The Complete Guide to Business-Owned Life Insurance in Canada

Acquiring business-owned life insurance should be a key part of your estate and financial planning toolkit as a business owner. It can be used to cover death tax liabilities, ensure you can afford to enact a shareholders’ agreement, and so much more. But there are plenty of limitations and restrictions in place that you must avoid to ensure you’re not hit with catastrophic tax repercussions.

To help you understand the intricacies, we’ve compiled our years of experience and knowledge into this complete guide to business-owned life insurance. We’ll start by discovering the two main categories of life insurance.

 

The Types of Life Insurance for Businesses

The types of life insurance for businesses are the same as personal insurance. We’ve briefly compared the two categories in the table below.

Term Life Insurance Permanent Life Insurance
Temporary protection Long-term protection
Protecting the business from the death of a key person
Covering loans
  • Funding a buyout clause
  • Succession planning
  • Adding cash flow
  • The business has money not necessary for daily running costs
For a predetermined period For life
Usually the cheapest type of life insurance Typically pricier than term life insurance
When you die, any beneficiaries could receive a lump sum of tax-free money It builds wealth over time which you can use while you’re alive
When you die, any beneficiaries could receive a lump sum of tax-free money
No savings component Yes, it comes with a savings component

To gain a deeper understanding, we’ll look at each category of business-owned life insurance in more detail before moving on.

 

Business-Owned Term Life Insurance

Business-owned term life insurance provides temporary coverage and a tax-free lump sum if the insured person (i.e., you, a key employee, or your business partner) dies within the specified period. The payout should cover any company debt, partner buyouts, or other expenses.

Here’s how it works:

  1. You choose the amount of coverage and the policy duration (for example, ten years).
  2. You add extra benefits to customize the policy to suit your needs.
  3. You pay the annual or monthly premiums.
  4. The term ends, your policy is automatically renewed, or you choose to extend the term or switch to permanent insurance.
  5. If you die during the policy period, your business, charity, or people named as a beneficiary receive a tax-free sum of money.

It’s usually the most affordable type of life insurance. But, a few factors influence the price, including:

  • Your age — The younger you are, the cheaper your life insurance.
  • Your gender — Generally speaking, women live longer than men. Thus, a female’s insurance could cost less.
  • Your health — Certain lifestyle choices (i.e., excessive alcohol consumption or smoking), chronic diseases, and genetic conditions boost the cost of insurance.
  • Your hobbies — Dangerous hobbies equal higher insurance premiums.

 

Business-Owned Permanent Life Insurance

With business-owned permanent life insurance, you get a tax-free payout for your business and the potential to build value while you’re alive. The added component gives your business increased financial flexibility that you can’t get with term life insurance.

There are two types of permanent insurance to choose from, each of which offers lifetime coverage and tax-free value accumulation. However, they’re structured slightly differently. Take a look at some of the features of both in the table below:

 

Participating Life Insurance Universal Life Insurance
  • You could get a yearly dividend.
  • The cash values and insurance payout are guaranteed.
  • Your premium payments stay the same throughout.
  • It offers your business monetary flexibility when you need it.
  • The cash values on select policies are guaranteed.
  • The insurance payout is guaranteed.
  • You can choose where you want your money invested.
  • You get flexibility in premium payments.
  • It’s usually less expensive than participating life insurance policies.

 

Similar to term life insurance, you can protect your business partners and your company with this type.

 

Owning Life Insurance as a Business

Your business can be a beneficiary on either type of life insurance policy. Usually, this means your company can pay the premiums and reap the death benefit when you pass away.

It’s worth noting that the premiums aren’t tax-deductible in this case. However, you can still finance the policy with corporate money, which is far more beneficial than using your own after-tax income.

When proceeds from the insurance plan come in, your business won’t have to pay tax on them. Plus, the same amount (the net of the adjusted cost basis) is placed in your company’s capital dividend account, which provides shareholders with a one-time tax-free payout.

We’ll traverse the seemingly murky waters of the capital dividend account later on; for now, we’ll cover the ACB (adjusted cost basis).

 

What Is The Adjusted Cost Basis?

To put it simply, the adjusted cost basis is the total of the premiums you’ve paid minus the net cost of pure insurance (NCPI) of the plan. The ACB grows to a point where the yearly NCPI is larger than the premiums paid. Once it hits that level, it slowly decreases.

Insurers calculate the NCPI annually by multiplying your mortality rating by the net amount at risk on the policy. They choose your mortality rating based on your age from a mortality table provided by Canadian tax laws.

With corporate-owned life insurance, having a higher adjusted cost basis might turn out to be a disadvantage. Why? Because a high ACB means you’re entitled to a lower amount credited into your CDA (capital dividend account).

 

The Uses for and Advantages of Business-Owned Life Insurance

Different business owners want different things from their life insurance policies. Your desires probably vary massively from an entrepreneur down the road.

Sim Gakhar can ensure your plan covers everything you need it to. But for now, here are some of the uses and advantages of business-owned life insurance that you can take advantage of:

 

#1 Key Person Protection

When a shareholder or key employee of your business dies, your company may experience financial strain in some departments. The problem likely lasts for a while, as you’ll probably find it difficult to replace them. Not to mention that it could take months or years before any new employees can work to the same level.

Of course, it can be detrimental for any business. But, small businesses find it especially difficult to bounce back from such a profit and efficiency loss.

However, business-owned life insurance plans take that particular worry off the table.

It provides you with cash flow to repay any debts, fund the cost of hiring and training a new employee, or boost working capital upon the death of a key person.

The key personnel can differ depending on the type of business you own. But some generally hard-to-replace people in companies are as follows:

  • Chief Executive Officer (CEO) — Sometimes called the company president, they support the others in the company and give them resources to take products or services to market.
  • Chief Operating Officer — They ensure all company operations work economically and seamlessly. They make sure deadlines and standards are met. Not to mention they must have intimate knowledge of your business.
  • Marketing Manager — Without effective marketing, you don’t have a business.
  • Production Manager — They have extensive industry knowledge and experience. They’re known for being increasingly difficult for businesses to replace upon death or retirement.

 

#2 Business Loan Protection

If you run a small business and wish to procure a loan, lenders will likely require you to personally guarantee the loan. Depending on the lender, they might also request life insurance for certain individuals for the lifetime of the loan.

Life insurance owned by your business can provide funds to repay the business loan, commercial mortgages, and other types of loans if you or a key person dies.

In fact, even if they don’t require insurance, it’s good practice to demonstrate protection. Not to mention that purchasing a business-owned plan frees up more opportunities to obtain loans and funds from other financial resources.

Purchasing a company-owned plan also protects your personal estate from repossession if your business cannot repay the loan.

 

#3 Reduced Estate Tax

As per paragraph 18 (1)(b) of the Income Tax Act, you can’t deduct premium payments from the income of the payor. Because of that, it can be advantageous for the policy to be owned and paid for by your business. Typically, the latter has a more preferable tax rate than you personally.

 

Let Us Look at an Example

You have a life insurance plan with a premium of $5,000 per year. Your marginal tax rate equals 50%, meaning it needs an outlay of $10,000 after tax.

The calculation for working out the real after-tax cost is:

your premium in dollars divided by one minus the percentage marginal tax rate

Now, somebody else’s corporation is paying for the exact same policy. The difference is that the business’ tax rate is a mere 17%, meaning it needs an outlay of just $6,024 after tax.

So, the savings over just 12 months of having a corporation-owned life insurance policy is $3,976. Over the years the policy is in place, the savings can add up substantially.

 

#4 Buy-Sell Agreements

Funding the buy-sell transactions that occur following a shareholder’s death is a common usage of life insurance by private companies.

Usually, the family of the deceased shareholder doesn’t want to be involved in the business, and the remaining shareholders don’t want the family to be involved either. So, the proceeds offered by life insurance policies can buy out the shares owned by the dearly departed shareholder’s beneficiaries or estate.

Utilizing the funds from the business-owned life insurance policy to pay for the buyout ensures the company can maintain operation while giving money to the beneficiaries. The buy-sell agreement isn’t typically straightforward as there are plenty of ways to go about it, such as:

  • Redeeming shares with the proceeds
  • Using the proceeds as a capital dividend payment to fund a personal purchase of the shares

To ensure your wishes pertaining to the buy-sell agreement are met, you must document everything in the shareholders’ agreement. Sim Gakhar can help you do this to avoid confusion and conflict upon the death of you or another shareholder.

 

#5 Succession Planning

Business succession planning is determining how you wish to transfer the ownership of your business while ensuring you maximize your personal finances.

There are multiple reasons for such planning, including:

  • Poor transition plans impact business results. In dire circumstances, they can result in company failure.
  • Proper succession planning can minimize any risks to your retirement capital as you near the end of your working life.
  • You need to coordinate your business plan with your estate plan if you want to transfer the company to a family member while taking advantage of tax deferrals.
  • Without the correct plan, the death or disability of a business partner or you could lead to catastrophic results.

Succession planning is a component of your larger business and estate plan. It lets you fund the transition plan regardless of whether you want to sell the company or give it to a family member. The right company-owned life insurance will do this for you, as well as:

  • Ensure the financial needs of your family, yourself, and your estate are met if you die or become disabled.
  • Make sure you have enough income in retirement.
  • Ensure you have a savings component to cover future expenses.

 

#6 Growing Net Worth

As long as you pick a permanent life insurance policy, you and your business benefit from worth accumulation in the investment component of the plan. A percentage of the premium payment goes into this asset pool, called the cash value, which earns interest over time. Depending on your specific policy, you can even invest in various stocks and shares.

The asset pool grows value while completely sheltered from tax. Plus, many insurers allow for extra deposits into the pot, allowing your corporation to accrue assets effectively.

Of course, you should consider the risks of investing. There’s a potential for you to lose money if you make the wrong decisions. If you’re unsure, Sim Gakhar can talk you through the options and help you make wise investment decisions for your business.

 

#7 Equal Distribution of Premium Payments

If one of your shareholders has a medical concern or health issue, or there is a significant age gap between you, owning personal policies can put unwarranted financial pressure on the person paying higher premiums.

For instance, it may appear in a buy-sell agreement that you and a shareholder want to buy each other’s shares upon death. Therefore, you would each need to own a life insurance policy on the other person. As the years continue, resentment and unfairness could build for the person paying the high price.

To stop such tensions, your corporation can own the policy and pay the premium, making it easier to share the payments with the shareholders equally. Or share them equal to their proportion of interest in the business.

 

#8 Streamlined Management

When you have multiple shareholders, there is a lot of confusion surrounding the various life insurance necessities.

If your company has four shareholders, for instance, and you all wished to go down the personal ownership route, 12 contracts must be drawn up (i.e., each shareholder needs three contracts to cover all eventualities).

However, if everyone chose a corporate-owned life insurance scenario, only four contracts are needed (i.e., one for each shareholder).

On top of the extra simplicity, all fees associated with the policy would be decreased, and you’d receive a more favourable premium price since the face amount of the contracts would be increased.

 

#9 Creditor Protection

A life insurance policy with a cash value is usually classed as a seizable asset. In other words, your creditors can repossess the cash value to cover any debts.

So, a corporation-owned policy becomes part of your corporation’s assets, and the cash value portion can be seized by a trustee if your business files for bankruptcy. Not to mention one of your corporation’s creditors could claim the death benefit following the passing of a shareholder.

However, allowing your business to become the owner of the policy protects the cash value from any personal creditors.

 

Everything You Need to Know About The Capital Dividend Account

As promised, we’ll tell you all you need to know about the capital dividend account right here.

In simple terms, the capital dividend account, otherwise known as the CDA, is included in the Income Tax Act as a component of the system of integration.

It exists to ensure that income is subject to equal total tax burdens regardless of whether a corporation or an individual earns it and distributes it to another entity. In short, it’s meant to enable the tax-free distribution of tax-free amounts obtained by a private company to its shareholders.

 

Here’s an example:

Your private corporation is named as a beneficiary of a life insurance policy. The plan has a death benefit of $1,000,000. At the time of the insured shareholder’s passing, the adjusted cost benefit is $150,000.

$1,000,000 minus the ACB equals $850,000. That amount is credited to your corporation’s capital dividend account. You can then pay the $850,000 out to your corporation’s shareholders tax-free. The $150,000 is paid to your corporation’s shareholders as a taxable chunk.

 

The Capital Dividend Account and Numerous Corporations

Nowadays, the Canada Revenue Agency takes a stand against life insurance ownership structures that unduly exploit the benefits associated with the capital dividend account (i.e., tax-free proceeds). Before the new implementations, some business-owned life insurance structures could allow corporations to get the entire death benefit as CDA credit.

While there were a bunch of ways to do this, it was typically done by getting a holding company to own the policy and designating an operating company as the beneficiary. Since the latter didn’t own the policy, it could claim the entire death benefit without suffering an ACB reduction.

But as of 2016, the federal budget ended this common practice. As we mentioned, the death benefit is now reduced by the ACB prior to hitting the CDA, no matter what kind of corporate ownership structure you implement.

 

When Do You Need Business-Owned Life Insurance?

Life insurance plays a major role in maintaining a smooth-running business. But, there isn’t a right or wrong answer as to when you need to purchase a policy.

With that said, it can help in all stages of your business life cycle, including:

  • When you are close to retirement — A smooth exit strategy is an essential component of your plan if you’re considering retiring. Business-owned life insurance, regardless of the type, can help sell your company or transfer ownership to a family member.
  • When you are just starting your business — Any entrepreneur knows that starting a business is tricky. Term life insurance protects your startup for a specified period when you need it most.
  • When you are continuing to expand your business — Permanent life insurance is typically best in this case. It helps protect your business now and in the future as you continue to grow.

 

Policy Ownership and Documentation As a Business

Depending on the size of your business and the type of life insurance you purchase, documenting the policy’s ownership can be confusing. But with the right guidance, it doesn’t have to be so daunting.

No matter what, the corporate ownership structure of the policy should be accurately recorded and documented inside your business’ minute books. The paperwork should state the reasons behind the defined ownership structure. So in tax audits, there is no other way of interpreting ownership that could lead to less-than-pleasant tax repercussions.

There are plenty of reasons why you can choose to structure the ownership in different ways. Some of the most common are as follows:

  • For asset purification to make sure all shares meet the requirements for the CGD
  • For paying for a shareholders’ agreement
  • For keeping the policy intact after the sale of the business
  • For protecting creditors

Speaking of ownership, there are four main options for business life insurance ownership structures. As you’ve probably gathered by now, choosing the best one for your business is vital. Sim Gakhar can lead you in the right direction during a consultation. But for now, consider the basics of each ownership structure below:

 

Ownership Through the Business

The first option is beautifully simple and often seems less pricey since you don’t pay the premiums; your business does. But, the simplicity overrides many other benefits like gaining tax-free premiums and non-deductible expenses.

 

Shareholder Ownership

Most companies decide to go with the shareholder life insurance policy ownership structure. The policy owner pays the premium as they receive the financial benefit offered by the policy.

Again, it’s an easy-to-understand affair, but it has plenty of shortcomings too.

 

Separate Entity Ownership

Often overlooked, this option involves setting up a trust and appointing a trustee to supervise the terms and carry out all the policy’s provisions as written in the agreement. Usually, the agreements are defined in simple terms, leaving no room for misinterpretation or ambiguity.

Another option under this category is to create an LILLC (Life Insurance Limited Liability Company). This entity has an “Operating Agreement” that sets out pertinent issues regarding the owners of the life insurance policy and the distribution of funds.

It might be wise to consider an LILLC owned business life insurance policy, thanks to the following benefits:

  • It decreases the number of policies you need.
  • It negates any problems with beneficiaries on your death.
  • It can easily allocate death benefits when the time is right.
  • It can easily redesignate policies that aren’t required for a buy-sell arrangement.
  • It protects the policy from creditors.

 

Trust Ownership

Many business owners are letting trusts own their life insurance policies as part of their asset protection planning. You get lots of benefits with this option, including freeing yourself from certain tax limitations.

 

Understanding Taxable Benefit in Business-Owned Life Insurance

When you set up the ownership structure for your corporate-owned life insurance, you need to consider the income inclusions or taxable benefits that come with the different combinations.

A few years ago, the Canada Revenue Agency considered whether the parent company could be named as a beneficiary on a policy where its subsidiary company is the policy’s owner. The conclusion — these situations result in a taxable benefit to the parent company as stated in the Income Tax Act § 15(1).

However, if the parent company pays the premiums on a policy where the subsidiary company is a beneficiary and owns the policy, the Canada Revenue Agency could apply a number of clauses, including:

 

Business-Owned Life Insurance Practical Structure Examples

Tax provisions are confusing, especially when you enter the world of corporation-owned life insurance. So, let’s work through some structural examples to better analyze the probable tax implications.

 

Example 1

  • Shareholder
    • Holding Company 1 (the death benefit beneficiary)
      • Operating Company 2 (the policy owner and the payor of the premiums)

Choosing this structure triggers subsection 15(1) of the Income Tax Act. Holding Company 1 must report a taxable benefit of the same amount as the premium if it chooses not to report the amount on its taxable income.

Plus, a policy with large cash values could present a tax disadvantage for Operating Company 2. Usually, this disadvantage presents itself as a potential capital gains loss upon the sale of the shares.

Moreover, the sale of Operating Company 2 and the policy transference could result in a disposition and provide a policy gain for the company. In certain circumstances, the ownership structure may risk the cash values if Operating Company 2 faces a lawsuit or files for bankruptcy.

 

Example 2

  • Shareholder
    • Holding Company 1 (the death benefit beneficiary, payor of the premiums, and the owner of the policy)
      • Operating Company 2

Here, neither Holding Company 1 nor Operating Company 2 receive taxable benefits. It also doesn’t present any creditor protection risks. Since Holding Company 1 is the policy’s owner, selling Operating Company 2 doesn’t lead to a policy transfer.

 

Example 3

  • Shareholder
    • Holding Company 1
      • Operating Company 2 (the death benefit beneficiary, payor of the premiums, and the owner of the policy)

Similar to Example 2, there aren’t taxable benefits for either company. But, if Operating Company 2 purchased a permanent life insurance plan with a savings component, the cash value could impact the QSBC (qualified small business corporation) status of the shares.

On top of that, transferring the policy ownership to Holding Company 1 may result in tax consequences. Namely, a taxable policy gain for Operating Company 2. Creditors may also seize the cash value if a lawsuit opens up against Operating Company 2 or if bankruptcy occurs.

 

Example 4

  • Shareholder
    • Holding Company 1 (the owner of the policy and payor of the premiums)
      • Operating Company 2 (the death benefit beneficiary)

Subsection 15(1) of the Income Tax Act wouldn’t apply to this structure. Instead, two situations result in different outcomes, as we’ve outlined below:

  1. When Operating Company 2 Reimburses Holding Company 1 for The Cost of Premiums — Paragraph 12 (1)(x) and section 9 of the Income Tax Act are reviewed to consider whether Holding Company 1 needs to report the reimbursed amount on its tax file. By paying a dividend in kind, you could negate the possible application of paragraph 12 (1)(x) of the Income Tax Act.
  2. When Operating Company 2 Does Not Reimburse Holding Company 1 for The Cost of Premiums — Subsection 246 (1) of the Income Tax Act could apply in this place. The value of the benefit must be included within Operating Company 2’s taxable income. The benefit amount received by Operating Company 2 depends on whether the beneficiary status is irrevocable or revocable.

 

Take The Pressure of Getting the Right Business-Owned Life Insurance Off with Sim Gakhar

Your job is to run your business, not understand all the intricacies of life insurance. We’ve revealed the basics here, but to ensure you cover all your bases, book a call with Sim Gakhar, an expert in estate planning for business owners. We’ll ensure you and your company are protected from all sorts of eventualities.