Life Insurance: Why would a business owner want it?
The traditional perception of life insurance is that it is a financial product providing income replacement at death, funding tax liabilities, partnership buyout agreements, covers key people in an organization or is used to equalize an estate.
Most ultra-high net worth Canadians are sufficiently self-insured by virtue of their assets. They feel, and rightly so, that they don’t need insurance for traditional risk mitigation purposes.
That said, corporate-owned life insurance can be used by wealthy individuals as a tax effective way to accumulate passive wealth inside a company, to access that wealth tax-free and to transfer it tax-free to surviving beneficiaries.
In many businesses, the retained profits or surplus cash are invested in taxable investments. This is often the case when the business owner doesn’t need the extra income and has a higher marginal tax rate than their business. Consequently, they take advantage of the low corporate tax rates on active business income by saving money in their corporations, if they don’t require it for personal purposes. This accomplishes a tax deferral, but eventually these assets will come out of the corporation and be taxed at high dividend tax rates, depending on the taxpayer’s post mortem planning. This TaxLetter® article on “the Tax Grind” articulates the problem.
A solution to this problem is to invest some of the retained profits in tax exempt permanent life insurance. There are two main benefits to making such an investment, namely:
- The savings component of the life insurance policy can grow on a tax-free basis; and
- A significant portion, if not all, of the policy proceeds payable at death can be paid to the shareholder’s estate as a tax-free capital dividend.
Other Income Tax Advantages of Corporate-Owned Life Insurance
One advantage of corporate-owned life insurance is that the premiums are paid with corporate after-tax dollars, which are taxed at a much lower tax rate than the individual shareholder’s personal tax rate. The corporate tax rate applicable to active business income in Ontario is approximately 15% and to investment income is 50%. The top individual marginal tax rate in Ontario is approximately 53.5%.
In addition to the foregoing, another advantage is that upon death, an individual is deemed to dispose of his/her property at its fair market value. As it pertains to shares of a corporation which owns a life insurance policy, the Income Tax Act dictates to value the life insurance policy at its cash surrender value immediately before death. Typically, this value will be significantly less than the policy’s payout following death, as well as being significantly less than the value of the property that would have otherwise been accumulated by the corporation had it not purchased the life insurance policy. Consequently, purchasing life insurance can also assist to lessen the tax payable at death in respect of shares of a private corporation, since it will usually lead to a lower valuation for the corporate shares than had no life insurance been purchased.
Some business owners are not comfortable tying up corporate funds in an illiquid investment such as a life insurance policy. Notwithstanding that it is never advisable to tie up a significant component of the corporation’s wealth in a single investment product, whether it be a permanent life insurance policy or otherwise, a solution does exist to this issue, namely the use of debt with the life insurance policy as collateral for the borrowing. This TaxLetter® article “Leverage and Life Insurance” explains how to acquire Life Insurance and preserve cash.