In our July 2016 Tax Alert we noted that new income tax legislation will impact the taxation of life insurance policies. Most notably, it will be advantageous, for estate planning purposes, to purchase life insurance before the end of 2016 to maximize the tax benefits associated with current life insurance rules.
Many who have been through the exercise of purchasing a life insurance policy can attest to the difficulty of selecting the appropriate insurance product given the wide variety and complexity of products in today’s marketplace.
Equally puzzling is choosing the optimal ownership structure for a life insurance policy that will be used to fund a buy/sell arrangement included in a shareholders agreement.
It is critical in any succession/estate plan to ensure that financing is in place to fund the purchase of a business interest. In the context of most privately held Canadian corporations, a shareholders agreement is often a means to include buy/sell provisions that reflect the needs and wishes of the surviving shareholders following the death of a shareholder.
Generally, buy/sell arrangements use one of three structures after the death of a shareholder:
- The surviving shareholders may purchase the deceased shareholder’s shares from the deceased’s estate.
- The corporation may purchase the deceased shareholder’s shares from the deceased’s estate.
- There is a combination of a purchase of some shares by the surviving shareholders and purchase by the corporation of the remaining shares from the deceased shareholder’s estate.
Regardless of the structure, life insurance generally is the most cost-efficient way to fund the obligation of a surviving shareholder/corporation. In selecting the appropriate ownership structure, many factors should be considered.
One key factor is deciding whether the life insurance policy should be held personally by the shareholders or by the operating corporation, given that the receipt of the death benefit proceeds is tax-free to both individual and corporate recipients. Furthermore, the excess of the death benefit proceeds, over the adjusted cost base of the life insurance policy immediately before the death of the life insured, may be paid out to the shareholder(s) of a corporation as a tax-free capital dividend, as the excess is added to a corporation’s capital dividend account. Thus, a corporate-owned life insurance policy allows for much of the insurance proceeds to be received free of corporate and personal tax.
Life insurance premiums generally are not deductible for income tax purposes. Accordingly, where possible, it is usually preferable to have a corporation own and pay for the life insurance policy, as corporate tax rates generally are lower than individual tax rates. The savings can be significant. For example, the highest marginal tax rate for an individual resident of Ontario is 53.53 per cent, while the general corporate income tax rate is 26.50 per cent. Thus, an individual already earning a salary of $220,000 would need to earn an additional $21,500 to pay for a life insurance policy with an annual premium of $10,000. In contrast, a corporation would only need to earn just over $13,600 to pay for the same $10,000 premium.
Creditor protection is another relevant factor. The death benefit received by a corporation may be subject to claims by the corporation’s creditors. However, as noted above, owning the life insurance policy personally to avoid claims by the corporation’s creditors can be costly. In such cases, it is possible to incorporate a holding company to hold the shares of the operating company. The holding company will not guarantee the debts of the operating company. The holding company is the owner and beneficiary of the life insurance so that any death benefit proceeds are received by the holding company and thus are not exposed to claims from the operating company’s creditors. The death benefit proceeds are then paid to the shareholder(s) as a tax-free capital dividend.
A further consideration is selecting an ownership structure that will ensure the premiums are paid. It is much more difficult to ensure that premiums on life insurance policies are being paid if the policies are owned by individual shareholders. Furthermore, there is always a risk that if death benefit proceeds are received by an individual shareholder, the funds will be used for purposes other than fulfilling the shareholder’s obligation under a buy/sell arrangement.
Where life insurance policies are owned by a corporation, either by an operating company or a holding company, each shareholder should be in a position to review the financial records of the corporation to ensure the premiums are paid on a timely basis. Further, the corporation is in a better position to ensure that the death benefit proceeds are used to fund the obligations under a buy/sell arrangement.
Another concern with personally owned life insurance is apparent where one shareholder is older or in poorer health than the other shareholder(s). The cost of the life insurance policy on the life of the older shareholder is higher and often is borne by the other shareholder(s), while the buy/sell arrangement is structured in a manner that requires the surviving shareholder(s) to purchase the shares of the deceased shareholder’s estate.
For example, at times a “criss-cross” purchase method is used to structure a buy/sell arrangement. With this method, each shareholder is the owner and beneficiary of a life insurance policy on the life of the other shareholder(s). When one shareholder dies, the surviving shareholder(s) will receive the death benefit proceeds, free of tax, and then use the funds to purchase the shares of the corporation from the deceased shareholder’s estate. If the deceased shareholder was much older, the other shareholder(s) will pay much higher premiums to own the life insurance policy on the life of the older shareholder.
On the other hand, the cost may be effectively shared among the shareholders according to their proportionate share in the corporation if the criss-cross purchase method is used in a manner wherein the corporation, preferably a holding company, owns all the life insurance policies of all the shareholders. Under this structure, a surviving shareholder may purchase the shares of the deceased shareholder’s estate. Instead of paying the estate in cash, the surviving shareholder issues a promissory note payable on demand. Following receipt of the tax-free death benefit proceeds, the corporation pays a tax-free capital dividend to the surviving shareholder who uses the funds to settle the promissory note.
A final consideration in structuring a buy/sell arrangement to be funded by life insurance is a possible transfer of the ownership of the life insurance policies that might occur at a later time. For example, this situation is often encountered when one shareholder sells his or her shares in a corporation.
A transfer of a life insurance policy to a shareholder is a disposition to a corporate owner for tax purposes, and there is a potential for a taxable benefit to the shareholder to the extent that the fair market value of the policy exceeds the consideration, if any, paid by the shareholder. However, where the shareholder does not deal at arm’s length with the corporate transferor, such disposition will be at the “value” of the policy, where no other consideration is given for the policy. For these purposes, “value” is defined as essentially the cash surrender value of the policy. As such, a policy gain, of which 100 per cent is taxable, will result only where the cash surrender value exceeds the adjusted cost base of the policy. Where the policy has no cash surrender value, the policy’s “value” is nil and thus no policy gain should result.
Consequently, in situations where a shareholder is the sole shareholder of a corporation, corporate-owned life insurance should be considered as the policy may potentially be distributed to the shareholder without triggering a policy gain to the corporation.
Where the shareholder does deal at arm’s length with a corporation, such as a minority shareholder, consideration should be given to transferring the shareholder’s interest in the corporation to a wholly owned holding company. A life insurance policy on the life of the shareholder may then be purchased by the holding company. Premiums may be paid from funds received from tax-free, inter-corporate dividends declared and paid by the operating corporation. Under this structure, the life insurance policy may be distributed to the shareholder should a sale of the operating corporation occur, and the shareholder may sell the shares of his or her holding company in order to use any capital gains exemption available.
Clearly, there are several alternatives available to shareholders for structuring a buy/sell arrangement. There is no one solution that fits all situations. Each alternative has its own advantages and disadvantages that must be analyzed in light of each set of circumstances. A Collins Barrow tax advisor can help navigate the many alternatives and help you structure a tax-effective buy/sell arrangement.
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.