At BeaconPoint ...

We focus on Retirement Income Planning and offer insurance, and investment strategies to individuals, businesses, and families at all states of life.

Using Corporate Owned Life Insurance to Reduce Passive Income Taxation

Executive Summary

Effective January 2019, new tax rules will come into effect that will have a dramatic impact on some small business owners. Starting in 2019, the Small Business Deduction Limit will be reduced by $5 for each $1 of passive income that exceeds $50,000 and will reach zero once $150,000 of passive income is earned in a year. This new tax rule may be leaving business owners wondering how they can redirect a portion of excess cash flow that would traditionally produce passive income, and subsequently some unfavorable tax consequences.

Corporate owned life insurance can offer a “two bird one stone” solution to business owners. If used appropriately, strategies such as these are a viable option for a private corporation with a substantial amount of excess income and a life insurance need. The information below provides an elementary overview of how life insurance can be used to defer tax and grow the corporation’s estate.

What You Need to Know

Who is This Strategy Suitable For?

A corporate owned asset transfer plan would be best suited to someone who is a shareholder of a CPCC that has a life insurance need, as well as significant assets in taxable investments and is looking for a way to reduce the tax on passive income earned on surplus cash in the corporation.

How Does This Strategy Work?

  • Purchase a participating whole life or universal life policy.
  • Pay the premiums with the corporation’s excess cash flow or by transferring assets from the corporation’s investment portfolio.
  • Cash value accumulates on a tax preferred basis.
  • If access to the cash is needed, it can be made available through a policy withdrawal, policy loan, or assigning the policy as collateral to a lending institution.
  • Upon death, the death benefit of the policy is paid tax free into the corporation.
  • Amount of death benefit in excess the ACB can be paid out as a tax-free dividend from the CDA.

Why Does This Strategy Work?

This strategy works because it addresses a CPPC’s life insurance need as a well as offering a legitimate way to reduce tax on passive income within a corporation’s investment holdings.

Investment earnings such as interest, dividends, or capital gains are taxed on a yearly basis. This yearly taxation can slow the accumulation of assets in a company over time. Also, with the new tax laws coming into effect in 2019, passive income can have a greater effect on a CPCC’s taxation than ever before. Having passive income exceeding $50,000 will reduce the small business deduction on a straight-line basis.

These changes are providing even more incentive to find alternative investment strategies in order to reduce the amount of passive income in a corporation. If properly executed, this strategy also addresses business owners concerns with regards to liquidity. While this strategy first and foremost focuses on building estate value, there are options available to access the accumulated cash value of the life insurance policy in the form of policy loans, withdrawals, or collateral loans.

Considerations

Correctly implementing this approach takes careful planning and consideration in order to avoid unintended tax consequences that could render this strategy unsuitable.

  1. When using life insurance in the way mentioned above, it is assumed that the shareholders of the corporation are taking a long-term planning approach. If the policy was surrendered prior to death there could be significant tax consequences in the form of a taxable gain.
  2. Accessing the cash value of a life insurance policy may not be the most efficient way to access funds in your corporation. There could be tax consequences for taking a policy loan, withdrawal, or surrender.
  3. How the premiums are paid depends on each entity’s unique situation, however transferring funds from investments such as stocks or mutual funds to pay the life insurance premium may trigger capital gains. It is important to work with a team of professionals to ensure that this is done in the most tax efficient manner possible.
  4. In order to qualify for a life insurance policy, the insured must be in reasonably good health.
  5. It would not be prudent to tie up any cash that may be needed in the short term for business operations. This strategy offers long-term, tax efficient solution for surplus cash.

The Bottom Line

Correctly implementing corporate asset transfer plans, such as the one outlined above, is a complex tax planning strategy. Business owners should work with their team of tax professionals to determine if they have the available capital to fund a long-term plan such as this. Your advisor can help guide you in how quickly and what portion of your corporate taxable surplus should be transferred into a policy, depending on your specific goals and timelines. It is important to remember, with plans such as these, that you are first and foremost purchasing a life insurance policy and then subsequently taking advantage of the tax benefits available to you.