Part 1: How Did We Get Here?
Many of us have recommended the benefits of permanent life insurance to our business owner clients as an effective planning tool that can address a multiple of key objectives, such as: minimizing corporate tax during the accumulation phase, minimizing tax at death through the capital dividend account, and finally, preserving and improving liquidity for the business. This popularity did not happen overnight though!
Due to the steady growth of surplus capital (or passive assets) building up in small business corporations across Canada over the last 15-20 years, the popularity of corporate life insurance solutions has taken hold. This build up of surplus capital is mainly due to the steady decline in corporate tax rates, relative to personal tax rates, which has created significant tax deferral opportunities for business owners. This environment has encouraged many business owners to amass wealth within their corporate structures as opposed to paying themselves personally and having less money to invest. To illustrate this point further, let’s look at the situation in the province of Ontario. A business owner in Ontario can defer up to 41% in taxed. The difference between the highest marginal tax rate for individuals of 53.53% and the corporate tax rate on the first $500K of active business income of 12.2%. Said differently, for every $100 the business generates in income, it can defer up to $41 in taxes. The more you’re able to defer, the longer you’re able to defer for, the larger the bucket of money you’ll be able to create for you and/or the next generation. A significant incentive for business owners to stockpile passive assets within their corporations, especially when that money is not required to support their current personal lifestyle goals. This story plays out in all provinces across Canada with slight variations.
The next challenge then becomes how to minimize the corporate taxes on the passive income (earnings) that this surplus capital generates, which in Ontario is currently at 50.17%. Permanent life insurance provides an opportunity to transfer existing taxable surplus to non-taxable surplus.
Now let’s fast forward some years into the future when the policy has started to build up significant cash values, tax deferred and the business owner client would like to access funds to supplement their lifestyle goals (maybe for retirement). Accessing cash values is not limited to this need only but can also be used for any purpose: i.e., source of cash for emergencies, to fund new business opportunities or to pay for operational expenses to mention a few. Although, the policyholder has a contractual right to approach the insurance company and request a policy loan or to simply request a partial surrender of the policy, neither of these options are ideal from a tax perspective. In general, the most tax efficient option is usually the collateral loan option. The cash value is used as collateral for a loan from a third-party lender, usually in the form of a line of credit that can provide a source of supplemental tax-free funds for the borrower. The next issue that needs to be addressed is, who will do the borrowing? Will it be the corporation or the shareholder?
As advisors, we’re given the tools via the carrier software to do comparisons between the insurance solution and the alternative/traditional investment from both an after-tax cash flow perspective and net after-tax estate values. Within the insurance solutions, we’re also able to select between either corporate borrowing or personal borrowing. Although, the amount the bank is willing to loan is identical, regardless who’s doing the borrowing. It doesn’t take long to realize that the personal borrowing option produces the best after-tax cash flow to the shareholder. The reason is simple: The difference lies in the additional layer of taxation created in the corporate borrowing option due to the funds being paid to the shareholder as a taxable dividend. The personal borrowing scenario doesn’t need to go through this additional step; therefore, the entire amount is tax free. So, case closed, personal borrowing wins? Not so fast! We owe to our clients to disclose all the facts. In the next segment, we’ll take a deeper dive and consider the other factors that need to be considered before making an informed decision on which option is best.
Stay tuned for Part 2, where we’ll look at the six crucial factors that must be considered!