Last week we talked about some of the advantages and perils of using corporate-owned life insurance. Today, we will talk about ways to maximize the tax advantage of such a strategy, and the product options that work best. This is a simple introduction, and not meant as personalized advice.
To briefly review, most profitable incorporated businesses accumulate cash in the business, and it's expensive to get that cash out to the shareholder owners, in the sense that tax must be paid.
Therefore, it makes more sense to use those corporate dollars to pay for life insurance, if required, on the owner. When the shareholder dies, the corporation gets the death benefit tax-free.
The new shareholders will likely be able to receive a tax-free capital dividend from the corporation, allowing them to remove much of the death benefit without paying taxes. This is facilitated because the amount by which the death benefit exceeds the adjusted cost basis (ACB) of the policy adds to the corporation's CDA, or capital dividend account.
In a business insurance plan that is designed properly, virtually all of the death benefit will create CDA. In a poorly designed plan, it's possible only some of the death benefit will create CDA, trapping the rest of the death-benefit cash inside the corporation.
A good insurance plan starts with a clear goal, and then the product options selected are tailored to that goal.
A poor design for maximizing CDA uses a life-policy option called "level death benefit." The better choice for maximum CDA and maximum tax-free death benefit is called "face plus account value" or something similar.
Take an example of a policy with an initial $1-million death benefit. This means if the insured shareholder of the corporation dies immediately after taking out the policy, the insurance company will pay $1 million to the corporation. The insurance company will keep track of the ACB of the policy, so the corporation's accountants know how much of the death benefit can be credited to the CDA.
With the level death benefit option, the death benefit will still be $1 million in 10 years, even though there may be a large cash value built up in the policy. In this situation, there will likely also be a high ACB, built up by the excess of premiums paid over the net pure cost of insurance.
It is this excess that builds the cash value, but also tends to build ACB, which negatively affects the CDA and the amount that can be paid out tax-free.
Better is to have the growing cash value added to the death benefit, otherwise known as the "face amount." Hence, this option is called "face plus account value" or similar.
This option increases the amount of the death benefit each year by the amount of the accumulated cash value in the investment accounts. Although the ACB may still build up, there is a faster growth in death benefit, so the addition to the CDA also grows. This means the death benefit may still exceed the amount of CDA created on death, but there will be a larger CDA account and more tax-free death benefit. Essentially, this converts investment income that would have been taxable each year into a tax-free payment of cash on death.
Universal life lets the policy-owner choose how much cash to deposit into the policy, between a minimum amount needed to keep the policy in force, and the maximum amount allowed by CRA. Choosing to pay less money into a policy will slow the growth of the ACB.
I am looking at two actual illustrations of a policy currently in force, and the effect of different premium choices in the future. This policy has a loan amount against it, which adds a different wrinkle.
One illustration shows an ACB returning to zero after 10 years, after premium payments had been stopped. The other illustration on the same policy, with continuing premium payments, shows an ACB ultimately growing to $2.9 million. That's a big difference. (It's also a very large policy.)
Brokers can create computer illustrations showing the ACB growth in the future. These definitely need to be part of the planning process.
Also note that the federal budget of 2012 introduced proposed changes to the rules governing the tax-exempt status of insurance policies, and the likelihood of changing the allowable interest rates on some loan strategies currently being used. Now, more than ever, business owners need to use insurance professionals who truly know their stuff.
Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.
David Christianson is a financial planner and adviser. He can be reached at email@example.com .