BUSINESS INSURANCE NEEDS
Depending on your business needs, life insurance can provide solutions following an individuals' death, or protect an owner against the loss of an employee, or retain key employees. The information below provides an overview of life insurance applications in the business context.
Key Person Insurance
Key person insurance uses life insurance to protect the business in the event of death of a business owner or key employee by providing instant cash flow to ensure the continued operations of a business and provide the liquidity to fund a replacement.
The death of a valuable business owner or key executive can result in a devastating financial loss not including all the time spent building knowledge, experience, relationships, reputation, and skills. During the disruption, employees and customers may lose confidence, creditors may apply pressure for payments, lenders may reduce credit, debtors may delay payments, and competition may take advantage of the situation.
Small businesses do not have the same luxury as large corporations when preparing for executive turnover. Large corporations are in a better situation just by their size and amount of individuals available for the position. Finding a replacement with the same qualifications as the previous executive in a small business can be quite a challenge. Most often small businesses need to look outside of the business to supersede the deceased executive. This could cause many delays and the business itself may suffer financially. In the event of death, the key person insurance application can provide a business with the financial rescue when cash is needed most. The business purchases a life insurance policy on the life of the business owner or key executive.
In the event of death, the life insurance proceeds provide a source of funds that will aid when finding a new replacement or in the case of a business owner an interim manager.
Life insurance premiums paid by the business for key person insurance protection are not deductible for tax purposes. However, life insurance proceeds received as a consequence of death are tax-free. In the case of a private corporation that receives life insurance proceeds as a consequence of death, the excess of the proceeds over the adjusted cost basis of the policy credits (increases) the capital dividend account of the corporation. Under subsection 83(2) of the Income Tax Act (the "Act"); the corporation can elect to pay tax-free capital dividends to the shareholders of the corporation to the extent of any balance in the capital dividend account. As you may be aware from reading the above, Key Person insurance can provide many benefits to a business whether it being the owner or owner's family members. By having protection, the business can assure employees and creditors that the business will continue in the event of death of a key person. The insurance proceeds provide the immediate financial relief at the time of death so that it covers all the business needs until a replacement has been found and trained. The value of Key Person insurance to a business in case of death of an owner or executive will usually far exceed the cost of the life insurance.
Business Loan Protection
Business loan protection application uses life insurance to generate capital for a business to repay business debts in the event of death of an owner or executive.
Small businesses may have difficulty in obtaining financing for their businesses. Creditors may want the business owner to guarantee a loan. The death of a business owner or key executive may cause creditors to demand repayment of outstanding business debts. This can place a significant obligation on the business and force the liquidation of key business assets at fire sale prices at a time when business results may already be impacted by the death. In addition, if the business owner personally guaranteed the debts incurred by the business, the owner or owner's estate may be liable for outstanding debts that the business may not be able to pay.
Proper planning is critical for the survival of a business when death of an owner or key executive occurs. A solution is to purchase a life insurance policy on the life of the owner of the business or key executive. Proceeds from the life insurance policy received due to death of the life insured is tax-free and may be used to pay outstanding business debts.
In some situations, a business owner may be required to purchase a collateral life insurance to protect the interest of the creditor since the death of a business owner could affect the value of the business assets used to secure the debt. In other cases, the business owner may simply want to ensure that business debts will be fully repaid if he or she dies to minimize financial risks for heirs and to permit the business to continue free of debt.
Generally, life insurance premiums paid for business loan protection are not deductible for tax purposes. However, if a life insurance policy has been collaterally assigned to a restricted financial institution, a portion of the premiums may be deductible.
As noted earlier, in the case of a private corporation the receipt of a death benefit under a life insurance policy will result in a credit to the corporation's capital dividend account. The credit to the capital dividend account is not affected by the fact that the insurance policy may have been collaterally assigned to a creditor.
A life insurance policy purchased for business loan protection can help a business negotiate loans and repay debts with tax-free life insurance proceeds when an owner or executive of a business dies. It can also prevent the business owner(s) or their estate from becoming personally liable for the business debts if the owner dies.
Buy-sell Funding
An essential part of financial planning is planning for business succession. The business interest usually consists of a portion of the wealth the business owner has amassed. In particularly with premature death, a buy-sell agreement allows for the smooth transfer of business interest and this will help the remaining business owners realize full value of the business interest and help with the transition. Changes in ownership may create financial obligations on the part of the remaining owners, and may also have income tax implications for the withdrawing owner and the remaining owners.
An important part of any succession plan is to make sure financing is in place to fund the purchase and sale of the business interest if an owner dies. The succession plan should also provide the business owner with enough liquidity to fund the related income taxes and if possible, take advantage of any tax deferral or tax minimization strategies that may be available.
Once the business succession plan has been developed, an agreement can be drafted to reflect the needs and wishes of the various parties. With closely held corporations or partnerships, one of the important tools for implementing a business succession plan is the shareholders agreement or partnership agreement.
Life insurance is generally an efficient way to fund the obligation that results from a buy/sell agreement when a shareholder or partner dies. There are many ways to structure a buyout on death and life insurance funding plays an important role in ensuring the buyout occurs. It should be kept in mind that there is no right way to proceed. Each method has its own pros and cons that must be considered when situations may arise.
An important consideration is whether to fund the buy/sell arrangement with corporate owned or personally owned life insurance. Each structure has differing advantages from a tax perspective and depending upon the facts one structure may be more favourable over another.
Funding Capital Gains Tax on a Business at Death
Life insurance can be an effective way to fund a tax liability that occurs because of a deemed disposition of capital property at death. Paragraph 70(5) of the Act indicates that, unless a rollover is available, a deceased taxpayer is deemed to have disposed of each capital property owned by him or her immediately before death for proceeds equal to the fair market value at that time. Should the fair market value surpass the deceased's adjusted cost base (ACB) of the property, a capital gain will be realized for tax purposes. The decease may use any capital gains exemption remaining if the property consists of "qualified small business corporation share" or "qualified farm property" (both terms are defined in subsection 110.6(1) of the Act). Any capital gains not protected by the capital gains exemption or qualify for a rollover will be subject to tax in the deceased's terminal return.
An individual who owns shares in a corporation, a partnership interest, or business assets (as in the case of a sole proprietorship) will be deemed to have disposed of these properties at death. A tax liability may occur as a result of capital gains and recaptured capital cost allowance. Should the business assets not be available to pay the tax liability, the shares or partnership interest may be sold, or the business assets may have to be liquidated for a price possibly lower than the fair market value.
Purchasing life insurance provides the funds needed to pay the tax liability that occurs from capital gains and recaptured depreciation triggered by a death. Life insurance is a valuable funding vehicle should the beneficiaries decide to retain the property or if the market conditions will not provide the estate with an amount equal to the fair market value of the property. The individual could own the life insurance policy or it could be owned by the corporation or partnership and dispersed to the individual's estate after death.
Executive Compensation
Business owners may offer supplementary benefit packages to attract and retain executives. These packages can offer a variety of benefits, which may include life insurance. The life insurance protection ensures that if the executive dies, his/her dependants receive an inflow of capital that can be used to cover funeral expenses, education costs, reduce debt, and provide future income.
The policy can be purchased by the business/employer, or it can be owned and funded jointly by the employer and the executive. The executive's dependents would be named as beneficiary of all or portion of the policy. Life insurance premiums paid by the employer on behalf of the executive's interest must be reported as a taxable benefit. The amount reported must represent a reasonable cost for the benefit received.
Retirement Funding
Normal practice in a public corporation and large private corporations is to provide retirement benefits to their employees through a form of a pension arrangement. Many executive's pension plans may be limited under statutory plans such as registered pension plans. In this type of situations, it is common for the employer to provide executives with some form of a "supplementary executive retirement plan" (SERP) to provide executives with pension income they could receive should there be no statutory limits.
A SERP is an assurance by the employer to provide supplementary retirement benefits aimed to bridge the gap between the retirement benefits given under statutory plans and the desired retirement benefit based on the executive's final average earnings.
SERP's can be funded or not funded. An unfunded SERP is an unsecured assurance of future benefits and has no immediate tax consequences. A funded SERP arises where the employer formally sets aside assets (typically in a trust) which are used to fund the obligation to the employee. One option is to use life insurance to fund the SERP. A funded SERP (whether or not funded with life insurance) will generally be taxed as a "retirement compensation arrangement" (RCA) as defined in the Income Tax Act.
There are complicated rules surrounding the taxation of RCA's. In general, contributions made by the employer to an RCA are deductible by the employer in the year the contributions are made and no taxable benefit accrues to the employee. A 50% refundable tax is imposed on all contributions to the RCA and all income earned by the RCA. The refundable tax accumulates (without interest) until distributions are made from the RCA. The RCA trust refunds $1 for every $2 of income paid to the plan beneficiary. Payments out of an RCA are fully taxable to the employee at the time they are received and payments are considered to be employment income.
When funding an RCA with a life insurance policy, the policy is subject to the same taxation rules as if the policy was outside of an RCA. The funds accrued in an exempt life insurance policy are not subject to the federal refundable tax. Hence, the funds are allowed to grow tax-sheltered. Any policy gain on a full or partial disposition of the life insurance policy will be subject to the 50% refundable tax. Death benefits are tax-free to the RCA, but additional distributions to the plan beneficiary would be taxable in their hands. The employer may also be a plan beneficiary, normally for any residual amounts remaining after the plan obligations to the employees are fully satisfied. Where death benefits received by the RCA are paid to the employer corporation, it would not be entitled to an increase in its capital dividend account. The payments received by the employer corporation are considered normal income. Once the executive decides to retire there are many choices available to the RCA trust to fund the executive's supplemental pension. Provided the RCA trust document provides the trustee with the power to do so, the trustee may: 1) Withdraw funds from the policy, 2) Collaterally assign the cash value to the bank and borrow against the cash value of the policy, or 3) Pledge the cash value as security for loans taken by the corporation, which in turn makes the pension payments to the executive. The choice of alternative selected will depend on the facts of the particular situation.
In summary, an over-funded life insurance policy can be an attractive method of funding a SERP (in the form of an RCA) due to the ability to shelter the growth in the policy from refundable tax.
Wealth Creation
Often business' profits or surplus cash whether an operating company or an investment holding company is invested in GIC's or taxable investments having not been paid out to the shareholders. If the business already needs life insurance for key person insurance, business loan protection, or some other business insurance need, an exempt life insurance policy could also be used as a vehicle for investing the company's excess profits.
An exempt, permanent life insurance policy allows for tax-deferred growth of the cash value and tax-free receipt of the proceeds at death. The cash value growth within an exempt policy is not subject to annual accrual taxation and is only subject to tax if there is a disposition of the policy. Substantial cash value can accumulate on a tax-deferred basis if the maximum deposits permitted by the Act are deposited into the exempt life insurance policy. The deposits can be designed so that they remain tax-sheltered within the contract and pay for the cost of insurance and expenses in future years.
This perhaps could be an appealing alternative to taxable investments for a corporation, which has excess cash reserves not set aside for a specific purpose. It is ideal for a private corporation or its owner who:
- Is interested in a higher mm estate value,
- Has annual income retained but not earmarked for any particular use,
- Is interested in a tax deferred investment, and
- Is interested in a tax-free death benefit.
If the corporation or shareholder needs access to the cash at some future date, the policy's cash surrender value can be accessed through withdrawals or a collateral loan secured against the insurance policy. Policy withdrawals may trigger some income tax at the time of the withdrawal. Advances to the corporation received as a collateral loan will be tax free and if the proceeds are used to earn income from a business or property, and the other requirements of 20(1)(c) of the Act are met, the interest expense may be deductible for tax purposes.
Split Dollar Life Insurance Arrangement
Life insurance provides many choices for meeting a dual needs experienced by a small business. It provides protection in the event of death of an individual for one party and another party may have a need or desire for a tax-sheltered investment vehicle. With these types of situations, life insurance can provide for the needs of both parties by using an arrangement commonly known as "split dollar life insurance". In these arrangements, one party typically owns and pays for a level death benefit portion of the policy and the other party owns and funds the remaining interest in the policy (generally the cash value). In the business context, a split dollar arrangement can be used in many different ways. An example would be an employer needing key person insurance on an executive and the executive might be interested in a tax-sheltered investment. The employer and the executive could enter into a split dollar arrangement where the employer pays for and owns a level death benefit on the life of the executive and the executive pays for and owns the cash surrender value component of the policy. The beneficiary of the level death benefit is the employer, and the beneficiary of the cash value designated by the executive (his or her spouse, for example).
The following provides other examples of split dollar insurance arrangements applicable to business situations:
| Death benefit need | Tax-sheltered investment need |
| Buy-sell funding (corporation/partnership) | Shareholder or partner investment vehicle |
| Business loan protection (corporation/partnership) | Shareholder or partner investment vehicle |
| Business loan protection (operating company) | Wealth creation (holding company) |
| Employee life insurance protection (employee) | Wealth creation (corporation) |
| Key person protection (employer) | RCA funding (RCA trust) |
Conclusion
Life insurance can be a solution to many needs in a business context. Life insurance can be used to protect the interests of a small business owner and ensure the continued operation of the business itself. It can provide security for creditors during a period of change and assurance that the business will continue even if a key person departs. It can also be instrumental in attracting and retaining excellent employees, who will work to assure the continued success of the company.
Tom Zaks, B.Comm,CFP is the author of the books "The Business Owner's Guide to Wealth Management" and "Financial Planning for the Canadian Business Owner". He is an Investment Advisor with RBC Dominion Securities in Mississauga, Ontario. If you would like more information, a complimentary copy of his book, or would like to find out about upcoming speaking engagements, please call 1-800-323-6645 or contact him directly via e-mail at tom.zaks@rbc.com. His Website is www.tomzaks.com .