Life insurance is a staple in most private companies.
For instance, insurance for the shareholders may be an integral part of the shareholders’ buy-sell arrangement. Alternatively, a lending institution may require insurance on shareholders’ lives as a condition of a loan agreement, or insurance may help a shareholder’s family fund a tax obligation that arises upon death. Still, if a corporation owns the insurance, then it’s important to understand the accounting treatment of transactions to ensure your client doesn’t misrepresent expenses.
There’s a standard methodology that needs to be considered in all accounting transactions. Public companies must report their financial statements using International Financial Reporting Standards (IFRS).
Meanwhile, private enterprises may choose to use IFRS or Canadian accounting standards for private enterprises (ASPE). However, neither IFRS nor ASPE address the accounting and financial presentation of corporate-owned life insurance.
Here’s what you need to know. The cash surrender value of a life insurance policy is an asset a company can control, so it should be recorded on its balance sheet. A future death benefit is an economic benefit—one the company can’t control, so it should not be recorded as an asset.
Understanding the type of life insurance is critical. Generally, if the life insurance policy has a cash surrender value, that value should appear on the balance sheet. Any cash outflow above the year-over-year increase in cash surrender value will be expensed and reflected on the income statement. Term insurance does not usually have a cash surrender value, whereas UL and WL generally do.
Life insurance policy
|Policy Year||Annual premium due during the fiscal year of the corporation||Cash surrender value of the life insurance policy at the year-end of the corporation|
Take this scenario. Aco Corp. purchases a permanent insurance policy on the life of its shareholder, Ben. The death benefit is $1 million. Aco pays premiums (see “Life insurance policy”) and the cash surrender value of the policy increases. In year 25, Aco receives a $1 million death benefit when Ben dies (see “Relevant accounting entries”).
Note: the accounting treatment of corporate-owned life insurance does not reflect the income tax treatment. The payment of life insurance premiums is generally not tax deductible. So, while the annual insurance expense in each of years 1 through 14 is $10,000 and an accounting entry is made to reflect the payment, the expense is not deductible against Aco’s taxable income. An accountant makes this tax adjustment when preparing Aco’s tax returns.
The increase in the year-over-year cash surrender value is not taxable. Nor is the receipt of life insurance proceeds taxable income. Again, an accounting entry reflects receipt of the insurance proceeds. When Aco’s financial statements are prepared, $750,000 will be removed from income for tax purposes. The other portion of the entry ($250,000) was simply eliminating the asset from the balance sheet. So Aco receives $1 million in cash as the death benefit, which is reflected on its financial statements; however, there is no tax liability from receiving those proceeds when Ben passes.
Aco will also receive a credit to its capital dividend account when the life insurance proceeds are received. But, there is no accounting entry at that time and it is a tax-specific issue. The cash surrender value in an insurance policy represents an asset and needs to be correctly recorded on the financial statements. So consider accounting and taxation issues separately.
Relevant accounting entries
|Each year when the annual premium is paid, Aco’s accountant will debit the insurance expense and credit the chequing account. This same entry is made in each of years 1 through 14.||Insurance expense||$10,000||To record the payment of annual insurance premium due|
|At Aco’s year-end, the accountant will write an adjusting entry to reflect the year-over-year increase in the cash surrender value.||Year 1||Cash surrender value||$3,000||To record cash surrender value at the end of the first year|
|Year 2||Cash surrender value||$3,000||To reflect the year-over-year increase in the cash surrender value|
|In year 12, the increase in the cash value ($14,000) of the life insurance policy is greater than the annual premium ($10,000). This means that on Aco’s income statement, there will be income of $4,000, rather than an expense.||Year 12||Cash surrender value||$14,000||To reflect the year-over-year
increase in the cash surrender value
|In year 15, the company did not pay an annual premium but chose to use the policy’s internal value to fund the cost of insurance. There is still an increase in cash surrender value ($2,000) over the prior year, which needs to be recorded.||Year 15||Cash surrender value||$2,000||To reflect the year-over-year
increase in the cash surrender value
|At the time of Ben’s death, Aco will receive a $1-million death benefit. The cash surrender value of the policy at the time of Ben’s death is $250,000. So $750,000 will appear on Aco’s income statement for the year.||Year 25||Chequing account||$1,000,000||To record receipt of $1 million of life insurance proceeds and to eliminate the $250,000 of cash surrender value sitting on Aco’s
|Cash surrender value||$250,000|
James Kraft , CPA, CA, MTax, TEP, CFP, is vice-president of Wealth Planning Services at BMO Financial Group. Deborah Kraft, MTax, TEP, CFP is director of the Master of Taxation Program at the University of Waterloo.
Originally published in Advisor's Edge Report
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