I frequently get the opportunity to work on cases that involve clients who’ve amassed a great deal of financial wealth in their lifetime. When I refer to the word’s, “wealth” or “wealthy”, I use it in reference to the client’s very own unique financial situation and not in relation to others. In other words, they’ve amassed more wealth than they’ll ever need to support themselves and their families during their lifetime. Said differently, they’ll never outlive their wealth! These clients have very similar concerns. They want to ensure that their wealth is preserved and distributed in the most tax-efficient manner. A common problem is that a growing asset portfolio is usually synonymous with a growing tax liability. As advisors, we understand the role permanent life insurance can play in addressing this tax liability in the most cost-effective manner. Life insurance proceeds can help families avoid borrowing or liquidating assets (assuming these are even options) from business operations at a critical time. Life insurance can produce the same result at a fraction of the price with less risk than other options. The challenge becomes how to communicate this message more effectively to improve client uptake. In this article, I’ll share with you some of those best practices: “Pennies on the Dollar”, “Pre-tax Equivalent Yield”, “Net Internal Rate of Return to the Estate”, and “Net Estate Values”. Metrics that often make sense to your clients and to their accountants as well.
Before we jump into the case study, let’s review ways to “disturb and motivate” our client by asking the right questions. If we hope to do the best job for our business owner clients, it’s crucial that we take the time to uncover their desires, concerns, and their needs. Here’s a sample list:
How confident are you that your estate will pass to your family in the most tax-efficient method possible?
Are you aware of the impact that taxes (capital gains) will have on your ability to transfer your business or (investment/real estate portfolio) intact to the next generation?
Are you looking for ways to minimize the impact that taxes have on your ability to transfer your wealth/business intact to your kids?
How important is it for you to ensure your family’s assets and wealth are transferred to the next generation in the most tax-efficient manner?
Do you know the amount of taxes that will be owed when your estate is transferred to your family and what is the Net Value of your Estate at that time?
Have you completed (or are you nearing completion of) the asset accumulation phase of your life?
In the event of your death, what would you wish to happen to your financial interest in the corporation?”
Do you have significant assets that would be taxed at death (e.g. the family cottage, shares in business, investment real estate property)?
Do you want to minimize personal income taxes on your estate?
Has anyone explained the tax impact of passing on the property depending on when or how it’s done?
Do you want to preserve the value of these assets for your heirs?
Are you looking for the most cost-effective way of preserving the value of your estate?
Do you qualify for life insurance?
Are you aware the impact that capital gains tax has on your estate?
A lack of proper planning could mean that your family cottage/business won’t stay in your family. Your estate may need to sell it to pay for the tax. How do you feel about that?
Now for the case study
A married couple, who are both in their late 60s. They’ve been very successful in accumulating a real-estate portfolio (both commercial and residential) worth over $60 million held in a number of corporate structures (we’re not going to get into this today). They don’t plan on flipping them during their lifetime but plan on gifting them intact to their kids at death. Although the offer was made, we didn’t undergo the process of calculating their current and projected tax liability. They felt fairly confident that it’s a least in the $10 million range. They currently have over $15 million in liquid investable assets (most GICs and other fixed-income investments) that are available to address the pending tax liability. The question then becomes,…is this the most efficient use of their corporate dollars?
Sample Script (Real Estate Wealth/Shares in family business)
You’ve been very successful in amassing a significant real estate portfolio over the course of your lifetime. One of the challenges you’ll experience is transferring those assets , intact to your kids. The increasing value of real estate properties will mean a growing tax liability. At death, 50% of the increase in the value of the property will be taxed. Unlike your principal residence which is exempt from tax on the increase in its value, your real estate properties (ie rental properties) could trigger a significant capital gains tax if transferred to your kids. This may possibly force the liquidation of some of your hard-earned real estate assets that were earmarked for your family to pay for the tax. The question becomes, how do you want to pay for this?
In the above script, you can substitute the “real-estate portfolio” asset for “shares in a family business.”
Moving along, we ran some numbers by redirecting (or re-purposing) some their liquid investable assets into a permanent life insurance plan so we can begin to demonstrate the advantages of using corporately held permanent life insurance. The amount we chose to work with was 20% of their existing investment portfolio ($3 Mill., spread over 10 yrs: $300K/yr). We showcased two options:
Option#1: Corporately-held traditional investment portfolio earning 5%
Option#2: Corporate-owned Permanent Life insurance (JTLD Par WL with maximum Deposit option)
Sample script to summarize the above chart:
Although you can use some of the funds currently available with your corporation to address this concern, it’s generally not considered the most cost-effective option. In fact, by age 85, for every net estate dollar needed to pay the tax bill, you’ll need to invest $1.15 ($3Mill/$2.6Mill). Life Insurance does the same with only 56 cents ($3Mill/$5.4Mill). Said differently, your existing portfolio within your corporation will need to earn an annual before-tax rate of return of *13.98% to generate the same net estate value produced by life insurance. All this, while at the same time allowing you to grow funds within the policy tax efficiently, with the ability to access funds during your lifetime, if needed.
Taking it a step further we provided some additional data that highlights the differences prior to age 85 as well as including two additional facts: (a) the market value of the corporate investment portfolio and (b) the cash value component of the life insurance plan. The purpose of this inclusion is to introduce the client to the multi-faceted aspect of permanent life, in its ability to maintain and preserve liquidity during one’s lifetime. This is sometimes referred to as the “borrowing capacity” (ie IFA, IRP).
Below you’ll see the “POST CLIENT MEETING EMAIL” summarizing our discussion (sent to client and accountant):
Further to our conversation yesterday, please see the presentation attached assuming life expectancy at age 85 (or yr 18). The purpose of this presentation is to highlight the advantages of using permanent life insurance, as an alternative to a traditional investment portfolio to address the eventual tax liability to your estate.
More about Slide #1 (as seen above):
Corporately Held Traditional investment vs. Corporate Held Permanent Whole life insurance:
Here’s where we attempt to compare the two options to determine which is more efficient or cost-effective. The assumption we’re making is that you deploy $300K/yr for 10 years of corporate funds either toward “permanent whole life insurance” or a “traditional investment portfolio earning 5%”. The initial amount deployed is not important, but rather the estate values it produces relative to one another. At the end of the 18 years (or age 85, assumed life expectancy), the investment nets out an after-tax estate value of approximately $2.6 Million. The same $300K/yr commitment for 10 years in a permanent life insurance plan produces an after-tax estate value of $5.4 Mill. A $3.5 Mill estate advantage. If we apply two other metrics 1) pennies on the dollar 2) internal rate of return, the same message rings through.
Pennies on the Dollar:
If we assume that we’ve invested $3 Mill of corporate money into a “traditional investment portfolio” which nets out an after-tax estate value of $2.6 Mill in 18 years this can be translated to our pennies on the dollar values noted in the slide (ie. $1.15/$1.00 or $3Mill/$2.6Mill). By deploying the same funds into a “permanent life insurance” alternative, you can conclude that it takes ‘less’ corporate dollars, only 56 cents for that matter, to create the same $1.00 net to the estate ($0.52/$1.00 or $3Mill/$5.4 Mill).
A much more efficient use of your corporate dollars or said differently, a much more cost-effective approach.
Internal Rate of Return (IRR):
This metric helps to highlight the relation between “money-in” and “money-out” from a rate of return perspective. In the “traditional investment” alternative, the $3Mill overall investment produces a net estate value of $2.6Mill in year 18, resulting in a rate of return (or IRR) of -1.13% net to the estate. The same funds deployed to the “permanent life insurance” option produced a net estate value of $6.1Mill resulting in a 4.44% return, net to the estate. A much better outcome.
You may argue that you can do better than a 5% rate of return on your corporate “tradition investment portfolio”. That’s fair! The question is can you do better than 13.98% (pre-tax)? This is what your portfolio needs to earn over a period of 18 yrs. to produce the same net estate values produced by the permanent life insurance alternative.
Corporate-owned life insurance and its competitive edge: WHY?
One of the MAIN REASONS permanent life insurance illustrates so well, is mostly due to its preferential tax treatment. Specifically in this case, because of the “capital dividend account” (CDA). A unique feature of life insurance is how a death benefit received by a private corporation credits its capital dividend account (CDA). Generally, the amount of the insurance payout less the policy’s adjusted cost basis (ACB) credits its CDA, which allows it to pay tax-free capital dividends to the Canadian resident shareholders (estates). This is a considerable advantage since a traditional corporate investment is paid out as taxable dividends.
When you consider that you currently have over $15Mill. currently invested in your corporation earmarked toward this goal (to pay the tax liability), we’re only suggesting less than 20% ($3Mill./$15Mill) of this to be redirected towards this more efficient or cost-effective solution. Please let us know if you have any further questions and how you wish to proceed.
Although, “pennies on the dollar”, “net estate values”, “net IRR”, and “pre-tax yield” are truly compelling metrics to showcase the value of insurance, make sure to always include the carrier’s product and sales strategy illustration in all your client presentations. This is not only for compliance reasons but also to provide support to the data provided in your presentation. I trust this will add value to your next presentation.
Tony Gallippi, B.A.S (Hons.) CFP CLU
Director, Advanced Planning, Insurance
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.