Corporate insurance beyond death
Most of us are aware that life insurance can be used by individuals to cover debts, funeral expenses and provide financial cushion to family after death. You may have even considered owning personal life insurance to fund the income tax bill resulting from the deemed disposition of your private company shares on your death. But did you know that life insurance can also be purchased and used by your corporation for a variety of issues that may arise upon your death? It can be used to pay off corporate debt, shore up operating capital and buy out shareholders’ estates.
There are a number of different types of life insurance available that fall into two basic categories: “term” and “permanent”.
- Term life insurance is the most basic type of life insurance: it provides coverage for a specific period of time and it is the least expensive type of insurance.
- Permanent insurance is designed to be maintained longterm until death. It includes universal life, whole life and term to 100 policies.
Universal life and whole life policies offer an investment component where additional funds over and above the cost of insurance are paid into the policy. These additional funds form the investment component which grows tax free in the policy and may increase the proceeds of the policy when the insured person passes away. The details of permanent policies are complex and vary significantly from one policy to the next. You should discuss any permanent policy in detail with your insurance broker before buying.
A corporation can be a beneficiary of a life insurance policy. This generally allows the corporation to pay the premiums for that policy and collect proceeds upon the death of the covered person. In most cases, the premiums are not deductible but they can still be financed by corporate dollars, which discover here is better than using after-tax personal dollars. Once the insurance proceeds are received, they are not taxable to the corporation and an equivalent amount (net of any adjusted cost basis) is added to the company’s capital dividend account which can then be paid out tax free to shareholders as a capital dividend. The adjusted cost basis of the policy is determined by the insurance company and is calculated by subtracting the annual pure cost of the life insurance from the premiums paid.
It’s important to ensure that any corporate owned insurance policy names the company as the beneficiary and policy owner, and names the shareholder as the covered person.
Estate tax and equalization. Consider a situation where shares in a family-owned corporation form the major part of the value of a person’s estate, and the estate has multiple beneficiaries, some of whom are not involved in running the company. Typically, shares of the family business are left to the family members involved in the company and the remaining estate assets are divided among the remaining family members. In this situation, there may not be enough cash to pay tax on the deemed disposition of shares let alone provide equivalent value to the uninvolved beneficiaries. By paying the proceeds to an estate via capital dividend, corporate owned life insurance can fund tax liabilities and equalize the value among beneficiaries,.
Loan protection. Often in small businesses, lenders will require that loans be personally guaranteed by the owner. In some cases, lenders may also require life insurance for key people for the duration of the loan. Even when lenders don’t require life insurance, it’s good practice to have it. A personal guarantee becomes a liability of the person’s estate meaning the estate could be held liable for outstanding debts that the business cannot pay. Having life insurance can also improve a business’ ability to obtain financing.
Corporate life insurance – Opportunities to die for
Key person protection. The death of a shareholder or key person can put financial strain on a company in a variety of ways. It is often very difficult to replace a key person and once found, it may be months or even years before that replacement can operate at the same level. This can be very disruptive to a small business and can cause problems with efficiency and profitability. Life insurance can provide a business with the cash flow needed to shore up working capital, or repay debts, or provide the funds necessary to hire and train a replacement when a key executive dies.
Buy-sell agreements. Life insurance is frequently used by private companies to fund buy-sell transactions that are triggered by a shareholders’ agreement upon death. In many cases, the surviving shareholders are not interested in having the ilies involved in the business. And those families may not be interested in staying involved in the business and forgoing the estate proceeds. Life insurance proceeds can be used to buy out the shares owned by the deceased shareholder’s estate or beneficiaries. Using corporate owned life insurance to fund the buyout helps ensure the business can carry on while providing cash to the deceased’s beneficiaries. There are a number ways to do this. For example, the proceeds can be used to redeem shares or can be paid as a capital dividend to fund a personal purchase of shares from the deceased’s estate.
Whenever possible, and to avoid confusion and potential conflict later, the buyout process should be documented in the shareholders’ agreement. Intended use of the life insurance proceeds and the capital dividend account should also be stipulated.
While there are many benefits and flexible planning opportunities when purchasing and using life insurance through a private corporation, there are a number of additional complexities to consider. Corporate tax issues, shareholder agreements, accounting for permanent insurance balances and additional compliance for capital dividends are just a few. You should always consult the appropriate accounting, tax, legal and insurance advisors to ensure the planning is done correctly and that compliance/administrative issues have been addressed. You’ll sleep better if you do.
Mike Veldhuizen is a tax senior manager in St. Catharines and has provided tax and business advice to a broad spectrum of privately held and managed clients, focusing on health care professionals, manufacturing and consumer business entities. Mike also brings a depth of experience to owners of private companies with a goal to enhance and preserve their personal wealth with advice that considers the entity and the individual.