Lane Cuthbert, Guest Author
This article is written by Lane Cuthbert of Lane Cuthbert Financial.
Lane is a financial advisor who helps families and individuals understand their finances, set realistic goals and invest wisely, so they can feel confident about their financial future.
There’s Lane and his family lookin’ adorable 👆
And one more thing to add is that tax planning can be a complex subject.
We've only provided general information in this article and we recommend consulting with your accountant before implementing any tax planning strategies.
Ok, on with the knowledge!
Types of Insurance
It’s safe to say that most people have heard of term insurance and understand how it works, but just in case, I’ll explain it real quick.
Term insurance offers a set benefit, for a set period of time (the term), for a fixed cost (the premium).
The most common terms are 10 years, 20 years, and 30 years.
Most don’t realize that there is another type of insurance called permanent insurance, or another name for this kind of insurance is whole life insurance.
Whole life insurance provides insurance from your current age until age 100.
What makes this type of insurance unique, however, is that you’re allowed to hold an investment inside your insurance policy.
Investing Inside an Insurance Policy
Without getting too technical, the government says that an investment is allowed within an insurance policy as long as it doesn’t cross above the MTAR line (which is a Federally mandated line that distinguishes an investment from an insurance).
Think about that for a second, why would the government care how much money you choose to put in an insurance policy?
Because holding an investment inside an insurance policy is extremely tax efficient and the Government doesn’t want these policies to be too lucrative, so they put certain limitations in place like the MTAR.
So what kind of returns does an insurance policy get?
Well there are several different insurance companies that offer these policies but they generally fall into these two main categories:
- Participating policies, and
- Non-Participating policies.
In a non-participating policy the returns are fixed at 5% for most companies.
In a participating policy, the returns are often higher because along with owning a policy you also become a co-op owner in the insurance company.
My preferred company for participating whole life insurance policies is Equitable Life of Canada which has a 30 year track record of averaging over +8% (and generally performs better than that in higher interest rate environments).
Sidenote: unlike other corporate investment income, the growth inside a whole life insurance policy does not affect the small business tax deduction, so the investment held in your policy
can grow tax sheltered without being counted towards your company’s passive income Limitations.
When a Corporation Owns an Insurance Policy
Now that you better understand the function of whole life policies here comes the exciting part for business owners: corporately owned whole life.
This is where things get interesting. Insurance policies can be taken out on anyone (with their permission of course), so a business owner can use these policies as a tool to leverage retained
earnings in the company for a multitude of different purposes.
It starts by a corporation owning a policy (the policy owner) on the life of the business owner (the life insured). So the corporation would use corporate dollars to pay for the insurance policy.
Depending on the structure of your company and how much money your business makes, the tax rate on corporate dollars can be as low as 11%.
While these premiums paid are not tax deductible for the corporation, they are usually stil lower taxed dollars than a personal marginal tax rate, which is a great benefit.
Using Cash Values
Once the corporation starts paying premiums into the insurance policy, the investment portion of the whole life insurance policy begins to grow from deposits and investment returns, this is
called the “cash value” of the policy.
The cash value acts like equity in your house, as it grows and becomes more valuable it can be used as collateral for a loan.
Since you’re the owner of the company and the life insured, it means that you can use the insurance policy to collateralize a loan which you use on a personal level, but in fact was funded
entirely by corporate dollars at a lower tax rate.
And that’s good news.
Not only utilizing lower taxed dollars, but the CRA doesn’t consider ‘borrowed’ money income, so any money that you use personally from the loan doesn’t affect your income tax.
And in some cases, using the borrowed money to invest in a non-registered investment allows you to deduct personally, any interest you’ve paid.
So the question becomes, do you need to pay this money back?
And the answer is “not necessarily.”
If you did pay the borrowed amount back it would mean that you could use that amount again in the future.
However, to maximize the efficiency of this kind of strategy you wouldn’t pay any of the borrowed money back.
Instead, when you pass away, the death benefit of the insurance policy would be used to cover any of the money that was borrowed while you were living.
And when done correctly, this offers another fancy perk known as a Capital Dividend Account Credit.
The “CDA” Credit
Hopefully I haven’t bored you to death with all this insurance jargon because I’m about to show you the cherry on top of this excellent insurance strategy.
A little unknown stipulation of these policies is that when the proceeds of an insurance policy flow through a corporation and are paid out to an orphan or a widow, the corporation receives a credit in their Capital Dividend Account.
The “CDA credit” amount is equivalent to the death benefit of the insurance policy, which means they can liquidate and withdraw corporate dollars, tax-free using their CDA credit.
So What Does That Mean for You?
Imagine that your corporation has a $1,000,000 whole life insurance policy with $500,000 of cash value.
While you’re alive you can use the cash value of this policy to collateralize a loan for $500,000 and spend it all as a part of your retirement, reinvesting, or just for fun.
When you pass away (knock on wood) the corporation would receive a death benefit of $1,000,000 cash (keep in mind that you owe the bank $500,000).
The plan would be to pass the entire $1,000,000 cash to your beneficiaries who would now be a “widow or orphan”.
They would use that cash to pay back the $500,000 loan to the bank and be left holding $500,000 of cash.
The corporation would then receive a credit in their CDA account for $1,000,000. This means your beneficiaries would be able to liquidate assets and withdraw retained earnings up to the credit maximum of $1,000,000 tax-free.
They would then be left holding $1,500,000 of cash, which would help them to minimize the tax burden of liquidating and closing the company (if that’s the right move for them).
The Re-sale Value of Insurance
But say your plan is to sell your business before you retire, is there still a benefit to using a strategy like this? Absolutely.
We’ve already talked about how retained earnings in the corporation could be invested without affecting the small business deduction, and that’s good news because instead of money sitting dormant in the corporation, those dollars could be put to work growing while you’re building your business.
Then when it comes time to sell your business, you can add the cash values to the valuation of your sale price, not to mention the tax savings benefit the new owners will receive in their CDA credit.
This will add direct value to the sale price of your business and will also set you apart making the business much more appealing to purchase if it comes with the added perk of tax-free benefits for the new owners.
Hopefully you’ve learned something new about the benefits of utilizing insurance through a corporation to add value to your business.
It works for your beneficiaries through proper generational tax planning and also to future potential buyers if your ideal strategy is to sell your business.
If you’re curious to learn more about this tax planning strategy, reach out to your accountant or contact Lane to find out more.