Maximizing your life insurance policy...
Life insurance gives a level of financial security for family members of the deceased. However, having a policy also has investment purposes or provides future liquidity. The decision as to who should own life insurance (whether personally or corporately) should be relevant to your circumstances. Over time, these circumstances may change and there may be a desire to change the holder of the policy.
In the absence of special rules, where a person (the transferor) transfers an asset to another person or entity, he/she is generally considered to have received fair market value (FMV) consideration in exchange for the asset. Thus, he/she will incur an income tax liability to the extent that the FMV exceeds the tax cost (value) of the asset to the transferor.
The rules surrounding the income tax treatment of life insurance are complex, and one such special rule currently applies to the transfer of life insurance between non-arm's length persons. Specifically, a transfer of a life insurance policy is considered to take place for proceeds equal to the cash surrender value (CSV) of the policy and not at the FMV of the policy.
In contrast to the FMV, the CSV represents the amount that the life insurer would pay if the policyholder were to cancel his/her policy before its maturity. The FMV may be substantially higher than the CSV if, for example, the insured has health problems that have resulted in a reduced life expectancy. Where this is the case, there may be an opportunity to extract tax-free corporate funds.
Consider the following example. Let's assume that Mr. Smith personally holds a life insurance policy that he has held for many years. Mr. Smith is in poor health. Let's assume that the cost of the policy is zero, the CSV is zero, but the FMV is $1 million because of Mr. Smith's reduced life expectancy.
Mr. Smith transfers the policy to his wholly owned corporation (SmithCo) in exchange for a demand promissory note of $1 million. Although Mr. Smith has received FMV consideration, he is deemed to dispose of the policy for no proceeds (i.e. at CSV) for income tax purposes. Consequently, since the proceeds of disposition in respect of the transferred policy are equal to the cost of the policy to Mr. Smith, no income tax will result on the transfer. At the same time, SmithCo may immediately repay the promissory note to Mr. Smith without any further income tax implications.
When Mr. Smith passes away, SmithCo will receive life insurance proceeds (on a tax-free basis) of $1 million. These funds will be added to SmithCo's capital dividend account (CDA), which is a notional account from which funds can be distributed to shareholders in a tax-free manner.
Because of this planning, Mr. Smith is able to both receive the life insurance proceeds on a tax-free basis (by way of the CDA) and extract $1 million cash from his company (by way of repayment of the promissory note) on a tax-free basis.
Mr. Smith was able to derive a tax benefit to the full FMV of the policy, but this may not always be the case. When the FMV of the life insurance policy exceeds its CSV, a similar set up will generally yield an income tax benefit. In summary, you can realize the greatest income tax benefits when the FMV is significantly higher than the CSV. In Mr. Smith's case, the CSV was nil resulting in the extent of the benefit being fully maximized.
The rules surrounding the tax treatment of life insurance are complex and the facts pertaining to a particular situation must be carefully and holistically considered to ensure that negative tax (or other) consequences are adequately considered. For example, there may be a loss of creditor protection by having the life insurance policy in the corporation, and/or a loss of a shareholder's ability to claim the lifetime capital gains exemption in respect of the shares of the corporation. In the right situation, however, careful planning may result in significant tax benefits.
The life insurance taxation system has recently been under heightened scrutiny by the Department of Finance and several changes to the taxation of life insurance products have already been enacted. It is possible that the rules allowing this particular tax benefit will change in the future. Consequently, if you personally hold a life insurance policy with a high FMV and lower CSV, immediate consideration of this planning opportunity is warranted.
As always, each situation is different, we recommend consulting with your Crowe Soberman professional advisor and your life insurance broker.
This article was prepared by Marissa Verskin who is a senior manager in Crowe Soberman's Tax Group.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
