Corporate life insurance is a tool used by business owners to protect their business in the event of a key person’s or shareholder’s death. It provides funds to the company when most needed and has certain tax advantages that allow for the stripping out of value from the company tax-free. The tax advantages can be used to reduce the tax in the estate of the shareholder or give a tax-free distribution to other shareholders so that they can buy out the deceased shareholder more easily.
Let’s take a look at the main uses and reasons for you to consider corporate life insurance for your business:
BUYOUT OF SHARES IN CASE OF DEATH
When the company has more than one owner, life insurance can help fund the buyout of the estate if a shareholder dies. Death is a situation that often creates a need for cash from the business because the shareholder’s shares are deemed to be sold at current value and not what they were worth when bought or issued, triggering a taxable capital gain. While there are exceptions to this rule, like if the shares are rolled to a spouse, in many cases the estate will be needing liquidity to pay the tax. It is likely that the company itself or other shareholders will want to buy out the deceased shareholder and life insurance can help finance the process.
The corporation should be the owner and beneficiary of life insurance on each of the shareholders in order to meet its obligations to re-purchase or redeem the shares of the deceased shareholder from his or her estate. A shareholders’ agreement usually has a method of valuing the shares for this purpose which can be used to determine the amount of insurance coverage needed.
KEY PERSON LIFE REPLACEMENT
Some roles are vital to the company’s success and insurance can provide sufficient funds to attract, train and employ a replacement in case of death.
Some examples of this “key person” include an individual who is responsible for the success of the company’s sales, an individual who designs much of the product, or a key administrator like the CEO.
The amount of life insurance coverage that the company would take on that key person is usually determined by an estimate as to how much the company would suffer financially if the key employee were to suddenly pass away. Sometimes this can be an arbitrary number, although the insurance company requires justification for any amount of coverage they would issue for this purpose. In other situations, an analysis is undertaken to estimate the loss to share value due to the death of the employee. Usually, this number would include two years’ salary in addition to acquisition and training costs.
LIFE INSURING DEBT
Often a business will make use of bank debt to produce income. This debt may be for normal operating expenses, purchase of an asset, payment of a dividend to shareholders, or to make a pension contribution for its employees, to name a few. Where the company has borrowed for a business purpose, it is prudent for the firm to insure the lives of the principals so that if there was a death, the loan would be repaid. This would protect the working capital of the firm and would contribute to guaranteeing the financial stability of the company even though it has just lost a key shareholder. Also, many lenders require the shareholders to provide personal guarantees to secure the loan. By life insuring the shareholder in this arrangement, the estate of the deceased is relieved of this burden.
There are some tax advantages for corporations to insure their shareholders to secure debt. If the bank requires the life insurance as a condition of the loan (or provides a letter to that effect), a portion of the premium may be tax deductible to the corporation. In order to obtain this deduction, the transaction must meet specific criteria as stated in the Income Tax Act. Upon the death of an insured shareholder, there is also a tax benefit to the surviving shareholders. Even though the entire proceeds of the life insurance are used to repay the loan, the life insurance payout is also an addition to the capital dividend account. This is a notional account for tax purposes that tracks how much dividends a private company can pay out tax-free. In effect, this means that other corporate earnings can be paid as a tax-free dividend to the remaining shareholders.
Corporate life insurance is also applied for more sophisticated arrangements. For example, some corporations use life insurance as part of a charitable giving strategy.
Our team of experts would be happy to assist you in determining where the needs for life insurance exist in your corporation and how to establish the appropriate amount. Should you have any questions, please don’t hesitate to contact one of our advisors.
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