Why business owners need life insurance
Life insurance for your business can be a flexible way to help maintain your business’ success. You can use it to protect yourself, your business partner and the future of your business.
If you choose permanent life insurance, money (called cash value) can build up in the policy that your corporation can use or leverage if needed (assuming you make the required premium payments and enough cash value has accumulated in the policy).
There are 2 types of permanent life insurance: participating life insurance and universal life insurance.
Accumulating and accessing cash value
Cash value is an amount accumulated by directing a portion of your premium payments to an investment account within the policy. This cash value can grow tax-free within the policy, subject to legislative maximum limits.
There are 3 ways businesses can access the cash value in their policy. Let’s look at how each option works and how it can affect your coverage and taxes.
Withdraw the policy’s cash value
The policy guarantees that the owner (your corporation) can withdraw some or all the cash value, adjusted for any outstanding policy loans or fees. Known as the cash value, withdrawals will however, reduce the policy’s coverage and may result in taxable income being reported to the corporation. The policy ends if the corporation withdraws all the policy’s cash value (called a policy surrender).
At death, the insurance proceeds are paid to the corporation on a tax-free basis. The capital dividend account of the private corporation can receive a credit equal to the payout on death less the adjusted cost basis of the policy. The capital dividend account credit typically allows the corporation to pay a tax-free dividend to the Canadian resident shareholders.
Borrow from the policy
The policy guarantees that the owner (your corporation) can borrow money from Canada Life against the policy’s cash value. The loan accrues interest. You can take advantage of the policy loan feature if the cash value in the policy is large enough and available. The policy loan is tax-free, up to the policy’s adjusted cost basis. Generally, the adjusted cost basis is the premiums paid minus the net cost of pure insurance, assuming no dispositions. The adjusted cost basis is defined in 148(9) of the Income Tax Act.
The policy loan doesn’t reduce the insurance coverage or affect the cash value growth or any dividends the policy may receive. However, if the loan isn’t repaid at the time of a policy surrender, or death of the life insured, any outstanding balance, including interest, will be deducted from the insurance payout or any cash value that is paid out.
At death, the insurance proceeds can be paid to the corporation on a tax-free basis. The capital dividend account of the private corporation can receive a credit equal to the payout on death less the adjusted cost basis of the policy. The capital dividend account credit typically allows the corporation to pay a tax-free dividend to the Canadian resident shareholders.
Use your policy as collateral for a loan or a line of credit
The corporation may be able to borrow from banks or other third-party lenders using the policy’s cash value as collateral. Known as a collateral loan, it is not a disposition of the policy for tax purposes, but the corporation pays loan interest to the lender. A collateral loan doesn’t reduce your insurance coverage or affect the cash value growth or any dividends the policy may receive, or the capital dividend account credit. However, the policyowner agrees to give the lender rights to control the policy, including surrendering it for its cash value if the loan is not repaid. If the loan isn’t repaid at the time of death of the life insured, the balance, including interest, is deducted by the insurer from the amount paid out at death and paid to the lender.
Depending on the lender, a collateral loan may be available at a lower interest rate. You should not purchase life insurance solely because of the future possibility of obtaining a collateral loan.
The policyowner may need to be underwritten by the lender to qualify for the loan and may need to make immediate repayment if lender calls in repayment of the loan.
Collateral loan repayment
Once the loan is repaid, you may have a capital dividend account balance higher than your remaining insurance payout at death. This extra room can provide your business with the flexibility to release other assets to shareholders as a tax-free capital dividend. There’s no guarantee a third-party lender will offer your corporation a loan using the policy as collateral. You’ll have to negotiate that with the lender, subject to their financial underwriting and requirements. Because it involves greater risks, you shouldn’t consider a collateral loan unless you have a high tolerance for risk. The corporation also needs enough income and capital to cover the interest and repay the loan, in addition to paying its required life insurance premium payments.