We have explained the importance of ensuring you have adequate life insurance for personal reasons. However, insurance can also play a crucial role in the financial stability and longevity of a business. For business owners, their business often makes up a majority portion of their net worth. It is important that those assets are adequately looked after.
There are many types of insurance products that a corporation could own; disability insurance, business overhead insurance, etc. As the title suggests, corporations can also own life insurance, which is the focus of this piece.
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Key Person Insurance
The first point we want to touch on is the protection of a key person inside the corporation. For a lot of businesses, their continued success can be attributed in large part to one of a few key people. If it were not for that key individual, the business would take a large hit.
Although life insurance cannot protect the person, it can protect the business in some regard if that person were to pass away. Upon the key person’s passing, the life insurance death benefit would be paid to the corporation. The corporation could then use those funds to replace the key individual.
Life insurance would only payout if the insured individual were to pass away. Other types of insurance, critical illness or disability insurance, could be used in much the same way.
When life insurance death benefits are paid to a corporation it also creates a CDA credit, which leads to our next point.
Creating a CDA
Capital Dividend Account (CDA), is a notional corporate tax account. It gives shareholders the ability to receive capital dividends, tax-free. It is technically a return of the shareholder’s capital. Whereas, when a regular dividend is elected it comes from the corporation’s retained earnings and is taxable to the shareholder.
It is important to remember that the presence of a CDA credit does not necessarily mean there is cash available inside the corp to utilize the credit.
There are three ways that a CDA can be created. The first is the realization of a capital gain inside the corporation. A capital gain is the difference between the adjusted cost base and the fair market value. The capital gain is subject to a 50% inclusion rate. This means that if you bought something for $100,000 and later sell it for $250,000, you have a $150,000 capital gain. Of that, $75,000 is taxable at your marginal tax rate. The remaining $75,000 that was not taxable creates a CDA credit.
The second way to create a CDA credit is through a life insurance death benefit. The size of the credit is equal to the death benefit paid minus the adjusted cost basis of the life insurance policy. Generally, the life insurance policy will have an ACB of $0 or close to that. For that reason, most people just say that the CDA credit is equal to the death benefit.
The third and final way to create a CDA is via transfer from related companies. This just means that companies related to one another can transfer CDA credits between them.
This is probably one of the most important reasons to own life insurance that is often overlooked, especially in small or family businesses. As we mentioned earlier, the success of a business can be largely dependant on one person or a small group of people.
In many businesses that key individual is also a shareholder of the corporation. If that individual passes away, not only with the business have to fill that position, they will likely have to deal with those outstanding shares. Those shares likely make up a large portion of the deceased’s estate. The estate will likely want the fair value of those shares. The business will likely want to retain control and not have the shares go to the estate.
This is where life insurance comes in. There are many ways that a buy-sell agreement can be structured. One such way is for the corporation to own life insurance on all shareholders who will be involved in the agreement.
The shareholder is the life insured. The corporation is the policyholder and beneficiary. Upon the passing of the shareholder, the death benefit is paid to the corporation. The corporation would then use those funds to purchase the shares from the deceased’s estate.
You will remember from earlier, that the death benefit also creates a CDA for the corporation. However, the proceeds from the death benefit are earmarked for the purchase of the shares. Once the shares have been bought back, if there is other cash available in the corp, the shareholders could elect to have the CDA paid out.
Often times with business owners, and specifically family businesses, not all of the heirs want to be involved in the business. However, parents generally want to ensure that their kids are treated fairly.
This can be accomplished using life insurance. A lot of businesses aren’t sitting on hoards of cash that can be given to the heir who doesn’t want to be involved in the business, even if the business is worth millions. However, the corporation can purchase insurance on the shareholder’s life, designating the shareholder’s estate as the beneficiary. The shareholder’s will and estate documents should then clearly outline that the death benefit is entitled to the heir(s) not active in the business.
Cheaper Carrying Costs
On top of everything else, the carrying cost of owning insurance inside a corporation is generally more efficient than owning it personally. This is because of the difference in tax rates that corporations and individuals are subject to.
Corporations are subject to much lower tax rates than individuals. In order for the individual to have enough cash net of taxes to pay the same premium, the corporation will have to pay out a large pre-tax amount.
Insurance inside a corporation can serve many purposes and can be vital to long-term business success. It can protect your business in the event a key person passes away. It can help to get tax-free money out of the corporation. Furthermore, it can also play a vital role in buy/sell agreements and succession planning. Lastly, it can also be held in a more efficient manner. Sit down and talk with your insurance advisor to ensure you have adequate insurance. Don’t have an insurance advisor, contact us.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy