Why Should A Corporation Own Life Insurance?
If you own a business, there are several reasons you would need life insurance in the context of your business. The most common reasons are the following:
Funding a buy-sell agreement – life insurance can provide the funds needed to buy out the interests of a deceased shareholder due to an unexpected death. This ensures that the deceased’s survivors are paid on a timely manner and the business functions smoothly for the surviving owners. In a corporate setting, it would be prudent to document the fact that the proceeds of the life insurance should be used to buy out the interests of a deceased shareholder in a binding shareholders agreement.
Key person protection – Upon the loss of a key employee or shareholder due to premature death, life insurance can provide the capital to maintain the operations of the business and find a replacement for the deceased key individual. The funds can provide the financial cushion needed until a suitable replacement can be found and stability is returned to the operation of the business. The coverage may include not only the cost of finding a replacement for the key person but also direct lost revenue and extraordinary expenses that may arise as a result.
Estate tax liabilities – Upon the death of a shareholder, his shares in the business are deemed disposed by Canada Revenue Agency and estatetax liabilities arise as a result. The good news is that qualifying small business corporation shares are entitled to make use of the $800,000 lifetime capital gains, and if interests in the business are rolled over to a surviving spouse, the tax related to the disposition of shares can also be deferred.
Income replacement – Business income is usually the main source of income for most business owners, and loss of your ability to earn an income due to an accident or sickness can be devastating if you happen to be the breadwinner of your family. Therefore, it is important to assess your personal and business needs at the same time to make sure that there is adequate funding in place to provide income for your family in the event of your death.
A common misconception is that life insurance premiums are tax-deductible for a corporation. The truth of the matter is: except in very isolated circumstances, life insurance premiums are not tax-deductible for a corporation just as they are not when a policy is owned personally.
However, if the premiums for the policy are paid by the corporation, it is generally less costly than paying the premiums personally. This is because personal marginal tax rates are considerably higher than corporate tax rates (for Canadian Controlled Private Corporations). The corporation can pay the premiums itself, or issue a dividend to the shareholder to pay the premiums personally. Since the shareholder will be taxed on the dividend, it means that less cash would be available for the purpose of paying premiums in the shareholders’ hands, thus requiring a larger dividend to be issued by the corporation in order to net down to the required amount needed for paying the premiums.
When it comes to the death benefit of a life insurance policy, it is paid out tax-free to the beneficiary of the policy, whether the beneficiary is an individual or a corporation. When a corporation owns a policy, either the corporation itself or a subsidiary corporation would be named as beneficiary. Otherwise, the payment of the death benefit could give rise to a taxable shareholder benefit. Similarly, if a corporation pays the premium on a policy owned by a shareholder, a shareholder benefit would arise.
While a corporation receives insurance proceeds tax-free, these proceeds (except in the case of key person insurance) still ultimately need to end up in the beneficiaries’ hands and need to be extracted from the corporation. Fortunately, there is a mechanism called the Capital Dividend Account that allows for the death benefit of a life insurance policy that is received by the corporation on a tax-free basis to be transferred into the hands of shareholders and beneficiaries on a tax-free basis.
A corporation’s capital dividend account or CDA is a notional account that keeps track of items such as life insurance proceeds and the non-taxable portion of capital gains. If the declared dividends to a shareholder are elected to come from the CDA, they will not be taxable. The CDA is consequently reduced by the amount of such dividends. This election may also apply to deemed dividends that occur when shares are redeemed. An example would be when a surviving spouse decides to wind up the corporation after the death of his/her business owner spouse.
Tax implications of funding and receiving insurance through a corporation are complex and you need to consult a financial advisor who is well-versed in dealing with estate planning issues relating to business owners, as well as your tax and legal advisors to put the right structures and coverage in place.
Tina Tehranchian is a Senior Financial Planner with Assante Estate and Insurance Services Inc. Please visit www.tinatehranchian.com or contact her at (905) 707-5220 for individual financial advice based on your personal circumstances before acting on any of the information above.