Part 2: Six Factors to Consider
In this segment, we will move beyond simply looking at the option that produces the highest after-tax income/cash flow as being the best and take a deeper dive and explore some of the other factors that need to be considered before making an informed decision.
For starters, how about considering the availability to deduct the interest cost on the loan. Interest on loans is deductible if borrowed funds are used to generate income from business or property or to pay a corporate dividend. In the personal borrowing scenario, interest deductibility is only available if funds are used for investments/business purposes and not to supplement personal income. In contrast, interest deductibility can be available in a corporate borrowing scenario, even if funds are used to pay a dividend to a shareholder, regardless how the funds are eventually used (lifestyle or investments). Assuming the scenario where funds are needed for personal lifestyle goals, the corporate borrowing with payment of dividend to shareholder with interest deductibility will likely produce the same after-tax income as the personal borrowing scenario. The question then becomes, can the corporation take advantage of the interest deduction? Will the corporation generate taxable income from other investments/business to use the deduction against?
Probably one of the most understated components between the two options is the issue regarding the guarantor fee. In a personal borrowing scenario, to head off any tax challenges from CRA on the benefit the shareholder derives from using a corporate asset (life insurance policy), a guarantor fee needs to be established. This additional fee is paid to the corporation to compensate it for the risk assumed when pledging the assets for a shareholder personal loan. If the cost is treated as a shareholder benefit rather than being actually paid to the corporation, the cost would be the tax charge on the guarantor fee benefit. If the guarantor fees are paid by the shareholder to the corporation, there would also be an impact on the share values as those funds accumulate in the company. There are different schools of thought on what value to give this guarantor fee (1% or 2% of the outstanding loan, etc.). Regardless of what it is, it’s a necessary requirement that needs to be addressed and will eventually erode the initial advantages that the personal borrowing had in producing a higher after-tax income.
Another area that is often glossed over when discussing the personal borrowing strategy, is what needs to happen when the loan is repaid at death. Corporate borrowing is much simpler to settle, as the loan outstanding is settled directly via the life insurance proceeds. If personal borrowing is used, the borrower/estate must ensure that the repayment comes from personal funds rather than corporate funds or arrange an alternative collateral to the bank in exchange for the corporate life insurance policy. Ignoring this crucial step will result in the entire loan balance being assessed as a taxable shareholder benefit. As you can imagine, when it comes to repaying the loan, personal borrowing does require more thought, planning, and coordination.
Rarely discussed, is the impact that either scenario will have on the valuation of the shares of the corporation. In a corporate borrowing scenario, the loan balance will reduce value of the shares whereas for personal borrowing, it will not. The financial impact on the share valuation would be the marginal tax rate on the taxable capital gains percentage (50%) multiplied by the outstanding loan balance at death (or second death in JLTD scenarios). This disadvantage between the two borrowing options can be avoided if the shareholder pays off any personal loan prior to death with other funds.
Last, but not least, is the issue regarding the capital dividend account (CDA). In the personal borrowing scenario, the CDA is often used to get funds to the shareholder’s estate to repay the loan. In corporate borrowing scenarios, the CDA is not utilized when the loan is repaid. This creates more excess CDA in the corporate borrowing option which can be used to flow other funds currently available out of the company tax free or flow future profits out tax free if the company remains operational and profitable. If we take this example where we assume an excess CDA balance of $1 million with a non-eligible dividend tax rate of 47%, this results in a potential tax savings of $470,000. This should not be overlooked!
All and all, there are six factors that need to be addressed before deciding which of the two borrowing options is best. At the end of the day, it comes down to whether the shareholder wants a higher after-tax cashflow during their lifetime or to leave a larger net after-tax estate value for their beneficiaries. If you factor in the availability to deduct interest cost in the corporate scenario and the impact guarantor fees have on cash flow produced in the personal borrowing scenario, the scales start to tilt in favour of corporate borrowing strategy, as the client can achieve both objectives. The great part of all this, is that the decision doesn’t have to be made today. Nonetheless, an informed client/accountant/lawyer, goes a long way in establishing your credibility and solidifies your role as a trusted advisor.
To reach me:
Tony Gallippi CFP CLU
Advanced Case Consultant