Among the many tax-reduction strategies pursued by Canadian small business owners, corporate life insurance stands out as a long-term approach. Individual shareholders realize tax advantages when they allow the corporation to own the policy and pay the required premiums. Sole proprietors who incorporate can use company funds to fund life insurance policies with dollars that are subject to lower tax rates than personal earnings. For instance, Ontario has the highest individual marginal tax rate at 46.4%. In contrast, small business earnings are only taxed at a maximum rate of 16.5%. Along with capitalizing on the disparity in personal and business tax rates, examine these benefits of corporate-owned life insurance.
Life insurance typically has one main thrust: to be in force when the insured dies so that a beneficiary can collect the death benefit. Personal beneficiaries look to maintain current income levels, while businesses may use the asset for continuity when a key shareholder passes away.
Permanent life insurance policies double as tax-deferred growth vehicles. Premiums contributed to variable universal life policies are left to grow unencumbered by personal or business taxes, maximizing the internal rates of return while the policy remains in force. These insurance funds can be allocated to various mutual funds whose potential for capital appreciation and diversification provide options that may outpace inflation and fixed-rate investments.
Cash values accumulated inside universal or whole life policies may also be used as collateral for loans that can fund operations or purchase capital equipment. However, the Canada Revenue Agency may consider the cash value inside a policy to be a passive asset. To qualify for the preferred rate tax benefit, 90% of a corporation’s assets must actively be used in the business. Therefore, it’s prudent to assess the composition of your business’s capital structure periodically to ensure you are benefiting from optimal tax rates.
While funds grow inside the contract, those amounts generally hold less value than the policy’s death benefit. As an estate planning tool, corporate-owned life insurance can be passed to heirs with no tax liability. The capital dividend account lets death benefits from a corporate policy be distributed as non-taxable income. The [CDA] (http://www.advisor.ca/tax/tax-news/harness-the-capital-dividend-acount-146144) prevents those proceeds from double taxation, as is seen with earnings taxed when received by the company and paid to shareholders. Lump-sum death benefits avoid this trap, as long as the insured is a shareholder of the corporation who pays the premium and owns the policy. The funds are received by the organization, which, in turn, pays prescribed beneficiaries in the form of tax-free dividends.
It is crucial for any shareholder to examine the adjusted cost basis of the policy when adopting the corporate-owned strategy. The ACB includes factors such as premiums paid and interest on policy loans that can erode tax-free payouts from the CDA to beneficiaries. These factors are likewise reduced by the pure cost of insurance inside the policy.