TAX Q&A: USING CORPORATE-OWNED LIFE INSURANCE TO ACCUMULATE WEALTH

July 04, 2020 BDO Tax Consultants

Corporate-owned life insurance can provide many benefits for business owners. In our “How corporate-owned life insurance can boost your liquidity” article, we discussed the role life insurance can play in managing business risk and tax costs in the event of the death of the owner-manager. This article will focus on the use of life insurance inside a corporation to build wealth over the long term.

Here are our answers to some key questions you may have:

What life insurance products should I consider?

In this article, we are focusing on the ability of a life insurance product to grow in value over time, rather than just deliver life insurance. Life insurance products generally fall into two categories—term and permanent. These are the main characteristics of each type:

Term life insurance

• Provides coverage for a specific term, typically five, 10, or 20 years
• Premiums stay the same for the duration of the term
• Relatively inexpensive form of life insurance
• Often used during working years to provide funds in the event the business owner dies to replace loss of income and cover liabilities

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Permanent life insurance

• Provides guaranteed coverage for life
• Many forms including whole, participating, and universal life
• Can provide both insurance protection and a tax-deferred investment component (subject to a limit)
• Includes a cash value component that accumulates over time and can be used as collateral for borrowing
• In the event the policy is voluntarily terminated before death or maturity, the cash surrender value is paid by the insurer to the policyholder
• Often used as part of estate planning to build value over the long term and cover estate taxes

Other than these two general categories, insurance products can vary greatly depending on several factors such as age, amount of investment potential, and overall health risk. In the context of building wealth, permanent life insurance would be chosen instead of term insurance. When buying insurance, you should consult with your insurance advisor to discuss your specific circumstances.

What makes permanent life insurance attractive from an income tax perspective is that the investment portion of the policy can accumulate in value without incurring tax on the earnings. The rate at which an insurance policy can accumulate without tax is set out in the income tax rules. A policy that adheres to these investment growth limits is known as an exempt policy. In almost all cases, life insurance issuers will ensure the policy is an exempt policy. If such a policy is held until death, none of the benefit paid because of death is taxable. If the policy is cashed in prior to death, some portion of the proceeds received will be taxable. However, in either case, there is no current taxation, allowing either a tax deferral on investment income or a complete exemption from tax.

Why might corporate-owned life insurance be more attractive beginning Jan. 1, 2019?

In the 2018 Federal Budget, the government proposed to restrict access to the small business limit—the amount of annual income eligible for the small business tax rate. The restriction will apply to Canadian-controlled private corporations (CCPCs) that earned more than $50,000 of passive investment income in the previous year. Under these proposals, the federal small business limit of $500,000 will be phased out at $5 for every $1 of investment income above the $50,000 threshold. The small business limit will be eliminated when investment income in the prior year reaches $150,000. This change has been passed into law and will take effect on Jan. 1, 2019.

For business owners, this means that there will be a cost—mostly in the form of a loss in tax deferral—to earning more than $50,000 of investment income inside a CCPC where the company also earns active business income that would otherwise be eligible for the small business rate. For more insight on this  change, see our “Passive investment income and its impact on the small business deduction” article.

Under the new rules, income from investment in an exempt life insurance policy will not be considered investment income for purposes of these new rules. As such, income from investment earned in an exempt policy will not affect your CCPC’s ability to claim the small business deduction and can be a vehicle to help you build wealth. As this change is to come into effect on Jan. 1, 2019, now is the time to consider planning to mitigate its impact. As previously noted, most life insurance policies are structured to be exempt. However, this should be confirmed with your life insurance provider when purchasing a policy.

What are the tax benefits of owning life insurance inside a corporation?

There are several tax advantages of owning life insurance inside a corporation. First, the cost to fund policy premiums will be lower if paid by the corporation rather than personally—assuming the corporation’s tax rate is lower than the personal tax rate (which is usually the case).

For example, Kate owns a CCPC and is considering buying life insurance with a monthly premium of $500. Kate’s personal marginal tax rate is 48% and her corporate tax rate is 12%. To fund the policy premiums personally, Kate will need to earn $962 each month to have $500 after tax to pay the premiums. If Kate’s corporation owns and pays for her life insurance policy, her corporation will need to earn only $568 before tax to fund the $500 premium. This equals savings of $394 each month if her corporation owns the life insurance policy and pays the premiums. It is important when the corporation pays the premium on the life insurance, that the corporation is also the beneficiary.

Second, business owners benefit from tax-deferred growth in the value of investments in an exempt permanent life policy held within the company until disposition. This benefit is comparable to the tax-deferred investment growth in a registered retirement savings plan by potentially allowing for greater asset growth because the earnings can accumulate free from tax.

The tax deferral benefit of permanent life insurance also applies to such insurance held personally. However, where the funds to invest are already in the company, investing the funds within the company will save the tax cost of paying the owner funds by way of salary or dividend to allow them to invest personally. Permanent life insurance products can be an attractive option where the business owner has excess funds in the company to invest on a long-term basis to accumulate wealth and ultimately transfer to the estate. As mentioned, this option may become increasingly popular due to the new rules that will restrict access to the small business limit based on a private corporation’s level of passive investment income.

Finally, as discussed in our related article, the life insurance proceeds over the cost basis of the policy can be paid as a tax-free capital dividend upon death.

Keep in mind that even if you already own life insurance personally, you may be able to transfer such a policy to your corporation. However, the costs and benefits of such a transfer are beyond the scope of this article. Your BDO tax advisor can assist you in making a determination of whether this would be beneficial to you.

What are the potential disadvantages of owning life insurance inside a corporation?

There are several potential disadvantages of owning life insurance in a corporation to bear in mind. Three of these risks are discussed in our companion article, and won’t be discussed here. However, there are two additional risks to mention when investing in a permanent life insurance policy in a corporation: liquidity and access to the capital gains exemption.

Liquidity

Investments in a permanent life insurance policy are typically for the long term and therefore do not have the liquidity of marketable securities. Before buying a permanent life insurance policy, you should consider your cash flow needs and how the policy will fit into your entire investment plan.

Access to the capital gains exemption

As a business owner, holding permanent life insurance within a corporation may affect your ability to claim the lifetime capital gains exemption (LCGE) on the shares of your corporation. In this way, the investment portion of a life insurance policy is treated in a similar manner to marketable securities and other passive investments. It is not an active business asset. Where the shareholder is the life insured, the life insurance policy will generally be valued at its cash surrender value for purposes of determining whether the share of the company will qualify for the LCGE. Since the LCGE applicable on the disposition of qualifying shares is $848,252 in 2018, the tax impact of whether your shares qualify may have a material impact on your taxes in the future.

What else should I keep in mind?

Overall, there are tax benefits of owning life insurance within a corporation, including the ability to accumulate wealth and transfer that wealth to family members in a tax-effective way. However, the suitability of different policies will depend on various tax and non-tax factors. We suggest you consult an insurance provider to explore different options and contact your BDO tax advisor who can help you assess the tax implications specific to your circumstances.