Business and life insurance

Risk management for the entrepreneurial set

True entrepreneurs don’t take risk – they assess it, exploit it and overcome it.

That assessment process requires an understanding of market gaps so you can frame a vision for your business that capitalizes on those opportunities. It is then up to your entrepreneurial initiative to plan and deliver the business. But none of us are infallible or invincible.

Contemplating your limitations – and especially your own mortality – is a sensitive area emotionally. But not being informed can be far worse in reality.

That’s why life insurance is such an important tool: to preserve the business, which in turn protects the family it supports. Even more though, it rounds out your business planning by shining a light on latent risks, providing comfort to lenders to advance funds (with potentially improved terms), and offering tax advantages unlike any other financial tool.

Five fundamental questions in your insurance decision

Insurance is not a frequent conversation topic for most people. In its simplest elements, you pay premiums to an insurer, and it pays out the face value of the policy on a death. Premium payments are not generally tax-deductible, but proceeds are received tax-free.

Appreciating it in a business setting adds a layer or two of complexity. In addition to assuring that all risks are identified, you need to consider the cost-effectiveness of premium payments and the tax-efficiency of the proceeds payout.

At a minimum, five questions have to be addressed in any insurance discussion:

1. What purpose does this insurance policy serve? In insurance-speak, the ‘risk’ is that a death occurs, and the ‘peril’ is that some economic damage will result. So, what damages are you protecting against?
2. What duration is the insurance needed for? Put another way, at what point in time will there no longer be a peril/damage to be concerned with, or will it always be there?
3. Who should own the insurance? This is who pays the premiums. In a personal situation, you may own on yourself, or spouses on each other, or parents on children – and there can be more variations. For a business, particularly when run through a corporation, there are at least as many considerations, including whether to own from within the business/corporation, or outside in personal hands.
4. Who should receive the proceeds? In some cases the recipient may be the owner, while in others it may be one or more named beneficiaries. In a business situation (again where a corporation may be involved), there can be many steps involved, requiring coordination with other personal and business documents, including trusts, Wills, corporate resolutions and shareholder agreements.
5. Finally, what amount of coverage is appropriate? This brings it full circle to the economic exchange you have with the insurer. Having asked and answered the preceding questions, you are now ready to turn to quantification, and affordability.

Four principal business purposes for insurance

Especially in a single-person operation, the overlap between personal and business needs can appear almost indistinguishable. Discerning the differences is critical to being able to make the best-informed decisions. Though not an exhaustive list, here are the most common situations for the use of life insurance in a business.

Buy-sell funding

A buy-sell agreement is only as good as the ability of the parties to carry it out. In the fullness of time, the expectation will be that each party will have the financial wherewithal to execute a buyout.

An early death can thwart that intention, potentially putting the business, the continuing owners, and the deceased’s family at risk. Insurance enables 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 – not just drafted, but executed.

Key person protection

Insurance can buy time for a business when someone critical to the operation is lost. It’s an injection of capital to help maintain the going concern value of the business on the loss of that 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

Tax on capital gains will arise when someone consciously disposes of capital property, or on a disposition that is deemed to have occurred in certain circumstances such as a person’s death. This applies to all business interests generally, though if the assets are qualifying small business corporation shares, the door is open to take advantage of the lifetime capital gains exemption, currently standing at $1,250,000 in 2024 (per the 20204 Budget), with indexing to re-commence in 2026.

If there remains tax liability on a capital disposition, it can be deferred if those assets are rolled to a surviving spouse. The deferral will carry through to when the spouse disposes of the assets, or on a deemed disposition on the spouse’s death. Either way, insurance still has a role to play, but now taking into consideration more participants in the arrangement.

Income replacement

The most common use of life insurance is as a proxy for the lost income-earning capacity of a breadwinner to a household. The insurance proceeds fund a pool of wealth that can be drawn down over the time that the deceased would have otherwise contributed income. Though not physically present, the person is still there in financial spirit.

Seeing the purposes both together and apart

The first three of the foregoing purposes are clearly commercial in nature, whereas income replacement is a personal need irrespective of the existence of any business. Even so, 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 held in the corporation, or multiple policies some of which will be held at the corporate level.

This may make good sense for convenience as a gathering point and for cost-efficiency, but care must be taken to assure that the calculated amount for each respective purpose will make it into the hands of the appropriate recipient. This will often require the coordination of terms in shareholders’ agreements, Wills and corporate documents, so early involvement of legal counsel is a prudent approach.

Assuming this all passes muster, attention may turn to the tax implications of funding and receiving insurance through a corporation.

Use of a corporation, and life insurance within it

Except in very limited 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.

However, corporately-paid premiums are nonetheless less costly than personally-paid premiums. The comparison is whether the corporation pays the premiums itself, or issues a dividend to the shareholder to pay the premiums personally. As the shareholder will be taxed on the dividend, 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.

On death of the life insured, the proceeds are received tax-free to the 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 complete their intended purpose. 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.

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. 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. Whether the full amount may come out tax-free depends on circumstances, but the bulk is usually treated this way. Again, informed legal and tax advice are a must, both at the time the insurance is established and when the payout happens.

Be aware that these are the fundamentals for understanding corporate ownership of life insurance. Things can get much more complicated in practice, which is why conscientious due diligence is critical – both in comprehending the technical issues, and in clearly understanding the needs of the business and the individuals behind it.

IPP suitability scorecard – Business owners and professionals

Expanded retirement tax-sheltering using defined benefit pension rules

Registered Retirement Savings Plan (RRSP) contribution room is calculated based on a percentage of an employee’s annual income. Comparatively, a defined benefit registered pension plan (your own RPP) combines income with actuarial factors such as an individual’s age and the plan’s features to open the way toward significantly larger tax-deductible deposits.

Qualified business owners and incorporated professionals may establish a plan for one person, or up to three pension members – including spouse and family employees.

Check the boxes here to see if it is suitable for you:

❏ Is the business owned by and run through a corporation? Or if it is a professional practice, is it operated through a corporation?

❏ Does the owner draw annual income of at least $70,000 to $100,000, either as employment income alone, or combined with dividends?

❏ Is the business owner or professional at least 38 years of age, but no older than age 72?

❏ Has the owner maximized RRSP contributions, but is still seeking more CRA-approved tax-sheltering opportunities?

❏ Is there surplus corporate cash that is exposed to the punitive corporate tax rates on passive income?

If you have at least three checks so far, then this could be your route to expanded tax-sheltered savings, and here’s more to consider.

❏ Would it be appealing to increase the amount for annual spousal income splitting, and make it available before age 65?

❏ Are there any concerns that business creditors may get access to corporate assets meant to fund the owner’s retirement?

❏ Are there family employees for whom the owner would like to arrange a tax-deferred estate transfer, bypassing creditors and probate?

❏ Is there an anticipated or pending business sale where excess assets may threaten the owner’s claim to the lifetime capital gains exemption?

❏ If planning to retire abroad, would the owner like allow for greater tax-deferral by limiting emigration tax on deemed dispositions?

The ideal candidate for this kind of retirement pension will have at least six checks.

To learn more about how this can work for you, see the article IPPs – Individual pension plans.

IPPs – Individual pension plans

A business owner’s option for retirement savings

As a successful business owner, you likely maximize your annual registered retirement savings plan (RRSP) contributions and still have more to invest. So, is there is a way for you to make even more use of tax-sheltered retirement savings tools?

As it turns out, the Income Tax Act allows you, as the owner of a corporation, to set up an individual pension plan (IPP) for yourself as an employee of the business. By doing so, your corporation will be able to make larger tax-deductible contributions than available under RRSP rules, which in turn means larger deposits into retirement tax-sheltering for you as an employee.

Larger contributions with an IPP

Every worker is entitled to RRSP contribution room based on 18% of the previous year’s earned income. There is a dollar limit to that, which is indexed from year to year. The 2024 limit is $31,560, reached at 2023 income of $175,333. Any RRSP room not used in a year can be carried forward to make contributions in future years.

Unlike this direct calculation of RRSP contribution room, an IPP is a ‘defined benefit’ arrangement where the amount to be contributed is based on the benefit that will be required to be paid out of it. For both RRSPs and IPPs, investment growth is tax-sheltered while in the plan, with tax being deferred until payments come out to the annuitant/pensioner.

An actuarial calculation is required to make the IPP contribution determination, based on factors such as the employee/pensioner’s age, past employment income and projected future employment income, and the amount and terms of the eventual pension to be paid. Up until about the age of 40, RRSP rules provide more contribution room, but an IPP allows increasingly greater room as you move beyond that age.

Additional administration

An individual RRSP can be set up with fairly simple administration and low cost. An IPP has more complexity and higher cost, but for qualified candidates this is more than compensated by the added flexibility the IPP provides for retirement savings. As well, all fees involved in arranging an IPP are deductible to the employer corporation.

As a conscientious business owner, you will want to do a cost-benefit analysis with your investment advisor and tax professional. With larger start-up and periodic maintenance costs, an IPP will likely only come into consideration for those at higher income levels, generally at least $100,000. Still, sometimes it may be desirable to establish one while at a lower income level, in anticipation of moving up in income as the business builds.

A trustee must be appointed to manage the IPP under a formal pension agreement, and tax filings are more involved than for RRSPs. An actuarial report must be prepared when the IPP is established and triennially (every three years) thereafter, and provincial pension reporting may be required.

Provincial Developments

Pension rules protect pensioners from potential mismanagement of funds by employer-sponsors. Given the connection between pensioner and employer in an IPP, some provinces allow IPPs to opt out of pension rules, exempting the employer from mandatory contributions, and reducing reporting obligations and associated fees.

Provinces currently allowing opt-out are British Columbia, Alberta, Manitoba, Ontario and Quebec.

IPPs that have opted out of provincial oversight still employ actuarial rules to determine the maximum amount of contributions that may be made to a plan. All IPPs must be registered with the Canada Revenue Agency, and must fulfill annual tax reporting obligations.

Source and timing of contributions

On startup of the IPP, it is possible to fund past employment service as far back as 1991. The allowed amount is calculated by an actuary, then funded by:

1. Transferring-in existing RRSP holdings;
2. Making a deductible employee/personal contribution up to the amount of unused RRSP room; and,
3. Making a deductible employer contribution for the remainder.

Ongoing, annual employer contributions by your corporation are also deductible. There is no income inclusion or tax benefit reported by the employee in the year those employer contributions are made.

The triennial actuarial test may reveal at some point that more has accumulated in the plan than is necessary for it to meet its pension obligation, based on the continuing contribution schedule. This would usually be a result of investment returns exceeding earlier expectations. When there is such a surplus, the employer/corporation’s funding will be temporarily reduced or suspended until things are back in line.

On the other hand, if the triennial test indicates a shortfall then the employer/corporation may be required to make further contributions. This built-in top-up feature allows an IPP to be replenished if investments underperform expectations, something that is not available under RRSP rules.

Per the information in the callout box on the first page, for an IPP that has opted out of provincial pension oversight the employer is exempt from mandatory annual contributions. For such plans, unused contribution room in a year may be carried forward to be used in future years at the discretion of the IPP trustee.

For all IPPs, the employer may be able to make a final deductible contribution before the pension begins if the actual conditions at that time differ from the assumptions used to fund the plan. This is called terminal funding.

Allowable investments

An IPP can usually invest in the same types of investments allowed for RRSPs. The rules are a little more restrictive, however, in that no more than 10% of the assets may be in any one security. This restriction does not normally apply to pooled investments like mutual funds, which themselves hold a basket of securities.

Pension payout time

There are three options on retirement:

1. Take the pension pursuant to the terms in the pension agreement;
2. Use the accumulated value in the IPP to purchase an annuity from an insurance company; or,
3. Commute the value to make a tax-free transfer into a locked-in retirement income fund. Often the commuted value will exceed the tax-free transfer limit, owing to the generous IPP contribution rules. The excess is taxable, but there are no restrictions on the pensioner’s use of the net amount after the tax is paid.

As a final point, IPPs may be entitled to greater creditor protection compared to RRSPs, though this may not be the case if the IPP has opted out of provincial pension supervision. This may be an important issue for an entrepreneur looking to balance business and personal financial risk.