It has been almost impossible to ignore the headlines and articles discussing the current Canadian government’s proposed tax reforms. These changes have far-reaching and unintended consequences for the very core of the Canadian economy; small business owners, which is why they are looking for tax reform solutions.
The current government is now quickly trying to dance and backtrack away from how their message was delivered, yet, they are determined to push their vision through. At the present time, they have completely backed away from the tax reform that would have restricted the conversion of income into capital gains. This will come as a great relief to farmers and other business owners trying to pass their businesses on to their children. They are not, however, out of the woods yet. Morneau has only promised to take a step back on this issue, for 1 years’ time, to reconsider this tax reform proposal.
The government has also clawed back their most controversial proposal related to passive income. They are now proposing taxing only passive earnings above and beyond $50,000 annually (the equivalent of a 5% return on $1 million invested). Even so, they still intend on ramming through the proposal aimed at income splitting.
As advisors and business owners alike, the question is: How can we help our business owner clients with long term planning solutions that will not be attacked by our very own government? Our answer is to use strategies and methods that the government has given multiple opinions, decisions, and precedence on in their CRA roundtable discussions.
One of these strategies, which has existed since the beginning of the century, is the use of life insurance. By its design, life insurance is one of the most tax efficient vehicles available. Accountants and financial experts have always insisted that business owners take as little out of their corporations as possible. The reason is to simply help defer the taxes on revenue earned in the business. This tax deferment can create a significant impact on an individual’s wealth over the long term. This ability to defer taxes is one of the reasons the government is attacking small business owners.
Life insurance not only provides business owners with this deferment opportunity, but it also provides tax free growth of a client’s money inside the policy itself. Additionally, it provides a 100% tax free benefit paid to the company on the passing away of the insured. The majority, if not all, of the benefit to the company is also able to flow tax free through the corporation’s Capital Dividend Account to the client’s family or intended beneficiary.
One of the reasons we consistently hear from accountants and business owners alike is that they do not want to use their excess dollars or working capital toward life insurance premiums if they can only expect a 4.5-5.5% long term rate of return. They would rather reinvest their money into the business, buy real estate, or other investments that can possibly generate a greater rate of return. These strategies are now being condemned by the government, however, a solution exists that can meet all of the client’s needs. Using certain insurance products and different carriers, we may be able to purchase life insurance for the client while still allowing them the use of their money back in the business. This concept is called an Immediate Financing Arrangement.
The general principle of the concept would allow a client to purchase a life insurance policy and receive some or potentially all of the premiums back immediately for use within the business or for investment purposes. The concept would involve assigning the life insurance policy, including its cash value and additional collateral (if required) to a bank. The bank could then lend some, or potentially all of the premiums back to the corporation. The cash values within the policy may grow large enough to have the policy fund itself in a short time frame (dependent on non-guaranteed dividend performance). Notably, this type of strategy usually entails premiums of $50,000 or more per year.
A potential advantage of this strategy could allow the corporation to buy a life insurance policy without tying up other liquid assets. Additionally, it could allow the interest on the loan as well as the life insurance premium or Net Cost of Pure Insurance (whichever is less) to be deductible. This could result in further tax savings for the corporation and reduce the net cost of borrowing involved with purchasing the policy. Other advantages include the ability to loan up to 90 or even 100% of the Cash Surrender Value (CSV) of the policy, as opposed to, between 50 and 75% of real estate. As well, the CSV is capital guaranteed in certain products.
Ultimately, we believe that life insurance will be used more prevalently in the corporate setting due to its inherent tax advantages and due to the upcoming tax reforms.
David LeNeveu, CIM, CEA
Founding Partner, Rockwood Wealth Management
The above is a simplified summary of the described concept of tax reform solutions. For complete tax rules, estate planning, risks and lending practices, please consult the appropriate tax, legal, accounting and lending specialists.
It is recommended that the appropriate tax, legal, lending and estate specialists be consulted before, during, and after implementing any planning scenario. Adverse tax consequences may occur if the proper steps and due cation aren’t exercised. It is recommended that any plan be monitored on a consistent and ongoing basis. Tax and lending practices are not guaranteed and are subject to change.
The above described are dependent on the performance of non-guaranteed features of life insurance policies. Please refer to a complete and individualized policy illustration for client specific details, risks and possible alternate scenarios.