Universal Life vs Whole Life: Should we consider CSV when comparing Net Estate Values?



Recently, while working on a corporate permanent life insurance case with an advisor, whereby we were comparing the net estate values produced by two viable options (UL vs WL), the client’s accountant asked an interesting question. They wanted to know whether our comparison should include the “potential” tax impact that the cash surrender value (CSV) of each policy may have on the net estate values presented. Interesting question, for sure. The answer….IT DEPENDS! This article will attempt to address an area that’s often overlooked by advisors and insurance practitioners, alike, but if addressed properly, can add a significant amount of credibility to your offering when dealing with your corporate client’s professional team (i.e. accountants and lawyers). Here, we’ll introduce the potential tax impact that the cash value of a corporate owned permanent life may have on the capital gains taxes on the terminal tax return under various post-mortem planning solutions.


Most advisors would agree that within a corporate setting, in addition to maintaining liquidity and minimizing taxes during the accumulation phase, permanent life insurance can greatly maximize the after-tax transfer of wealth to the heirs (or next generation), when compared to traditional investments. Assuming, as was in this case, the number one objective of the client was to maximize net estate values, a simplistic approach would be to compare the net estate values arising from a various corporate owned life insurance options (i.e. Universal Life vs Par WL), all deposits and duration being equal. However, it’s important to remember that taxes also arise on the death as result of deemed disposition of the shares. The cash value of a corporate owned life insurance policy (immediately before death) is generally included in the valuation of the common shares for the purpose of the deemed disposition at death rules. So, it stands to reason that the capital gains tax arising on the value of shares attributable to the cash value of the life insurance policy should reduce the net estate value said to arise from the policy. However, since there are post-mortem planning strategies that can be considered to reduce the tax burden on the shares, along with potential the stop loss rules that may apply, the answer to their question is still…IT DEPENDS!!!


Before we dive into the actual case, let me quickly summarize what happens on death with “NO POST-MORTEM PLANNING”. Quite simply, doing nothing, will result in double taxation. The deceased shareholder can face capital gains taxes on their terminal tax return due to deemed disposition of shares (capital gains taxes of $26.765% in Ontario) , and the estate can face dividend tax rates on those same shares on either windup or redemption (non-eligible dividend tax rates of 47.74% in Ontario). Now let’s look at two commonly used planning strategies to help reduce the liability of double taxation (high level explanation only):


  1. Section 164 Loss Carryback: this is where capital losses on the estate’s sale (redemption/windup) of shares partially or completely (depending on the stop loss rules) eliminates the deceased shareholder’s capital gains triggered on deemed disposition. For this to work, this must be done within 1 year of deceased’s death. This results in the shares being taxed at the non-eligible dividend tax rate of 47.74% only ( and/or eligible dividend tax rate of 39.34% in ON, to the extent that there’s available GRIP)

  2. Pipeline Planning: in which the increase to the adjusted cost base (ACB) of the deceased’s shares is channeled into a tax-free loan to the estate. This results in the shares being taxed at the capital gains tax rate of 26.765% only. Although attractive, it’s worth noting, that this planning strategy is not as simple as it looks. It usually takes up to 3-5 years following the deceased’s death to play out and funds to be fully distributed to the estate. Not to mention, this strategy is at risk of being scrapped by CRA.


Now for our case example:


Client information:

Mr and Mrs T (61/60)

Owner: Holdco

Deposit/Premium: $100K for 10 yrs


Plan design options:


Option#1: Universal Life

Initial death benefit: $2.7 Mill

CSV exist only to pay cost of insurance beyond yr 10.


Option#2: Participating Whole Life insurance with max. Additional Deposits

Initial death benefit: $1.5 Mill


COMPARISON

At first glance, based on net estate values and without factoring in the potential tax impact created by the existence of CSV, the WL options seems better. What happens if we do factor the CSV impact into our comparison? Although, a policy's CSV does increase the shares of the corporation for deemed disposition purpose, determining whether CSV of a policy should be considered when assessing whether UL or WL is better from a NET ESTATE VALUE perspective, will depend on the type of POST-MORTEM PLANNING strategy being contemplated. Even if there is an impact, one needs to consider the larger death benefit (NEV), produced by the whole life solution, in most circumstances. The chart below provides a quick cheat sheet as to IF and WHEN to include the CSV impact in our comparison:


INCLUDE CSV OR NOT?

In all, but the “Loss Carryback” strategy, all of the CSV of will be exposed to capital gains taxes. In the Loss Carryback strategy, if the taxable dividend produced on wind up or redemption is equal to or greater than 50% of the capital gains produced on death, this will result in none of the policy's CSV being exposed to capital gains taxes. If the taxable dividend is LESS than the 50% of the capital gains produced on death, some (or a portion) of the CSV may still be exposed to capital gains tax. A mouthful, I know!


Taxable dividends are produced when the corporation has other assets (i.e. Real Estate, GIC, Mutual Funds, Stocks, other investments) and/or when the “50% Solution” strategy is implemented with respect to the payout of the life insurance proceeds (resulting in 50% of CDA balance left behind for the heirs of the corporation).


Assuming most business owners will plan their affairs to avoid the DOUBLE TAXATION scenario, let’s look at the worst-case scenario of the 2 remaining post-mortem planning strategies from a CSV perspective: Pipeline strategy (since ALL of the CSV is taken into account):


Worst Case Scenario example: PIPELINE strategy in YR 30

When considering the worst-case scenario (going out to yr 30, in this example), the balance tips slightly in favour of Universal Life. Although, it is important to note that “Section 164 Loss Carry Back strategy” is the MORE COMMON and the MORE PLAUSIBLE, post-mortem planning strategy of the two. Other planning factors that need to be considered when choosing the right plan design will depend on the client’s need for liquidity. If this need is HIGH, then you must design a plan that has a growing CSV. That being said, accessing CSV via collateral loan will offset the impact the CSV may have on the valuation of shares for deemed disposition purposes (corporate borrowing only). It’s also possible to undertake a hybrid approach (attempts to combine the best of both strategies) to lessen the impact. All and all, one needs to consider CSV when comparing various permanent life insurance solutions.


Tony Gallippi

Advanced Case Consultant

Qualified Financial Services

tony.gallippi@qfscanada.com





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.