Split-Dollar Critical Illness (Or Shared Ownership CI Strategy): A Cautionary Tale!
I was recently parachuted into a case where three shareholders/partners were contemplating a “Split Dollar CI” using a 15-pay permanent plan with a return of premium on cancellation/surrender in yr. 15(ROP15 or in yr 15). The reliance on the product illustration to determine the proper premium split between corporation and shareholder left me somewhat concerned and motivated me to write this article. For those of you who are familiar with the CI product landscape, you are probably aware that in this case, the cost with respect to the ROP15 rider is relatively small in comparison to the overall premium. This is in contrast to the other types of plan designs such as “Life pay” or “Level to 75”. Adding a ROPC/E on cancellation/expiry to those structures usually results in a split being more reasonable, but still a far cry from what CRA would deem reasonable. Allocating the cost according to the illustration can set one up for a potential tax-ticking time bomb. The purpose of this article is to throw a cautionary note on the Split Dollar CI sales concept and provide a road map on how to best minimize a potential tax problem in the future.
What is Split Dollar CI?
Split-Dollar CI is an insurance concept where a private corporation and a shareholder/key employee agree to jointly purchase a critical illness policy with a ROPC/E rider (cancellation or surrender/expiry) which insures the shareholder/key employee. The company will pay for a portion of the premium for the insurance benefit, and you (shareholder/key employee) will pay for the remaining portion for the ROPC/E benefit. Under the Split-Dollar CI arrangement, although both the company and you own the policy jointly, the benefit is not shared. Either your company will receive a benefit (CI payout) or you (ROP payout).
Why Split Dollar CI?
As with death, a sudden, and prolonged illness of a key shareholder/employee can have a significant and lasting negative impact on the future success of the business. During that time, creditors may hold back new loans, or worst yet demand repayment of existing loans, debtors may delay payments, and employees and customers may lose confidence. In the absence of proper planning, the very survival of the business is a stake. A solution is for the business to purchase critical illness insurance on the life of the key employee. If you experience a ‘covered critical illness’ and survive the waiting period the corporation receives the proceeds which can provide the business with the much-needed working capital to meet the immediate cash needs and to supply a source of funds for finding, attracting, hiring, and training a replacement for the key person. Proceeds may serve to temporarily replace loss profits as a result of the illness, until the business is able to recover or a plan for succession has been initiated. The downside, assuming that you’ve set up a Split Dollar CI, is that you as an employee or shareholder receive NOTHING for the ROPC/E premium paid. However, if you remain HEALTHY and the policy is eligible for cancellation, you can decide to cancel the policy. Upon cancellation or expiry, you (the shareholder/employee) will receive all the premiums paid by both you and your corporation. Most of the time these concepts are positioned as a way to extract money from the corporation tax-free (often exaggerated). In fact, if the ROPC/E is paid, there may be tax consequences to you. Let’s explore.
Taxation and Critical Illness:
Before we jump into potential tax consequences to the ROPC/E owner let me provide some background concerning Taxation and CI. Although the Income Tax Act provides a comprehensive set of rules as it pertains to the taxing of holders of life insurance policies, it does not contain any specific rules for the taxation of other types of insurance policies. Therefore, we’re left with some uncertainty when it comes to the taxation of accident and sickness insurance, specifically critical illness insurance in this case. For this reason, we need to rely on the provincial legislation which defines the various forms of insurance, case law, and Canada Revenue Agency (CRA) technical interpretations for guidance.
What we do know so far:
Premium paid for CI coverage and the premiums paid for the ROPC/E or ROPD values are not tax deductible.
Where the policyholder is a corporation, the CI benefit will be received tax-free. However, this amount will not be credited to the capital dividend account. If payments are to be made to the shareholder/employee, they can only be payable as a taxable dividend, salary, or bonus.
If a corporation sets up a Grouped CI (2 or more individual CI plans) as a common plan to qualify as a group sickness and accident insurance program (GSAIP). In these circumstances, part or all of the premiums paid by the corporation may be deductible as a cost of doing business and the premium payment will be a taxable benefit to the covered employee. Should the employee suffer a critical illness, the benefit payable under the plan will be paid tax-free to the employee. If a ROPC/E or ROPD is added to the plan, CRA has commented that this will result in the arrangement no longer qualifying as a GSAIP.
CRA has confirmed that in Quebec, it is the primary (non-accessory) coverage, which determines the characterization of the policy. In other words, it’s treated as a CI policy. However, CRA suggested that in common law jurisdictions, where CI policy includes a ROPD (on death), they’re not entirely clear whether life insurance tax laws (section 148) apply. Worst case, such a scenario can create taxable disposition. CALU has gone back to CRA and requested more clarity. If CRA’s interpretation holds firm, the insurance industry can be expected to strongly oppose this. To what end, your guess is as good as mine. The good news is that including ROPC/E will not “in and of itself” recharacterize the CI policy as a life insurance contract.
If the ownership of the critical illness insurance coverage is transferred to the shareholder/employee, from the corporation, the fair market value of the benefit may be a taxable shareholder or employee benefit.
Where the owner (and payee) of the ROPC/E value is different from the corporation, a taxable shareholder/employee benefit may arise from the payment of any ROPC/E or ROPD value.
Is there a taxable benefit to the shareholder/employee (ROPC/E owner)?
The simple answer is MAYBE. Sorry, but that is truly the extent of the issue at hand here. Unfortunately, in the absence of an actual Income Tax Act pertaining to critical illness insurance, we only have case law, and CRA technical interpretation to rely on for guidance. This doesn’t absolve us from carrying out our due diligence but simply requires more care. If an employee or shareholder pays less than a reasonable amount for the ROPC/E, CRA has indicated that a taxable benefit could arise. Given the contingent nature of the ROP benefit (any such benefit will be reduced to the extent critical illness benefits have been paid to the corporation), it might be argued that the assessment of a taxable benefit would only occur at the time the ROP benefit is actually paid.
So what is a “reasonable amount”? Let’s begin by dispelling the misconception that the illustration provided by an insurer provides us with a reasonable split. IT DOESN’T! Some plan designs are closer to being considered “reasonable” than others (ie. Level 75 with ROPC/E vs Permanent 15pay ROPC15) but should still undergo analysis to be more certain. This is definitely worth it if you’re trying to avoid the potential tax consequences that come about due to an “unreasonable split”. The good news is that some carriers have tools available to assess what a “reasonable split” should look like.
CRA has been asked to comment on the taxable benefit issue on several occasions and has made the following general statements where the ROP benefit is owned by a shareholder. This should provide some “rules of thumb”:
Where the corporation has been “impoverished” as a result of the arrangement, the payment by the corporation of the CI premium will constitute a shareholder benefit. The term ‘’impoverishment” shows up often in the tax guide and simply looks to determine if one party (the corporation) has conferred a benefit on the other party (the shareholder/employee) by paying “too much” and thereby “impoverishing” itself, for the benefits to which it is entitled.
The value of the shareholder benefit could be determined based on what the shareholder would have to pay to an arm’s length person in similar circumstances to obtain the same benefit
The cost of the rider as determined by the insurer is not necessarily indicative of fair market value. Ac\
Even where the shareholder pays all the premiums for the ROP benefits, it continues to be a question of fact whether the ROP benefit when paid is taxable to the recipient.
So, there you have it! A little clearer but far from crystal clear. Here is an approach most professional tax advisors are comfortable with which is also supported by the various tools that some carriers have made available to us. To minimize the issue of corporate impoverishment which could result in the CRA determining that there is or would be a taxable benefit for the shareholder or key employee on payment of the health benefit, the corporation should pay the portion of the premiums related to the cost of the critical illness and death coverages only. Also, they should only pay for the coverage period needed by the corporation (ie 10yrs, 15yrs, 20yrs, etc). The corporation’s portion of the total premiums paid must correspond to what it would pay for an equivalent term policy for the same coverage period.
The shareholder or key employee pays the portion of the premiums related to the health benefits coverage, plus any portion of the critical illness and death coverages extending beyond the coverage period needed by the corporation.
To illustrate this point, I’ll also refer back to the case that motivated me to write this article in the first place:
Male 50 n/s (1 of 3 shareholders contemplating Split Dollar CI)
Product design: Permanent Pay for 15 years with ROP with early surrender option rider (Yr 15)
Split based on product illustration:
CI benefit premium: $42,260
ROP rider premium $5,150
Policy fee $75
Total premium $47,485
Split based on Split-dollar illustration (from the carrier):
Benefit Owner and Beneficiary
CI benefit corporation
ROPC benefit shareholder/employee
If we’re assuming that the corporation requires coverage for 20 yrs only (therefore applying a term 20 pricing to the original coverage amount), the recommended “reasonable” split is as follows:
The portion paid by Corp (CI benefit) $16,496
The portion paid by Shareholder/Employee (ROP15) $30,989
Total premium $47,485
If we approached the split based on the numbers provided in the product illustration, the shareholder/employee would be advised to pay only $5,150/yr. Assuming they remained healthy and canceled (or surrendered) the policy in yr 15, they would expect to receive $712,275 tax-free, personally. Not bad for a mere, $77,250 commitment ($5,150 X 15). Instead, if we put our compliant hat on and viewed this through the lens of CRA, more than likely, they will come back and reassess this transaction by imposing a shareholder benefit (section 15.1) of $387,585 (the difference between what CRA thinks the shareholder should have paid ($30,989/yr X 15 = $464,835) and what they actually paid ($5,150/yr X $77,250)).
Unfortunately, the basis of the split (as per the carrier split dollar illustration) is only one approach (although a strong one) that may or may not resolve the issue. It is always recommended to seek the advice of a professional tax advisor. The client’s tax advisor will consult on the appropriateness of the split on how to administer and facilitate the split in payment. Our job is to provide them with the tools to make an informed decision.
Tony Gallippi, B.A.S (Hons.) CFP CLU
Advanced Case Consultant
This communication reflects the views of Qualified Financial Services Inc. as of the date published. The information in this publication is for general information purposes only and is not to be construed as providing individual legal, tax, financial or other professional advice. Qualified Financial Services Inc. assumes no responsibility for any errors or omissions in the information contained herein nor for any reliance placed on such information. Please seek independent professional advice before making any decisions.