Using Life Insurance To Extract Corporate Funds Tax-Free

For a shareholder of a private corporation, the transfer of a personally owned life insurance policy to the corporation can offer a way to extract value from the corporation without triggering immediate taxation. The strategy works best if the policy has, relative to its face value, a high fair market value (FMV) and a low cash surrender value (CSV)--the amount that the life insurance company will pay if the policy is cancelled.

A high FMV is important because it determines the maximum amount that the corporation can pay for the policy without creating a taxable benefit. This might occur, for example, if the person whose life is insured has a reduced life expectancy (perhaps due to high blood pressure or a heart condition) relative to what is normal for his or her age. In the extreme, the FMV could approach the policy's face value (its death benefit) if the insured person has a terminal illness or has been critically injured and is not expected to recover (Interpretation Bulletin IT-416R3, "Valuation of Shares of a Corporation Receiving Life Insurance Proceeds on Death of a Shareholder," July 10, 1987). A lower but still substantial FMV could exist if the insured person is elderly and has had the policy for many years. In either case, an actuary would have to determine the policy's FMV.

A low CSV is important because on a non-arm's-length transfer (as in this case) the policyholder will be taxed on the amount, if any, by which the CSV exceeds the adjusted cost base (ACB) of the policy (see subsections 148(7) and 148(9)). Thus, term policies (including term-to-100 policies) are particularly suitable for this planning technique, since they have no CSV.

Consider, for example, an individual (Mr. A) who is the sole owner of a private corporation (A Co). Mr. A is 65 years old and has recently been diagnosed with some health probleMs. Mr. A had purchased a $1 million life insurance policy at age 40, when he was in good health. At the time the policy was purchased, its FMV would have been nominal; because of the change in Mr. A's health, it is worth $500,000 now. In this situation, Mr. A can have A Co purchase the life insurance policy for $500,000, thus extracting that amount from the corporation on a tax-free basis (provided that the policy's CSV does not exceed its ACB).

An additional benefit of corporate ownership is that the policy premiums, although they are generally not tax-deductible, can be paid out of corporate funds, which are taxed at a lower rate than income earned by Mr. A.

The CRA is aware of this type of planning and has indicated that such transactions may not be consistent with the intention of the legislation (see, for example, CRA document nos. 2002-0127455, 2003-0040145, and 2008-0303971E5). However, there have been no further indications that this planning is considered abusive or otherwise problematic.

The immediate tax benefits should be weighed against a number of other factors:

• the loss of creditor protection that would generally otherwise exist with personal ownership;
• the difficulty of removing the policy or its proceeds from the corporation in the future (one reason being that the policy will have a low ACB--the amount of the CSV); and
• the potential loss of the capital gains exemption in cases where owning the policy could cause the corporation to fail the 50 percent or 90 percent active business asset test.

Nathan Wright
Cadesky and Associates LLP
nwright@cadesky.com