Most insurance advisors will have long and fulfilling careers operating almost entirely within the personal planning arena.
For many though, the capability to service the business market may be seen as a useful complement or arguably a mandatory add-on to help build a moat around clients. Still others might view that business market as their one true calling all on its own – and it certainly can be a financially rewarding calling to those who handle it well.
Whichever approach an advisor may take, informed needs analysis remains the core skill, often applied at an enhanced technical level, including a solid grounding in tax matters.
In the business context, determined needs may stand on their own, or they may be layered upon or be intertwined with personal needs. This integration of business and personal needs can present both opportunities and challenges where the business is operated through a corporation, as is the preferred mode of operation for most growing businesses.
Business needs framework
Though not exhaustive, these are the most common life insurance needs associated with a business:
Buy-sell funding … provides the financial means for a buy-out of a business on an unexpected death. This paves the way for the timely payout to the deceased’s survivors, and smooth continuity of the enterprise for the continuing owners. In the case of a corporation, it is most prudently documented in a binding shareholders’ agreement
Key person protection … contributes capital to maintain the going concern value of the business on the loss of a key contributor. Whether or not the deceased was an owner, the cash acts as a financial bridge until a suitable replacement can be found, or at least until operations can be stabilized. It may also include an estimate of direct lost revenue and extraordinary expenses.
Estate tax liabilities … arise on deemed disposition of capital assets. This applies to business interests generally, though qualifying small business corporation shares are entitled to make use of the $750,000 lifetime capital gains exemption (going up to $800,000 next year). As well, the disposition related tax can be deferred if those capital assets are rolled to a surviving spouse.
Income replacement … is a proxy for the lost income-earning capacity of a breadwinner to a household. In effect, the insurance proceeds create a pool of wealth that can be drawn down over the time that the deceased would have otherwise contributed to the household. Though unfortunately not physically present, the person is still there in financial spirit.
The first three of these needs are clearly commercial in nature, whereas income replacement is a personal need irrespective of the existence of any business. The reason why this latter personal need is addressed here is that it is not uncommon for a business owner – and particularly a shareholder running a corporation – to wish to combine multiple insurance needs into a single contract, or at least to fund coverage at the corporate level.
A careful review of the personal and business particulars is crucial to assure that such an approach does not compromise the availability of funds for each respective purpose at the appropriate time. Assuming this passes muster, attention may turn to the tax implications of funding and receiving insurance through a corporation.
Corporate economics examined
To deal with a common misconception first, except in very isolated circumstances (none of which apply here), life insurance premiums are not tax-deductible for a corporation, no more than they would be for personally-owned life insurance.
Even so, corporately-paid premiums are generally less costly than personally-paid premiums. This is because the corporation can pay the premiums itself, or issue a dividend to the shareholder to pay the premiums personally. Of course the shareholder will be taxed on the dividend, meaning less cash would be available for the purpose in those personal hands, thus requiring a larger dividend in order to net down to the required dollars for the premium cost.
In turn, life insurance proceeds are a tax-free receipt to a beneficiary, whether that beneficiary is a corporation or an individual. For a policy owned in a corporation, the corporation itself or a subsidiary corporation would be named as beneficiary; if not, the payment of the death benefit could give rise to a taxable shareholder benefit. (Similarly, a shareholder benefit would apply if a corporation pays the premium on a policy owned by a shareholder.)
Comforting though it is to know that a corporation receives insurance proceeds tax-free, even these business-based needs (except key person) still ultimately require the insurance proceeds to make it into personal hands to be most effective. Fortunately, there is a mechanism that allows for the transfer of tax-free amounts received at the corporate level to make their way into shareholder hands, intact as tax-free amounts.
A corporation’s capital dividend account or CDA keeps track of items such as life insurance proceeds and the non-taxable portion of capital gains. Declared dividends to a shareholder will not be taxable if they are elected to come from the CDA, which consequently is reduced by the amount of such dividends. This election may also apply to deemed dividends that occur when shares are redeemed, for example when a surviving spouse decides to wind up the corporation after the death of a business owner spouse.
Appreciating the limits
Bear in mind that these are the fundamental tax issues underlying the corporate ownership of life insurance. As one might expect, things can get much more complicated in practice, which is why conscientious due diligence is critical – both in terms of building ongoing technical expertise, and in clearly understanding the needs of the business and the individuals behind it.