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

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

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

4. 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

5. 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”)

6. 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

7. 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

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

9. 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.

10. 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

11. 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

12. 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

13. 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

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

15. 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

16. 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

17. 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

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

35. Discussion…