about how the business will continue when you pass away. There are many ways in which life insurance can be used as part of a business continuation strategy to ensure that the business continues to thrive, even upon any future ownership transition.
Buy/Sell Agreement is a contract that stipulates the process in which shareholders or owners of a business may purchase shares of a deceased business owner or partner. A buy/sell agreement can be funded by a life insurance policy whereby the death benefit of the policy can be used to buy out the remaining shares of the deceased partner from their heirs. When I run insurance quotes for clients the premiums being paid out over the lifetime of the shareholders are always lower than the cash required to ‘buy out’ the deceased partners shares. Insurance is almost always the cheapest way to protect the business. We’ve seen situations where the surviving business partner had to sell the business to generate the cash required to satisfy the shareholder’s agreement. This agreement prevents the business partners from having to use personal funds or business assets to buy out the deceased business partner’s shares. In some cases, the business partners may choose to individually own a policy on the other partners. However, a better strategy is to have the whole life insurance owned by the business, so that it can be more efficiently managed and used to fund the purchase of the shares of the deceased partner.
Key person insurance is a life insurance policy owned and paid for by a business, covering the life of a key employee, deemed critically important to the company’s operations. If the covered key person passes away, the business receives a tax-free death benefit which can be used to meet expenses, repay debts, or even hire a replacement. Key person protection is a cost-effective way to help ensure the continued viability and profitability of the business in the face of a specific risk. The proceeds from the life insurance can effectively be used as a buffer against any contingent reduction in sales or business growth that may occur as the company navigates the transition in its operations from the loss of life of a key employee or shareholder of the corporation.
Estate Equalization is a strategy to transfer assets in a fair manner to one or more beneficiaries of a shareholder. Whole life insurance becomes an effective tool to accomplish estate equalization in situations where the business owner has some beneficiaries who are involved in the business and some who are not. The members of the family with an interest in the estate inherit the family business or family assets, while other members are bequeathed an equivalent cash value to the estate from the tax-free proceeds of a life insurance policy. I have had businesses that use insurance as an ‘equalizer’ for estates. Sons/daughters may not all participate in family businesses equally, insurance can be a great way to treat everyone fairly.
Life Insurance Collateral Assignment is another benefit of business-owned insurance. The death payout of a life insurance policy is the main benefit that most people consider, but there are living benefits to life insurance as well. In addition to your death benefit, a whole life policy accumulates a cash value. If you need quick cash for your business, you can get a policy loan from your policy’s cash value or use the policy as collateral from the bank for secured funding. I have had business clients that have taken advantage of this benefit. It really got them out of a short-term cash flow jam. There may be restrictions on how much cash value your policy must accumulate before you can start borrowing against it. Additionally, if you cannot make the loan payments and the collateral of the cash value must be used, then the interest and the loan amount can cut into the policy’s death benefit.