Business size matters, and in Canada, small businesses matter.
Did you know?
- Almost 98% of all businesses in Canada are small businesses? That’s 1.14 million small enterprises, defined as those having 1-99 employees.
- Micro-enterprises with 1 to 4 employees make up 54% of all private employers.1
If you’ve worked with business owners, you know they work hard to build the value of their corporations. The “terrible twos,” however, can slow their progress toward their business goals:
- Taxes on investment income can limit the growth of their business during their lifetime, for business owners with traditional investments.
- Taxes on deferred gains at death can erode the value of their business and their estate.
As part of your business-owner client’s team of advisors, these challenges can represent an opportunity for you. Corporate-owned life insurance can help protect clients’ wealth by minimizing the taxes the business has to pay. It can also play a critical role in maximizing the value of the business at death, helping to ensure the shareholder beneficiaries receive full value for their share of the business.
With corporate-owned life insurance, the corporation becomes the policy owner and beneficiary, and pays the premiums from the corporation’s cash flow. Life insurance premiums aren’t deductible, but if the corporation qualifies for the low small business tax rate on its first $500,000 of income, it will pay those premiums using money that has been taxed at a much lower rate than its shareholders. There’s no tax on any growth of the fund value within the policy, and the death benefit is paid tax-free to the corporation at the life insured’s death.
When the business is a Canadian-controlled private corporation (CCPC) and is eligible for the small business deduction, the owner enjoys the biggest and best corporate tax advantage.2
The Capital Dividend Account (CDA) is one of the key tax-planning tools available to owners of CCPCs. The CDA is a notional account created for tax purposes. It allows the corporation to keep track of tax-free items that can be paid to its shareholders through the declaration of a capital dividend. It includes but is not limited to:
- the non-taxable portion of net capital gains realized by the corporation,
- capital dividends received by the corporation, less capital dividends paid, and
- life insurance proceeds paid to the corporation, net of the policy’s adjusted cost basis (ACB).
The ACB is the tax cost of the policyholder’s interest in the insurance policy. It’s the value from which policy gains are measured.
The universal life (UL) option for better business value
Generally, when a corporation owns and is the beneficiary of a life insurance policy, and the life insured dies, the corporation receives the life insurance death benefit tax-free. Whether the corporation can pay all or part of the death benefit tax-free to its shareholders as a tax-free capital dividend depends on its CDA.
Generally, the lower the ACB, the higher the CDA credit and the more that can be passed tax-free to the corporation’s shareholders at death.
Over time, the ACB of the policy will typically decrease to zero. However, in early policy years, the ACB can remain quite high, reducing the amount that can be credited to the corporation’s CDA. If the life insured dies before the ACB reaches zero, the corporation’s CDA credit will not reflect the full value of the death benefit.
Can business owners optimize business value where death occurs before the ACB reaches zero? Once again, life insurance may hold the answer. Let’s take a closer look.
The type of policy you use will depend on the client – UL insurance isn’t for everyone. For business owners, UL insurance is uniquely positioned to provide them with flexibility, and can help them respond to changing personal and market conditions.
UL insurance offers:
- Premium payment flexibility – clients can make additional premium payments (within limits) to the policy fund for additional tax-preferred savings growth, and can start or stop payments anytime. This gives business clients with fluctuating cash flows the ability to fund their policy, or if their policy value is enough to pay future charges, temporarily stop payments based on the cash flows in their business.
- Investment options – clients can select investment account options that match their risk tolerance, and they can change their options as their needs change.
- Choice – through the choice of death benefit and cost of insurance (COI) options, clients can customize their solution to meet the long-term needs of their business.
- Tax-preferred savings growth – additional deposits can grow on a tax-preferred basis, resulting in a larger death benefit, further enhancing the overall estate benefit for the surviving shareholders.
- Liquidity – clients can access the value of their policy through withdrawals, a policy loan or through a collateral assignment of their policy for a series of loans from a third-party lender.
UL insurance can help business owners address their planning needs and maximize business assets both before and after death. But can it help ensure business owners are optimizing credits to the corporation’s CDA if death occurs before the ACB reaches zero?
One solution would be to use a level death benefit structure and adjust the insurance amount to reflect changes in the ACB of the policy:
- In early years as the ACB is rising, the insurance amount increases by an amount equal to the change in ACB.
- As the ACB starts to decline, the insurance amount will reduce accordingly.
- Once the ACB reaches zero, the death benefit will be equal to the greater of the initial insurance amount or the policy fund value.
This structure will ensure that the corporation will always be able to credit the CDA with an amount at least equal to the initial insurance amount even in early policy years before the ACB reaches zero. Depending on the client’s age and funding level of the policy, this solution can deliver a higher CDA credit and net payment to shareholders past life expectancy than a traditional face-plus-fund death benefit structure.
How can this work to your clients’ advantage?
One way is by helping business owners with their personal planning. Clients generally buy life insurance to cover a need for money at their death, expecting their beneficiaries to receive the entire death benefit. But with traditional corporate-owned life insurance, as long as the policy’s ACB is above zero, not all of the death benefit can be posted to the CDA. That means some of the death benefit is lost to taxes for the surviving shareholders (who, in many cases would be the client’s heirs, such as the surviving spouse and/or children), and the client’s original purpose for buying life insurance can’t be fully satisfied.
If the life insurance policy death benefit adjusts to reflect changes in the policy’s ACB, with proper funding, the surviving shareholders can always expect to receive, after-tax, an amount equal to at least the policy’s face amount, if not more. Clients can therefore take a more confident approach to planning, knowing that the need they bought life insurance for will be covered, without losing part of the death benefit to taxes.
This structure also provides an advantage for businesses that have purchased life insurance for key person protection. Generally, a policy’s ACB will grow during the policy’s early years because the premiums paid will exceed the policy’s annual net cost of pure insurance (NCPI). Under the tax rules that govern life insurance policies in Canada, premiums paid increase a policy’s ACB while NCPI charges reduce ACB. Each year a policy’s NCPI grows, while premiums generally stay the same. As a result, a policy’s ACB will grow more slowly each year as time passes, reach a peak, and then begin to decline, in some cases to zero.
The impact on a policy depends on many factors, such as the type of policy, premiums paid, and the life insured’s age when the policy is issued. But certainly during the policy’s early years (which can coincide with the client’s working years), this type of structure can increase the death benefit each year, providing more money for a business if the life insured dies during the policy’s early years.
Use Sun Life Financial’s new illustration system to show clients the benefits of UL.
UL insurance can be a great solution for business owners, especially owners of CCPCs. When you think about how many there are in Canada, it’s a huge opportunity for you to explain how they can meet their insurance needs and pay less tax. The more they understand, the more your business can grow.
Looking for solutions for your business-owner clients?
- Learn more about SunUniversalLife II and the Level insurance amount plus ACB death benefit option in the Flexibility for business clients brochure.
- For more information about CCPC, read “Changes to corporation taxation: what you need to know..”
1 Key Small Business statistics, Government of Canada, June 2016. As of December 31, 2015, there were 1,143,630 businesses with 1-99 employees, or 97.9%, out of a total of 1,167,978 businesses in Canada.
2Susan Ward, “Corporate Tax Advantages – Canadian-Controlled Private Corporation, November 7, 2016. https://www.thebalance.com/controlled-private-corporation-advantages-2948059