Demystifying Corporate Owned

Life Insurance

CIFPS Annual National Conference

Kevin Wark, LLB, CFP

Many insurance advisors shy away from working with business owners due to concerns about planning complexities…

However, a high level understanding of the planning points around corporate owned insurance will put you in the driver’s seat

1. Exempt Test Rules

Exempt Policies: Qualify for tax deferred growth on cash

values Tax-free death benefit Disposition of policy may give rise to tax if

if policy’s cash value exceeds its adjusted cost basis (“ACB”)

Rules for corporate owned policies similar to individually-owned policies

1. Exempt Test Rules

ACB Calculation Determined in same way as for

individual policyholders Increased by premiums paid and

certain other amounts Decreased by “proceeds of

disposition” and the net cost of pure insurance (“NCPI”)

1. Exempt Test Rules

Dispositions Include: Surrender of policy (including

partial surrender or cash withdrawals)

Policy loan after March 1978 Maturity of policy (e.g. endowment) Policy dividends Gift or non-arm’s length transfer

1. Exempt Test Rules

Planning Tips: Can reduce current income in a private

corporation through investing in an exempt policy

Policy gains can be converted to tax-free death benefit and distributed tax-free to shareholders via capital dividend account

Leveraging concepts allow cash values to be accessed on tax-free basis

2. Deductibility of Premiums

Insurance premiums are generally not deductible by a corporation.

Exceptions: Collateral insurance Charitable gifting Employee benefits RCAs

2. Deductibility of Premiums

Planning Tip: Have premium paid by corporation if in lower

tax bracketExample:Assume premium of $1000, corporation in 20%

tax bracket and shareholder in 50% tax bracket. Corporation has to earn $1250 before tax to pay premium. Shareholder has to earn $2000 before tax to pay same premium.

3. Capital Dividend Account

Capital Dividend Account (CDA) Notional tax account for private

corporations Represents amounts that would be

tax-free if received directly by shareholder

Difference between insurance death benefit and ACB of policy included in CDA

3. Capital Dividend Account

ACB reduced by NCPI Actuarial calculation of the cost of

insurance under the policy Generally equal to the “Net Amount

at Risk” (death benefit less the cash surrender value of the policy) multiplied by a mortality charge specified in the ITA

3. Capital Dividend Account

Planning Tips: Clear out CDA on regular basis to

reduce value of company and potential capital gains

Split dollar with company owning risk component of the policy

Holdco owns policy with Opco as beneficiary

4. Creditor Protection

A corporate owned policy is subject to claims of corporate creditors

If spouse of life insured is named as beneficiary may be able to claim creditor protection but will have shareholder benefit issues

Same benefit issue if a shareholder is named as an irrevocable beneficiary

4. Creditor Protection

Planning Tips: Split dollar/split beneficiary

insurance Holdco owns and is beneficiary of

the policy Collateral Insurance (Term)

5. Buy-Sell Agreements

Death is a triggering event under most buy-sell agreements

Life insurance usually most cost effective method of funding obligation to purchase shares

Need to work closely with lawyer to ensure life insurance lines up with terms of agreement

5. Buy-Sell Funding

Corporate Owned - Share Redemption

Corporation owns insurance on each shareholder’s life

On death the corporation redeems shares of deceased shareholder

5. Buy-Sell Funding

Pre-stop loss rules: Capital gain realized by shareholder in

year of death could be offset by capital loss realized in estate

Corporate owned insurance used to redeem shares of deceased from estate

Loss realized by estate when shares are redeemed by corporation

Estate receives tax-free capital dividend from corporation

5. Buy-Sell Funding

Pre-Stop Loss Rules - Example Joan owns shares worth $1 million,

ACB=0 Opco owns $1 million life insurance On Joan’s death, estate files terminal

return with $1 million capital gain Redemption of shares creates

$1 million deemed dividend, tax-free from CDA

5. Buy-Sell Funding

Pre Stop Loss Rules - Example Joan’s estate realizes a capital loss

of $1 million on share redemption Capital loss can be carried back to

final tax return to offset $1 million capital gain

Joan and estate pay no tax, but surviving shareholders have future $1 million gain

5. Buy-Sell Funding

Post stop loss rules: Loss reduced in amount by which capital

dividend exceeds 50% of lesser of:(i) capital gain realized on death; and

(ii) capital loss realized in estate Rule means that 50% of redemption proceeds

can still be paid as a tax- free capital dividend BUT double taxation can result if if not

properly structured

5. Buy-Sell Funding

Grandfathered Arrangements: Redemption agreement in writing before

April 27, 1995 Acquisition of new or updated life

insurance coverage to fund agreement will not affect access to grandfathering

Changes to grandfathered agreements may cause loss of preferential status even if changes do not affect buy-sell provision on shareholders death

5. Buy-Sell Funding

Grandfathered Arrangements: Also available for insurance policies

inforce on April 26, 1995; where A main purpose of the insurance was to

redeem shares held by a deceased shareholder

5. Buy-Sell Funding

Planning Tips: Look for “grandfathered” situations Transfer shares to surviving spouse and

then redeem shares using insurance proceeds

Structure as share redemption but only use 50% of CDA (hybrid agreement)

Simplify matters by using corporate owned promissory note method

6. Valuation of Corporate Owned Policy

While Policyholder is Living: Generally valued at “fair market value” Look to a number of factors including

policy’s csv, health of life insured, cost of a new policy etc. (IC-89-3)

On disposition of policy its value = CSV of policy

6. Valuation of Corporate Owned Insurance

On Policyholders Death (IT-416R3): Policy on deceased’s life or other

non-arm’s length persons valued at its CSV immediately before death (i.e. ignore death benefit)

Policies on “arm’s length” lives valued at “fair market value” which could take into account part or all of the death benefit

7. Capital Gains Exemption and Corporate Owned Insurance

Can shelter up to $500,000 of capital gains on disposition of shares in a CCPC

90% or more of corporation’s assets have to be used in an “active” business

Insurance cash values not considered to be part of active business assets

7. Capital Gains Exemption and Corporate Owned Insurance

Planning Tips: Keep cash values low in relation to

other assets in the corporation Use split dollar to hold cash values

outside the company Use a holding company to own the

policy

7. Reasonable Expectation of Profit Test (REOP)

Taxpayer can only claim a loss from business or property where it is reasonable to assume there will be a cumulative profit

“Profit” does not include capital gains

Annual test Rules to be effective after 2004

7. REOP Test

Could impact a number of planning ideas using leveraging to acquire corporate owned insurance:

Corporate back to backs 10/8 insurance programs Corporate insured retirement

programs

7. REOP Test

Planning Tips: Better to borrow to invest in a

business rather than other types of investments

Make sure client has other sources of income to utilize deductions

Work closely with client’s tax and accounting advisors

8. Sale of Business

Corporation owns $1 million UL policy with CSV of $100,000 and ACB of $40,000

Assume shareholder wants to sell all shares in corporation

Shareholder wants to retain ownership of the policy

8. Sale of Business and Transfer of Insurance Policy

Transfer of policy to shareholder will be a disposition - taxable gain to corporation of $60,000

Shareholder will be in receipt of a taxable benefit – at least $100,000 and possibly a higher amount if not in good health

8. Sale of Business and Transfer of Insurance Policy

Planning Tips: Ideally set up ownership of policy in

holding company from beginning Establish holding company and distribute

policy as tax-free dividend Use policy to repay any outstanding

shareholder loans Transfer out as employee benefit so

corporation can deduct the payment

Corporate Owned Insurance

It’s as easy as learning your ABCs…

ACB =

CDA =

CSV =

FMV =

NCPI =

RCA =

REOP =

Discussion…