Demystifying Corporate Owned Life Insurance Kevin Wark, LLB, CFP CIFPS Annual National Conference

Many insurance advisors shy away from working with business owners due to concerns about planning complexities…

However, a high level understanding of the planning points around corporate owned insurance will put you in the driver’s seat

1. Exempt Test Rules Exempt Policies: Qualify for tax deferred growth on cash values Tax-free death benefit Disposition of policy may give rise to tax if if policy’s cash value exceeds its adjusted cost basis (“ACB”) Rules for corporate owned policies similar to individually-owned policies

1. Exempt Test Rules ACB Calculation Determined in same way as for individual policyholders Increased by premiums paid and certain other amounts Decreased by “proceeds of disposition” and the net cost of pure insurance (“NCPI”)

1. Exempt Test Rules Dispositions Include: Surrender of policy (including partial surrender or cash withdrawals) Policy loan after March 1978 Maturity of policy (e.g. endowment) Policy dividends Gift or non-arm’s length transfer

1. Exempt Test Rules Planning Tips: Can reduce current income in a private corporation through investing in an exempt policy Policy gains can be converted to tax-free death benefit and distributed tax-free to shareholders via capital dividend account Leveraging concepts allow cash values to be accessed on tax-free basis

2. Deductibility of Premiums Insurance premiums are generally not deductible by a corporation. Exceptions: Collateral insurance Charitable gifting Employee benefits RCAs

2. Deductibility of Premiums Planning Tip: Have premium paid by corporation if in lower tax bracket Example: Assume premium of $1000, corporation in 20% tax bracket and shareholder in 50% tax bracket. Corporation has to earn $1250 before tax to pay premium. Shareholder has to earn $2000 before tax to pay same premium.

3. Capital Dividend Account Capital Dividend Account (CDA) Notional tax account for private corporations Represents amounts that would be tax-free if received directly by shareholder Difference between insurance death benefit and ACB of policy included in CDA

3. Capital Dividend Account ACB reduced by NCPI Actuarial calculation of the cost of insurance under the policy Generally equal to the “Net Amount at Risk” (death benefit less the cash surrender value of the policy) multiplied by a mortality charge specified in the ITA

3. Capital Dividend Account Planning Tips: Clear out CDA on regular basis to reduce value of company and potential capital gains Split dollar with company owning risk component of the policy Holdco owns policy with Opco as beneficiary

4. Creditor Protection A corporate owned policy is subject to claims of corporate creditors If spouse of life insured is named as beneficiary may be able to claim creditor protection but will have shareholder benefit issues Same benefit issue if a shareholder is named as an irrevocable beneficiary

4. Creditor Protection Planning Tips: Split dollar/split beneficiary insurance Holdco owns and is beneficiary of the policy Collateral Insurance (Term)

5. Buy-Sell Agreements Death is a triggering event under most buy-sell agreements Life insurance usually most cost effective method of funding obligation to purchase shares Need to work closely with lawyer to ensure life insurance lines up with terms of agreement

5. Buy-Sell Funding Corporate Owned - Share Redemption Corporation owns insurance on each shareholder’s life On death the corporation redeems shares of deceased shareholder

5. Buy-Sell Funding Pre-stop loss rules: Capital gain realized by shareholder in year of death could be offset by capital loss realized in estate Corporate owned insurance used to redeem shares of deceased from estate Loss realized by estate when shares are redeemed by corporation Estate receives tax-free capital dividend from corporation

5. Buy-Sell Funding Pre-Stop Loss Rules - Example Joan owns shares worth $1 million, ACB=0 Opco owns $1 million life insurance On Joan’s death, estate files terminal return with $1 million capital gain Redemption of shares creates $1 million deemed dividend, tax-free from CDA

5. Buy-Sell Funding Pre Stop Loss Rules - Example Joan’s estate realizes a capital loss of $1 million on share redemption Capital loss can be carried back to final tax return to offset $1 million capital gain Joan and estate pay no tax, but surviving shareholders have future $1 million gain

5. Buy-Sell Funding Post stop loss rules: Loss reduced in amount by which capital dividend exceeds 50% of lesser of: (i) capital gain realized on death; and (ii) capital loss realized in estate Rule means that 50% of redemption proceeds can still be paid as a tax- free capital dividend BUT double taxation can result if if not properly structured

5. Buy-Sell Funding Grandfathered Arrangements: Redemption agreement in writing before April 27, 1995 Acquisition of new or updated life insurance coverage to fund agreement will not affect access to grandfathering Changes to grandfathered agreements may cause loss of preferential status even if changes do not affect buy-sell provision on shareholders death

5. Buy-Sell Funding Grandfathered Arrangements: Also available for insurance policies inforce on April 26, 1995; where A main purpose of the insurance was to redeem shares held by a deceased shareholder

5. Buy-Sell Funding Planning Tips: Look for “grandfathered” situations Transfer shares to surviving spouse and then redeem shares using insurance proceeds Structure as share redemption but only use 50% of CDA (hybrid agreement) Simplify matters by using corporate owned promissory note method

6. Valuation of Corporate Owned Policy While Policyholder is Living: Generally valued at “fair market value” Look to a number of factors including policy’s csv, health of life insured, cost of a new policy etc. (IC-89-3) On disposition of policy its value = CSV of policy

6. Valuation of Corporate Owned Insurance On Policyholders Death (IT-416R3): Policy on deceased’s life or other non-arm’s length persons valued at its CSV immediately before death (i.e. ignore death benefit) Policies on “arm’s length” lives valued at “fair market value” which could take into account part or all of the death benefit

7. Capital Gains Exemption and Corporate Owned Insurance Can shelter up to $500,000 of capital gains on disposition of shares in a CCPC 90% or more of corporation’s assets have to be used in an “active” business Insurance cash values not considered to be part of active business assets

7. Capital Gains Exemption and Corporate Owned Insurance Planning Tips: Keep cash values low in relation to other assets in the corporation Use split dollar to hold cash values outside the company Use a holding company to own the policy

7. Reasonable Expectation of Profit Test (REOP) Taxpayer can only claim a loss from business or property where it is reasonable to assume there will be a cumulative profit “Profit” does not include capital gains Annual test Rules to be effective after 2004

7. REOP Test Could impact a number of planning ideas using leveraging to acquire corporate owned insurance: Corporate back to backs 10/8 insurance programs Corporate insured retirement programs

7. REOP Test Planning Tips: Better to borrow to invest in a business rather than other types of investments Make sure client has other sources of income to utilize deductions Work closely with client’s tax and accounting advisors

8. Sale of Business Corporation owns $1 million UL policy with CSV of $100,000 and ACB of $40,000 Assume shareholder wants to sell all shares in corporation Shareholder wants to retain ownership of the policy

8. Sale of Business and Transfer of Insurance Policy Transfer of policy to shareholder will be a disposition - taxable gain to corporation of $60,000 Shareholder will be in receipt of a taxable benefit – at least $100,000 and possibly a higher amount if not in good health

8. Sale of Business and Transfer of Insurance Policy Planning Tips: Ideally set up ownership of policy in holding company from beginning Establish holding company and distribute policy as tax-free dividend Use policy to repay any outstanding shareholder loans Transfer out as employee benefit so corporation can deduct the payment

Corporate Owned Insurance It’s as easy as learning your ABCs… ACB = CDA = CSV = FMV = NCPI = RCA = REOP =

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