Building Insurance into Your Client’s Estate Plan Kevin Wark, LLB, CFP CIFPS Annual National Conference

Your client, Ron is 65 years old Married to Lisa (62) – second marriage Ron has two children, Mary (32) and Richard (27) both from first marriage Currently 2 grandchildren – uncertain if there will be more in the future Case Study

Ron started a manufacturing company 20 years ago, currently valued at $3 million and drawing salary/bonus of $200,000 per year Mary is involved in the business as VP Marketing Richard currently traveling in Europe Commercial property acquired for $400,000 in 1996, currently valued at $600,000 – rented to business for $40,000 pa. and has UCC of $200,000

Case Study Ron’s other main assets consist of personal residence, $300,000 in RRSPs, $200,000 in shareholder loans Ron has personally guaranteed $1 million loan to business Ron is President of local hospital board Home (valued at $400,000) has no mortgage and no other major debts

Ron’s Estate Objectives Ensure Lisa has income of at least $200,000 per year (before-tax) if he predeceases her Pass on business to daughter (Mary) Treat son (Richard) “fairly” on his death Minimize impact of taxes on his estate

Ron’s Estate Objectives Provide gifts to grandchildren for post secondary education and other significant obligations Creditor protect his estate Large gift to the hospital on death

Some Observations Value of estate assets (before tax) is approximately $4.5 million Taxes could reduce estate by approx. 20% ($900,000) Major asset (representing almost 75% of aggregate estate) going to daughter

Conflicting Demands on the Estate Plan Ron wants major estate asset to go to the daughter – impact on income to Lisa and ability to be “fair” to Richard Significant tax and other liabilities may impact viability of estate plan How to fund gifts to grandchildren and charity from estate?? Family law implications

Planning Idea #1– Collateral Insurance Corporation acquires $1 million term or permanent policy on Ron’s life Corporation assigns or hypothecates policy to bank as collateral for loan Corporation can deduct lesser of premium and “net cost of pure insurance”

Planning Idea #1 – Collateral Insurance Insurance proceeds would repay loan on Ron’s death and corporation would receive credit to its capital dividend account (CDA) CDA could be used to flow tax-free dividends to Lisa to provide required level of income (subject to availability of cash in the corporation) or convert to secured shareholder loan Removes significant liability from corporation and Ron’s estate

Planning Idea #2 – Creditor Protection/Capital Growth Ron has significant wealth tied up in his business Ron also has $200,000 shareholder loan account subject to business risks Corporation could repay shareholder loan and replace with conventional bank debt Split dollar arrangement between corporation and Ron for $1 million exempt UL contract

Planning Idea #2 – Creditor Protection/Capital Growth Under a split dollar arrangement the Corporation owns death benefit and pays term costs of policy Ron owns the cash value and funds with proceeds from the repaid shareholder loan Corporation assigns its interest to the bank and can deduct lesser of premium and net cost of insurance On Ron’s death the corporate debt is repaid by insurance proceeds and cash values flow to Lisa on tax-free basis outside of estate

Planning Idea #2 – Creditor Protection/Capital Growth Corporation pays $31,000 per year for insurance coverage of $1 million Ron pays $24,000 per year for 10 years and owns tax-deferred cash values Assuming death at age 85, corporation receives $1 million (full credit to CDA) and Ron’s estate receives over $700,000 Represents a total return of 5.5% (after- tax) and 10% (before-tax) on Ron’s deposits

Planning Idea #3 – Estate Freeze/ Buy-Sell with Mary Ron converts common shares into two classes of shares redeemable for $500,000 and $2.5 million respectively (total of $3 million) As part of this transaction Ron also completes an estate freeze and increases cost base of first class of preference shares to $500,000 Deferred tax liability on shares of approximately $600,000 New common shares issued to Mary

Planning Idea #3 – Estate Freeze/Buy-Sell with Mary Buy-sell agreement between Ron, Lisa, Richard and Mary funded by corporate owned insurance Corporation acquires $3 million permanent insurance policy on Ron’s life Under Ron’s will $2.5 million low ACB shares are transferred to Lisa and $500,000 high ACB shares to Richard Lisa’s shares are redeemed by the Corporation – no gain or loss on redemption as funded by capital dividend arising from insurance proceeds

Planning Idea #3 – Estate Freeze/Buy-Sell with Mary Mary buys Richard’s shares for $500,000 with a promissory note Remainder of insurance proceeds flowed out to Mary to repay promissory note Lisa receives $2.5 million tax-free, Richard $500,000 tax-free and Mary has all common shares (worth at least $3 million) with $500,000 ACB

Planning Idea #4 - Estate Equalization Ron wants to ensure Richard and Mary are treated “equitably” on his death Mary will be sole owner of a corporation worth between $3-4 million Assume Richard has received $500,000 tax-free on sale of preferred shares to Mary Still significant disparity in values being received by children upon Ron’s death

Planning Idea #4 – Estate Equalization Simplest and most cost effective approach would be to purchase joint second to die insurance on lives of Ron and Lisa Make Richard beneficiary of policy On death of surviving parent Richard will receive a tax-free gift outside of the estate Cost of $500,000 UL policy - $6,600 p.a.

Planning Idea #5 - Estate Equalization Another option would be for Ron to transfer the commercial property to his Corporation on a rollover basis Ron would take back redeemable preference shares with redemption value of $600,000 and ACB of $200,000 Mary would enter into agreement with Ron to purchase shares on Ron’s death

Planning Idea #5 - Estate Equalization Mary would acquire a $600,000 policy on Ron’s life to fund purchase of shares Taxable gain in Ron’s estate on shares Ron’s will would provide for after-tax sale proceeds to flow to Richard Mary would own preference shares with full cost base

Charitable Gifting Number of ways to cost effectively structure major gifts on death Can be funded through personal or corporate dollars Can structure to receive tax credit for premium payments or death benefit

Planning Idea #6 – Personal Charitable Gift while Alive Ron could purchase $200,000 insurance policy and gift to the hospital Ron would be able to claim a tax credit for premiums paid on policy after transfer 10 Year Direction to hold would exclude gift from charity’s disbursement quota

Planning Idea #7 – Personal Charitable Gift on Death Ron acquires $200,000 insurance policy and designates hospital as beneficiary No charitable credit for premiums paid On Ron’s death estate can claim entire death benefit as charitable gift Gift bypasses estate and potential creditors Tax credit available to offset gains on death (i.e. from sale of preference shares to Mary)

Planning Idea #8 – Corporate Charitable Gift Ron’s Corporation could purchase $200,000 policy on his life On Ron’s death life insurance proceeds could be gifted to the hospital (cannot designate hospital as direct beneficiary) Corporation can claim deduction for donation Corporation also receives $200,000 credit to the capital dividend account – tax free dividends

Planning Idea #9 – Gifts to Grandchildren Complicated by fact these are not natural grandchildren of Ron’s wife Ron will want to take steps to “protect their inheritance” Purchase insurance to provide gifts on death Could establish life insurance trusts to hold benefits for grandchildren Benefits include bypassing the estate and management of funds while grand children are minors

Three years later… Ron has incorporated a holding company, sold the operating business and invested after-tax proceeds in the holding company

Planning Idea #10 – Corporate Insured Annuities Objectives of Program Increase corporate investment yield and cash flow Increase value of estate by reducing taxes Facilitate distribution of corporate assets on tax effective basis

Corporate Insured Annuities - Process Corporation applies for $4 million joint first to die UL on Ron and Lisa’s life Corporation liquidates $4 million of investments to purchase a “life 0” annuity with payments to the first death of Ron and Lisa Corporation borrows $4 million to replace investment portfolio Corporation assigns both contracts to bank as security for loan and pays interest annually

Corporate Insured Annuities – Cash Flow Annuity payments used to: Pay insurance premium ($177,500 pa) Pay loan interest 8.5% Pay taxes on annuity (non-prescribed) * $36,600 in year 1 * $80,600 in year 2 and declines every year thereafter

Corporate Insured Annuities – Cash Flow Corporate Income Taxes Reduced by: Loan interest expense ($340,000) NCPI deduction ($146,000 in year 1 and increases to equal total premium in year 3) Loan is repaid with insurance proceeds on Ron’s death

Corporate Insured Annuities – Cash Flow in Year 1 Inflow Outflow Annuity $367,000 Insurance $177,500 Loan Interest 340,000 Tax on Annuity* 36,600 Tax Savings* $243,000 Net Cash Flow $60,000 * Assuming 50% corporate rate

Corporate Insured Annuities – Cash Flow in Year 2 Inflow Outflow Annuity $367,000 Insurance $177,500 Loan Interest 340,000 Tax on Annuity* 80,600 Tax Savings* $259,000 Net Cash flow $30,000 * Assuming 50% corporate tax rate

Corporate Insured Annuities – Impact while Ron is Alive No reduction in corporate investments (except for any tax payable on disposition) Loan fully secured (other security may be required) Positive cash flow as a result of tax deductions

Corporate Insured Annuities – Tax consequences on Death Corporate shares deemed disposed of at FMV – insured annuity has no value for tax purposes Corporate value reduced by bank loan of $4 million (tax savings of up to $1 million) CDA credit of $4 million less ACB of policy (allowing corporate investments to be extracted on tax-free basis)

Corporate Insured Annuity - Risks Liquidation of corporate assets may have tax consequence and/or penalties for early termination Interest rate fluctuations – borrowing rates may rise but annuity rates are fixed No commutation value for annuity Separate insurers should be used for life insurance and annuity contracts

Corporate Insured Annuities - Risks General anti-avoidance rule (has value of company really been reduced?) Interest deductibility (new REOP proposals requires annual testing) Financial strength of insurance companies backing the arrangement

Other Planning Tips Joint second to die insurance if Ron is substandard/uninsurable or for corporate back to back scenario Use of holding companies for corporate- owned insurance (creditor proofing, avoids transfer on sale of operating business, valuation issues) Having other family members or business partners share in costs of insurance

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