Your client owns a successful business – and its value continues to grow. The downside? Personal capital gains taxes at death will be substantial. Your client needs life insurance protection to help cover the tax liability and ensure the business continues to thrive.
While term insurance offers highly affordable protection, the protection isn’t permanent and expires when the term ends. That’s why many business owners choose a corporate-owned permanent whole life or universal life insurance solution to help ensure that estate tax liabilities are provided-for.
Cash value life insurance – is it needed?
One of the additional benefits of permanent life insurance – aside from guaranteed protection for life – is the tax-preferred asset growth within the policy as premiums are paid. The increasing cash value of these policies over time can bolster a company’s balance sheet – and preserve and improve liquidity for the business.
But what if a business doesn’t want or need additional liquidity over time. Or the business wants to minimize company assets with cash value for other tax reasons?
That’s where a minimally-funded universal life (UL) insurance policy, or a Term to 100 (T-100) policy, can play a critical role.
Minimizing the cash value of permanent life insurance
It’s true – permanent life insurance with little or no cash value can provide the permanent insurance protection a business owner needs at a lower premium cost than a cash value policy. But why would a business owner choose not to benefit from tax-preferred asset growth within a permanent insurance policy?
It could be for a couple of reasons:
- The business has other assets that it can use if a liquidity need arises – and the business owner would rather put the additional funds that could have funded a cash value policy to a different use.
- The business owner has other tax reasons for minimizing assets with cash value within the corporation at death. Specifically, they want to ensure that their corporation’s shares remain qualified small business corporation shares (QSBCS) and eligible for the lifetime capital gains tax exemption.
The QSBC test explained
The test for QSBC shares has many elements, but a key one is that at the time the business owner sells their shares or dies, substantially all (90% or more) of the fair market value of a company’s assets must be used in carrying on an active Canadian business.1
The issue is that life insurance is a passive asset, and the fair market value of the policy would be included in this 90% test. If the business owner is the person insured, the fair market value of the policy immediately prior to the business owner’s death is deemed to be its cash surrender value (CSV). If this CSV is too high, this could put the corporation’s shares offside the QSBC requirements.
Cash value life insurance may also increase the overall tax liability at death. When a shareholder dies, their corporate shares are deemed to be sold the day before death at their current market value. The overall value of a corporation’s shares (including the cash value of life insurance) is compared to the adjusted cost base of the shares, and previously unrecognized gains and losses (such as the growth in the cash value of the policy) would thereby be recognized for tax purposes.
For these reasons, a corporation may prefer a permanent life insurance policy, such as Term to 100, or minimally-funded Universal Life policy with little or no CSV. This provides the permanent insurance protection they need without impacting the qualification for QSBC shares.
The holding company option
Another strategy for permanent life insurance – with or without a cash value – is having it held in a holding company rather than the operating company.
To avoid the QSBC passive asset issue associated with holding cash value life insurance in an operating company, corporate-owned permanent life insurance policies are often held in a holding company, typically set up for creditor protection or some other planning purpose.
This not only avoids causing issues related to QSBC status, it also avoids the need to transfer the policy if the operating company is sold in the future.
Rethink the cash value story
When discussing permanent insurance options with your corporate clients, assess whether a no cash value option is worth considering. A few questions about the business’ need for liquidity and its QSBC status is all it takes.
While permanent cash value life insurance will continue to provide exceptional benefits to many business clients, the potential need for no or low cash value life insurance is always worth considering.