Mr. Elbaz is head of legacy planning at Heritage 1887. This commentary is part of our ongoing Insurance series.
A corporate-owned life insurance policy may be one of the longest-lived assets in a business owner’s financial plan. The company around it may be almost unrecognizable by the time the policy pays out.
A policy may have been purchased, for example, when the business had two shareholders, significant bank debt and a clear succession plan. Years later, the debt may be gone, ownership may have changed, the corporate structure may have been reorganized, and the family’s estate objectives may look very different.
Yet the insurance often remains exactly where it started.
That does not necessarily mean anything is wrong with the policy. But it raises a more important question: Does the structure around the policy still accomplish what it was designed to do? Policy ownership, premium payments, beneficiary designations, collateral assignments and the corporation that ultimately receives the death benefit can all affect the tax and estate result.
A sale can change the equation
One of the clearest times to revisit the ownership and beneficiary structure of a corporate-owned policy is before the sale of a business.
If an operating company owns a permanent policy and the shareholders later decide to sell the company, the policy may not be an asset they want to transfer to the buyer. Moving it elsewhere beforehand, however, is not necessarily a simple administrative exercise.
A transfer of a life insurance policy between non-arm’s-length parties is subject to specific tax rules. Depending on the policy’s cash surrender value, adjusted cost basis and the consideration paid, the transfer can produce a taxable policy gain. If a corporation transfers a policy to a shareholder for less than fair market value, a shareholder benefit may also arise. Waiting until a transaction is imminent can therefore introduce another tax and legal issue into an already complex sale.
The policy can also matter to the sale in another way. For purposes of the Qualified Small Business Corporation tests—which must be passed for the lifetime capital gains tax exemption to apply—a corporate-owned policy on a shareholder’s life is generally valued at its cash surrender value. Where the policy is not an active business asset, that value can work against the applicable QSBC active-asset thresholds. A corporate-owned policy does not automatically prevent access to the lifetime capital gains exemption, but it should form part of the broader presale review, particularly where the corporation also holds other passive assets.
When the corporate structure changes
A business may also evolve without being sold. A reorganization may place an operating company within a holding-company structure, transfer shares within a related corporate group or introduce new share classes as part of an estate freeze. Children may become shareholders, a partner may leave, or a new shareholder may enter.
The insurance arrangement that was logical under the old structure may not fit neatly within the new one. The simplest arrangement is often for the same corporation to own the policy, pay the premiums and be the beneficiary. More complicated structures, such as one corporation owning and paying for the policy while another receives the death benefit, require careful tax analysis. Depending on the circumstances, benefit or income-inclusion issues can arise.
Therefore, when the corporate structure changes, the ownership, beneficiary designations and purpose of the insurance should be reviewed alongside it.
The same principle applies when life insurance is intended to provide the liquidity needed to satisfy a purchase obligation under a buy-sell provision following a shareholder’s death. Coverage established years earlier may no longer reflect current ownership percentages, the value of the business or the terms of the agreement.
When the debt that shaped the original plan disappears
The company’s borrowing and financing needs may change just as significantly as its ownership structure.
A policy may originally have been acquired because a lender required life insurance as security for a significant business loan. Years later, the company may have substantially reduced or eliminated the borrowing while the policy remains in force.
Where the requirements of the Income Tax Act are satisfied, a limited portion of premiums on a policy assigned as collateral for qualifying borrowing may be deductible. The amount potentially deductible is tied in part to the amount of qualifying debt outstanding. As the loan balance declines, the deductible amount may therefore decline as well. Once the debt has been repaid, the conditions supporting that deduction will no longer be present, and any collateral assignment should also be formally released.
More importantly, repayment changes the planning question. If debt protection was the reason the policy was purchased, what purpose does the coverage serve now? It may be estate liquidity, succession funding or intergenerational wealth rather than creditor protection.
The estate result may have changed, too
For many business owners, permanent insurance eventually becomes less about protecting the operating business and more about creating liquidity and transferring wealth.
When a private corporation receives life insurance proceeds as a consequence of death, the death benefit is generally not included in the corporation’s income. Broadly, the death benefit in excess of the policy’s adjusted cost basis immediately before death may increase the corporation’s capital dividend account. A positive CDA balance can generally be distributed to Canadian-resident shareholders as a tax-free capital dividend if the required election is properly made.
That treatment can be extremely valuable, but it makes the surrounding ownership structure important. Which corporation will receive the proceeds? Who will own that corporation at that time? Are those shareholders the people the estate plan is intended to benefit?
An estate freeze, corporate reorganization, business sale or change in family succession can alter the answers. The insurance company may still pay exactly what the contract promises, while the proceeds arrive in a corporate structure that no longer matches the family’s objectives.
Review the purpose, not just the policy
A meaningful corporate insurance review should therefore begin with a simple question: What is this policy supposed to accomplish today?
The answer may still be debt protection, buy-sell funding or key-person coverage. It may now be estate liquidity, tax-efficient wealth transfer or equalization among family members. In some cases, the original need may have disappeared altogether.
That does not mean an older policy should automatically be moved, surrendered or replaced. Changing an established policy can itself produce tax consequences, affect contractual guarantees or require new underwriting if replacement coverage is contemplated. Leaving it untouched may be exactly the right decision.
Businesses evolve. Ownership evolves. Families evolve. A life insurance policy can remain in force for decades. The longer it lasts, the more important it becomes to ensure that the plan around it has not quietly moved on.
Salomon Elbaz, F. Pl., CFP, CIM, TEP, MFA-P, FCSI, is head of legacy planning at Heritage 1887, where he leads the firm’s financial planning practice. He works with incorporated professionals, business owners and high-net-worth families on integrated tax, estate, retirement, insurance, philanthropic and intergenerational planning.
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