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Overview: Why Adjusted Cost Basis Mistakes Are So Common
In Canadian corporate tax planning, few concepts create as much confusion—or as much unexpected tax exposure—as the adjusted cost basis of a corporate-owned life insurance policy. While life insurance is often acquired to fund succession planning, shareholder buyouts, or post-mortem distributions, errors in understanding or tracking adjusted cost basis frequently undermine the intended Capital Dividend Account outcome.
For owner-managed corporations and estate planning structures, adjusted cost basis traps represent one of the most common causes of Capital Dividend Account shortfalls and excess capital dividends.
What 'Adjusted Cost Basis' Means for Capital Dividend Account Planning
Adjusted cost basis generally represents the cumulative net cost of a life insurance policy for tax purposes. At death, the portion of the insurance proceeds that may be credited to the Capital Dividend Account is equal to the death benefit received by the corporation minus the policy's adjusted cost basis at that time.
In long-standing policies, the adjusted cost basis often declines significantly over time, which leads many taxpayers to assume it is negligible or nil. This assumption is one of the most frequent and costly planning errors in insurance-funded Capital Dividend Account planning.
Common Adjusted Cost Basis Traps
One recurring trap is assuming the adjusted cost basis is zero without obtaining confirmation from the insurer. Even small remaining adjusted cost basis amounts can materially affect the Capital Dividend Account where large death benefits are involved.
Another frequent issue arises where policies have been altered over time. Policy loans, partial surrenders, coverage changes, premium holidays, or corporate reorganizations can all affect adjusted cost basis calculations in ways that are not intuitively obvious.
Ownership changes also present risk. When a life insurance policy is transferred between related corporations, partnerships, or shareholders, the adjusted cost basis may reset or be modified, altering the expected Capital Dividend Account credit at death.
Tax Audit and Reassessment Risk
Adjusted cost basis errors frequently come to light during tax audit reviews or following a tax reassessment, often years after capital dividends have already been paid. When the Canada Revenue Agency recalculates the adjusted cost basis and determines that the Capital Dividend Account was overstated, the result may be an excess capital dividend subject to the 60 percent Part III penalty tax.
These outcomes are particularly problematic in post-mortem planning contexts, where funds have already been distributed and unwinding transactions may be impractical.
Overlap With Excess Capital Dividend Penalties
Where adjusted cost basis is overstated or ignored, corporations often declare capital dividends that exceed their true Capital Dividend Account balance. The excess portion is subject to punitive penalty tax under Part III of the Income Tax Act, regardless of whether the error was inadvertent or based on professional assumptions.
This risk is magnified where insurance proceeds are substantial, making disciplined adjusted cost basis verification a critical element of prudent dividend tax planning.
Planning Strategies to Reduce Adjusted Cost Basis Risk
Conservative insurance planning begins with obtaining written adjusted cost basis confirmations from the insurer immediately upon death of the insured person. These confirmations should be retained as part of the corporation's permanent tax records.
Capital dividends should not be declared until adjusted cost basis figures are confirmed and integrated into the Capital Dividend Account calculation. Where uncertainty remains, declaring multiple separate capital dividends rather than a single distribution can help limit exposure if later adjustments arise.
Most importantly, insurance planning should be coordinated with corporate, estate, and dividend tax planning under the guidance of an experienced tax lawyer in Canada.
Pro Tax Tips for Adjusted Cost Basis Planning
- Never assume the adjusted cost basis of a corporate-owned life insurance policy is nil without insurer confirmation.
- Review adjusted cost basis implications whenever insurance policies are amended, borrowed against, or transferred.
- Delay capital dividend declarations until adjusted cost basis figures are finalized and documented.
- Incorporate adjusted cost basis verification into post-mortem and succession planning checklists.
Frequently Asked Questions
What is the adjusted cost basis of a corporate-owned life insurance policy?
The adjusted cost basis generally reflects the cumulative net cost of the policy for tax purposes and is used to determine how much of the insurance proceeds may be credited to the Capital Dividend Account.
Why does adjusted cost basis matter for Capital Dividend Account planning?
The amount added to the Capital Dividend Account is equal to the insurance proceeds received minus the adjusted cost basis at death, meaning even modest errors can significantly reduce the available CDA.
Can the adjusted cost basis ever be assumed to be nil?
No. The adjusted cost basis should never be assumed to be nil without written confirmation from the insurer, particularly where policies have been in force for many years or have been amended.
What happens if the adjusted cost basis is overstated or ignored?
An incorrect adjusted cost basis can result in an overstated Capital Dividend Account and the payment of an excess capital dividend, exposing the corporation to the 60 percent Part III penalty tax.
When should adjusted cost basis be confirmed?
Adjusted cost basis should be confirmed immediately upon death of the insured person and before any capital dividend is declared.
Conclusion: Small Adjusted Cost Basis Errors Can Have Large Tax Consequences
Adjusted cost basis traps are a leading cause of unexpected Capital Dividend Account shortfalls in corporate life insurance planning. Even minor errors can translate into significant excess capital dividends and punitive penalty tax exposure. Careful documentation, conservative timing, and professional oversight are essential to preserving the intended tax benefits of insurance-funded Capital Dividend Account strategies.
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.
