This column is aimed at business owners, small and large. Whether a business is run as a sole practitionership, partnership or corporation, there is likely a need for life insurance for owners and key people.
We will look at those needs in more detail, and then touch on some of the strategies that can save taxes on the death of a shareholder, by creating a balance in the corporation's Capital Dividend Account.
First, how do you determine if there is a need for life insurance? Step 1 is to use your imagination, and go through the list of owners and important people. In each case, make the unpleasant assumption that the person had passed away yesterday.
Would the bank be calling in loans, out of nervousness? How much cash would be needed to pay these off?
If there is more than one owner, would the remaining owners want to be in business with the spouse or family of the deceased owner? Often, there is an agreement on what will happen on the death of a shareholder. Hopefully, this has been written down in a buy-sell agreement and, hopefully, has life insurance funding to ensure that the agreement can be fulfilled.
In a partnership or corporation with more than one shareholder, life insurance to fund buy-sell agreements is one of the most important needs to be filled.
Proper forward planning would have life insurance on each of the partners, in an amount adequate to cover the expected value of the shares in the future (not just today), based on the formula outlined in the buy-sell agreement.
Many business owners have loaned substantial amounts of money to their companies, as shareholder loans. Their estates have a legitimate claim to demand this money back, which means a need for liquidity in the business on the death of the shareholder -- hence life insurance.
Would a key person in the business need to be replaced? How much would that cost, to search and then hire? Would people have to be hired temporarily to fill the gap? This applies to employees, as well as owners, as some are key to the business success.
In all cases, would revenues be hurt or other expenses go up as the business of the company is interrupted by the death? If this would be a significant or permanent cost, then life insurance should be in place.
Remember taxes? We all love paying those, and the bonus when you die is that there may be extra taxes to pay. If a corporation has been operating for many years and has substantial retained earnings, then the shares have a high current value. However, when the corporation was formed, the shares typically had a notional value, like $100. That's the cost base.
When the owner dies, the shares are deemed to be sold (for tax purposes) at the fair market value, even if no cash is received for them. Half of the gain is taxable at the tax rate of the deceased taxpayer on death. Since RRSPs were also taxable that year, the taxpayer might be in the top rate.
Unless there is a surviving spouse to whom this tax liability can be passed, or the shares are eligible for the $750,000 capital gains exemption on qualifying small business shares or shares of a farm corporation, this could give rise to a huge need for personal life insurance to pay these taxes.
But wait, there's more! On top of the gain on the shares, those retained earnings remain in the corporation as a "trapped corporate surplus." When this is paid out as a dividend to the estate or the inheriting shareholders, this amount is taxed again as a dividend.
If the corporation owns permanent life insurance on the shareholder, with the corporation as beneficiary, then virtually all of the death benefit of the policy creates a balance in the corporation's Capital Dividend Account (CDA). Canada Revenue Agency allows the corporation to pay out the CDA tax-free as a capital dividend to its shareholders.
More sophisticated life insurance strategies deposit corporate money into such a permanent life insurance policy, and then use the policy cash value as collateral to borrow money to invest, or return to the corporation to create income. Either way, the interest on the loan is tax deductible (while the investment income earned on cash value is tax-sheltered) and the capital is still being put to use. In this way, the net, after-tax cost of insurance can be very low, while saving as much as 38 per cent tax that would otherwise be payable on a taxable dividend.
To quote Ed Sullivan, "Kids, do not try this at home." Consult an insurance professional with experience and expertise in this area, especially if you are getting into "back-to-back" or "triple back-to-back" strategies, corporate IRP with shareholder personal borrowing, split-dollar arrangements or other sophisticated concepts.
Always double check all of the tax assumptions with your accountant, and ask to talk to other business owners who have tried the strategies, so you have a good feel for any complications involved in the implementation.
David Christianson is a financial planner and portfolio manager at Wellington West Total Wealth Management Inc. He can be reached at