Note: This is part eight of a series on tax and insurance. Find the full series here.
An immediate leveraged insurance arrangement, secured by the cash values of a life insurance policy, can benefit clients who require permanent life insurance coverage and who are also looking to profit from investing the borrowed funds.
However, to make the most of such an arrangement, advisors and their clients must consider certain tips and traps.
An earlier article explained the mechanics of borrowing against the cash values of a life insurance policy, the typical terms and conditions of such loans, and the associated risks.
To recap: under an immediate leveraged insurance strategy, the policyholder (an individual or corporation) makes additional deposits to the policy to create an early cash surrender value. The policyholder then applies to a financial institution (typically a bank or insurance company) for a line of credit secured by the policy’s cash value and used for investment purposes (e.g., to invest in a business).
Depending on the arrangement’s structure, the policyholder can claim an interest expense deduction as well as a collateral insurance deduction. In effect, this arrangement can reduce the after-tax cash flow costs of funding a life insurance policy, with the loan ultimately repaid with the insurance proceeds.
Tips and traps
In today’s low interest rate environment, a leveraged strategy can look attractive, particularly if the client purchases a participating life insurance policy. However, future increases in the loan interest rate and variability in the credited rate to the policy could result in the outstanding loan (plus accumulating interest) exceeding the policy’s cash accumulations. If that happens, the borrower has a collateral deficiency and must post additional collateral and/or repay a portion of the outstanding loan.
To avoid a client being faced with unexpected results, it’s important to provide illustrations using a variety of interest, policy dividend or credited rates. Also, clients should have sufficient liquid assets in addition to the policy’s cash value if circumstances require the posting of additional security or partial loan repayment.
The loan arrangement must comply with rules under the Income Tax Act governing deductibility of interest. For example, the client should properly structure and manage the borrowed money to demonstrate that the funds are used for investment or business purposes.
Another important consideration is the borrower’s ability to utilize the interest expense deduction throughout the lifetime of the arrangement. Assuming the loan remains outstanding until the death of the life insured, the interest expense could grow to exceed the borrower’s taxable income. In this case the tax benefits of the interest expense deduction will be diminished.
Collateral insurance deduction
The collateral insurance deduction is available where a taxpayer borrows funds from a “restricted financial institution” (e.g., a bank or insurance company), the funds are used for income-earning purposes and the life insurance policy is required by the lender to secure the debt. As discussed in a prior article, there are circumstances where this deduction may not be available (for example, if the loan interest isn’t deductible) or may be pro-rated.
The borrower and policyholder must be the same person, so no collateral insurance deduction can be claimed where a corporation is the policyholder and a shareholder is the borrower (or vice versa).
Surrender of the policy
A prospective client should also understand the implications of surrendering the policy due to a default under the loan agreement or other changes in financial circumstances.
A disposition of the policy will result in the excess of the cash surrender value over the adjusted cost basis of the policy being included in the policyholder’s income and subject to tax. However, depending on the ratio of loan to cash value, the remaining cash after repaying the loan may be insufficient to pay this tax, so the borrower would have to access other assets to pay this liability. As well, the policyholder would lose access to insurance coverage required to fulfill estate planning needs.
Shareholder benefit issues
It’s possible to structure a leveraged insurance arrangement where the shareholder of a private corporation borrows the money, secured by a corporate-owned life insurance policy on the shareholder’s life. However, clients must be aware that a shareholder benefit issue might arise from the corporate guarantee. This risk can be mitigated by the shareholder paying a reasonable guarantee fee to the corporation.
Similarly, a shareholder benefit issue can arise on the shareholder’s death, if insurance proceeds (otherwise payable to the corporation as beneficiary) are directly remitted to the lender under the guarantee. Steps must be taken at time of death to ensure that the shareholder’s estate repays the loan or reimburses the corporation for any payment made under the guarantee to avoid the assessment of a shareholder benefit.
Critical tax and financial issues must be considered and addressed by advisors and their clients before proceeding with an immediate leveraged insurance arrangement. This article highlights some of the key considerations that will help ensure the leveraged arrangement performs to everyone’s expectations.