Life insurance is a crucial financial, estate planning, and tax-free wealth transfer vehicle for corporations and high-net-worth individuals.
Beyond providing a financial safety net, life insurance can mitigate tax liabilities at death, secure funds for shareholder agreements, and protect business interests.
When a corporation is the beneficiary of a life insurance policy, the proceeds, minus the policy’s adjusted cost basis (ACB), can be credited to the company’s Capital Dividend Account (CDA), offering significant tax benefits to shareholders. Here’s a comprehensive look at how this works and some strategic considerations for corporate-owned life insurance.
How Life Insurance Enhances the Capital Dividend Account
The Capital Dividend Account (CDA) allows certain tax-free capital amounts, such as life insurance death benefits, to be paid out to shareholders tax-free. When a company receives a life insurance payout as a beneficiary, the amount eligible for the CDA credit is the death benefit minus the adjusted cost basis (ACB) of the policy.
Example: Life Insurance Payout and CDA Credits
Consider a corporation as the beneficiary of a $5,000,000 million life insurance policy. If the policy’s ACB at the shareholder’s death is $500,000, then $4,500,000 (calculated as $5,000,000 - $500,000) can be credited to the CDA. The company can distribute this amount to shareholders as a tax-free capital dividend. The remaining $500,000, reflecting the ACB, would be treated as a taxable dividend if distributed. In many cases, the Adjusted Cost Basis (ACB) may eventually decrease to zero over time.
Understanding the Adjusted Cost Basis (ACB)
The ACB of a life insurance policy is calculated by the insurance provider using a complex formula. This calculation considers factors such as policy deposits, any withdrawals or loans, dividends paid on the policy, and insurance charges.
To put it simply, the ACB is the total premiums paid (excluding costs for ancillary benefits like accidental death and disability coverage) minus the net cost of pure insurance (NCPI). NCPI is determined by a mortality charge on the risk amount. Over time, the ACB typically increases in the early years of the policy and declines in later years as the NCPI exceeds premiums paid.
Structuring Corporate Ownership of Life Insurance Policies
Private corporations can structure life insurance ownership in ways that maximize tax benefits. Here are some common structures:
- One Company as Both Owner and Beneficiary: The operating company both owns the policy and is the beneficiary, making it straightforward to add the death benefit (less ACB) to the CDA upon the insured’s death.
- Split Ownership: Sometimes, the operating company is the beneficiary, while a holding company owns the policy and pays premiums. While this strategy was once used to allow full death benefit credit to the CDA, rules now require the ACB reduction in all cases.
Regardless of structure, companies must now subtract the ACB when calculating the CDA credit from the death benefit.
Using Life Insurance as Collateral for Corporate Loans
Corporations can leverage a life insurance policy as collateral when applying for loans. This strategy may involve assigning the policy to a financial institution, providing the lender with security while enabling the company to access financing.
In the event of the insured’s death, the lender is typically paid the loan balance directly from the insurance proceeds, with any remaining amount going to the designated company beneficiary. The CDA benefit still applies in these cases—the company can add the death benefit (minus the ACB) to its CDA, allowing for potential tax-free dividends to shareholders.
Benefits of Corporately Owned Life Insurance and CDA for Business Owners
- Tax-Efficient Wealth Distribution: Life insurance proceeds credited to the CDA enable tax-free capital dividends, allowing shareholders to benefit without incurring personal tax.
- Estate Planning and Continuity: Life insurance can provide liquidity to cover estate taxes and support the continuation of the business in the absence of key personnel or shareholders.
- Flexibility in Funding Agreements: Life insurance serves as a funding mechanism for buy-sell or shareholder agreements, ensuring that surviving owners or successors have the means to buy out shares from the estate of a deceased partner.
Key Considerations When Using Corporate Life Insurance and CDA
- Policy Structuring: Proper planning is essential for the structure and ownership of policies to ensure maximum tax benefits for the corporation and shareholders.
- CDA Calculation and Reporting: Accurately reporting ACB and CDA credits is vital to avoid tax complications or miscalculations.
- Loan Collateralization: When using life insurance as loan collateral, businesses should work with advisors to ensure they understand the tax implications for CDA credits.
Conclusion
Corporately owned life insurance, combined with the Capital Dividend Account, is a powerful financial strategy for business owners. Properly structured, it provides a tax-efficient vehicle for distributing wealth to shareholders, securing liquidity for business continuity, and enhancing overall estate planning. With professional guidance, companies can maximize these tools to protect and grow their legacy.
