Drawbacks of corporate-owned life insurance

This article is aimed primarily at life insurance agents and business owners. Both need to be aware of potential pitfalls when using corporate-owned life insurance.

This is a positive strategy in many cases, with definite benefits for business owners. In the case of small businesses, having a corporation own a life insurance policy on the owner's life can be more efficient. The premiums can be paid with dollars that have been taxed at the lower small-business rate, as opposed to paying premiums with personal money, which has probably been taxed at a higher rate.

In simpler terms, if it is the corporation that earns the money from a business, then inside the corporation is where the money is. There is a tax cost to removing that money in order to pay premiums (or other expenses) personally, so the better decision is to pay inside the company.

One caveat -- if such expenses are purely personal, then CRA will want the corporation to issue a T4 slip to the owner for the taxable benefit. This will not happen with the life insurance if the corporation is named as the owner and beneficiary.

Here's the big caution. Life insurance death benefits are tax-free to the recipient. If the corporation is the beneficiary, then it receives the death benefit tax-free when the insured dies. However, the goal is to get that cash out of the corporation and into the hands of the shareholders, also tax-free.

This is where the sales pitch and the reality can differ.

Insurance professionals explain the death benefit received by the corporation can be paid out tax-free to the shareholders in the following way. Any death benefit received adds to the corporation's capital dividend account, or CDA. This is a notional tax account into which things such as the tax-free half of capital gains are added.

The corporation can pay a tax-free dividend at any time to the shareholders, up to the balance of the CDA. If the insured person dies and the company receives a death benefit of, say, $100,000, then $100,000 is added to the CDA, allowing for a $100,000 capital dividend to be paid out tax-free.

Or does it?

It turns out it's a little more complicated, a fact that's not known to all insurance professionals. Not all of the death benefit is credited to the CDA balance if the policy has a positive adjusted cost basis, or ACB.

In my example, if that policy had an ACB of $40,000 when the corporation received the $100,000 death benefit, then only $60,000 would be added to the notional CDA, and only $60,000 of the death benefit could be paid out tax-free to the shareholders. The remaining amount would have to be paid out as a taxable dividend.

This is the situation where the corporation is the both the owner and beneficiary, which is usually the case. If the corporation is not owner, but only beneficiary, then the entire death benefit adds to the CDA.

So what determines the ACB?

Adding to the ACB are premiums paid, interest paid on policy loans and other minor factors. Decreasing ACB is the NPCI -- the net pure cost of insurance, which is the mortality charge for the death benefit of the policy.

Think of it this way -- the growth in cash value of the policy is generally tax-free, so many policy owners want to maximize this growth. The government allows this (up to a limit), but has to have an offsetting factor on the death benefit, for those who maximize the cash accumulation.

To get the accurate ACB, the policy owner has to ask the insurance company. For all corporate-owned insurance policies, I recommend this number be determined now, and an "in-force illustration" be requested to project how the ACB will change in the future.

You don't want to be in the position of the company owner dying and receiving the rude surprise that not all of the death benefit can be removed from the corporation tax-free, as you thought.

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Dollars and Sense is meant as an introduction to this topic and should not be construed as a replacement for personalized professional advice.

David Christianson is a financial planner and adviser. He can be reached at dchristianson@wellwest.ca .

Republished from the Winnipeg Free Press print edition October 19, 2012 B14