Permanent life insurance can be a great solution for paying estate taxes or funding shareholder agreements. The premiums are significantly higher than premiums for term insurance, however, and most successful business owners and affluent, savvy investors feel they can earn better returns by investing in their business or investment portfolios. Many business owners also have liquidity needs for maintaining business operations that may prevent them from paying high premiums for permanent life insurance.
By using the Immediate Financing Arrangement strategy, you can purchase a participating life insurance policy without forgoing the opportunity to invest in your business or portfolio.
Simply put, with this strategy you purchase a permanent participating life insurance policy, then assign the policy to a third-party lending institution such as a bank. Then you use the cash surrender value of the policy as collateral to borrow up to 90 per cent of the cash surrender value of the policy. You can also post additional collateral and borrow against a line of credit secured by other properties you own and that way borrow up to 100 per cent of the premium that you have to pay for your policy each year. Then you can invest the proceeds of the loan against your policy and other collateral – that could be up to the total premium for your life insurance policy – in your business, in real estate or in an income producing investment. By doing this, the interest on the loan plus a portion of the premium (the Net Cost of Pure Insurance, or NCPI) may be tax deductible each year.
You can choose to pay the loan interest out of your cash flow each year, or you can capitalize the interest payments and let the interest be added to your loan balance each year, in which case your loan balance would increase more rapidly.
On death, the death benefit of your policy will pay off the loan against the policy, and the remainder of the death benefit will be paid on a tax-free basis to your beneficiaries. If the policy is owned by a corporation, and the corporation is the beneficiary, then the death benefit would be paid to the company on a tax-free basis and the death benefit minus the adjusted cost base (ACB) of the policy would be credited to the capital dividend account of the corporation, and that amount can be paid out as a tax-free dividend to the shareholders following rules set out in the Income Tax Act (Canada).
Is this the right strategy for you?
This strategy would work best for healthy individuals with a stable financial situation and consistent cash flow. They should also be comfortable with borrowing and the risks of leveraging and be under 65 years of age.
This strategy can work well for individuals as well as for business owners.
This strategy is particularly suitable if you are a shareholder of a successful business and have a need for permanent life insurance (including key person, funding a buy-sell agreement, funding capital gains liabilities and other permanent needs such as the desire to leave a tax-efficient legacy to your heirs or to your favourite charities), your corporation will often generate a significant annual surplus or have large retained earnings sitting in taxable investments.
What are the benefits?
If you are a business owner, by using this strategy you will benefit from the ability to shelter growth on corporate invested assets from tax, inside the life insurance policy, during your lifetime. The Immediate Financing Arrangement strategy also allows a corporately owned participating life insurance policy to be used as collateral for a tax-free loan that enables the corporation to reinvest into its business or other income producing investments.
As a business owner, you can also reduce passive income in your corporation by allowing assets to grow tax-sheltered inside a permanent life insurance policy.
If a corporate loan is being used to earn income from a business or other investments, the interest on the tax-free loan may be tax deductible to the corporation. Additionally, a portion of the life insurance policy’s premiums may also be tax deductible when the lender requires the life insurance for a collateral loan.
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The strategy will also provide liquidity for corporate life insurance needs, such as coverage for a key person, debts or to fund buy-sell agreements or dividend payments to shareholders.
Whether you are a business owner or not, the death benefit proceeds of the policy can also be used to help fund tax liabilities, estate equalization or to leave a legacy to heirs or favourite charities.
In case of policies that are owned by a corporation and where the corporation is the beneficiary of the policy, the death benefit in excess of the policy’s adjusted cost basis will create a credit to the corporation’s capital dividend account (which is a notional account only available to Canadian Controlled Private Corporations). It is important to note that the capital dividend account is credited with the total death benefit in excess of the policy’s adjusted cost basis, not simply the excess death benefit minus the loan amount. The net value in the capital dividend account may be used to distribute other trapped surplus tax-free over and above the net life insurance proceeds paid out as a death benefit.
What are the risks?
If you are considering an Immediate Financing Arrangement you should consider the following:
• You need to have sufficient income to pay the insurance premiums and meet the loan obligations and qualify to write off interest payments and take advantage of the collateral premium deduction for income tax purposes.
• The loan interest rate charged by the third-party lender for the loan may be greater than the interest rate assumed in the life insurance company’s illustrations. Make sure reasonable and conservative assumptions are used for the loan interest in the illustrations.
• Loan interest rates are not guaranteed and are subject to change by the lender.
• The cash surrender values for the life insurance product illustrations are independent of the loan rate charged by the lender.
• Total cash surrender values are not guaranteed and depend on the dividend scale of each company, which is subject to change.
• The third-party lender may reserve the right to demand payment of the loan in full at any time in accordance with the terms and conditions for the loan prior to the time the illustration assumes it will be paid.
• You have to ensure that if the life insurance illustration that you consider is a participating whole life insurance policy, it will not expire during your lifetime as long as the premiums are paid and the policy remains in force, even if the dividend scale of the life insurance company is reduced by 2 per cent compared to the current dividend scale.
• If the loan amount exceeds the cash surrender value of the policy, or the cash surrender value of the policy plus the collateral that was pledged to acquire the loan, the lender may require additional collateral be pledged, or the lender may demand repayment of all or part of the outstanding loan balance.
• The lender may demand repayment of all or part of the outstanding loan balance.
As with any financial strategy, you need to ensure that it is a good fit for you and your situation and makes sense in the context of your overall financial and estate planning. Immediate Financing Arrangements can be a powerful strategy that can enable you to purchase permanent participating life insurance with minimal cost, but it is not risk free and you should explore this strategy with the help of your financial and tax advisors to ensure that it is the right fit for you and your estate planning needs.
Tina Tehranchian, MA, CFP®, CLU®, CHFC®, MFA-PTM (Philanthropy) is a FP CanadaTM Fellow and a Senior Wealth Advisor at Assante Capital Management Ltd. in Richmond Hill, Ont. She can be reached at (905) 707-5220 or through her website at www.tinatehranchian.com. Assante Capital Management Ltd. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. Before acting on any of the above, please make sure to see a professional advisor for individual financial advice based on your personal circumstances.