The Immediate Financing Arrangement is a financial strategy that provides an opportunity for individuals and incorporated business owners to obtain the permanent life insurance coverage they need while still preserving cash for investment or business opportunities.
The strategy uses the cash surrender value (CSV) of a participating whole life insurance policy, and in some cases additional assets as required by the lender, as collateral for a loan or line of credit from a third party lending institution. As the cash surrender value of the policy increases, loans are taken from the third party lending institution. The loan proceeds are used to invest in a business or other income producing investment and the interest expense may be tax deductible. In addition to the interest expense, some or all of the policy premiums may also be deductible when the policy is used to secure a collateral loan. The outstanding loan balance is paid from the death benefit payable under the insurance policy when the life insured dies.
For incorporated business owners, the corporation is the owner and beneficiary under the insurance policy. Under current tax laws, when the insured business owner dies, the company receives the proceeds of the policy tax-free and also receives a credit to its capital dividend account (CDA) for the proceeds minus the adjusted cost basis of the policy. Capital dividends may then be paid out to shareholders tax-free by following set protocols as laid out by the Income Tax Act (Canada).
The Challenge
- Permanent life insurance needs can put stress on cash flows for both individuals and incorporated business owners
- Business owners may require the funds they would otherwise use for permanent life insurance for maintaining business operations, growing their business or other investment opportunities
- Similarly, individuals may elect to put their money towards investment opportunities instead of permanent life insurance
How It Works
- The corporation purchases a permanent participating life insurance policy on the life of the business owner that creates significant cash surrender value in the early years of the policy. The corporation is the owner and beneficiary of the policy
- Note: this type of life insurance policy contains both life protection and cash equity that builds inside the policy, available to the owner when they are alive
- The policy is then assigned to a lending institution as collateral to secure a line of credit taken out by the corporation
- The corporation pays the recurring policy premiums and the interest on the loan, monthly or annually. Other options include capitalizing the interest payments
- The corporation borrows up to 100% of the policy cash surrender value (assuming a participating whole life insurance policy), or may borrow an amount up to the entire annual policy premium that has been paid by providing additional collateral security
- The corporation uses the line of credit for investment purposes, for example, to fund an operating business, purchase real estate or invest in other income producing assets
- Steps 3 to 5 are repeated annually
- When the life insured passes away, the outstanding loan is repaid, directly to the lender, out of the policy death benefit and the remaining proceeds are paid to the corporation. The total death benefit proceeds are paid out tax free. The corporation’s Capital Dividend Account will receive a credit for the full death benefit minus the adjusted cost basis of the policy
Please Note:
The basic Immediate Financing Arrangement concept assumes the borrower has sufficient income to pay the insurance premiums to meet the loan obligations, qualifies to write off interest payments, and take advantage of the collateral premium deduction for income tax purposes. The loan interest rate charged by the third party lender for the loan may be greater than the interest rate assumed in this article. Loan interest rates are not guaranteed and are subject to change by the lender. The cash surrender values for the life insurance product illustration are independent of the loan rate charged by the lender. Total cash surrender values are not guaranteed. The third party lender may reserve the right to demand payment of the loan in full at any time in accordance with the terms and conditions for the loan prior to the time the illustration assumes it will be paid. The life insurance illustrated in this sales concept presentation, is a participating whole life insurance policy that will not expire during the lifetime of the life insured as long as the premiums are paid and the policy remains in force. If the loan amount exceeds the cash surrender value of the policy or the cash surrender value of the policy plus the collateral that was pledged to acquire the loan, the lender may require additional collateral be pledged or, the lender may demand repayment of all or part of the outstanding loan balance.
The Benefits
- Business owners will benefit from the ability to shelter growth on corporate invested assets from tax, inside the life insurance policy, during their lifetime. Although owners can use the retained earnings sitting within a participating life insurance policy as they see fit, the Immediate Financing Arrangement strategy allows a corporately owned participating life insurance policy to be used as collateral for a tax-free loan that enables the corporation to re-invest into its business or other income producing investment
- If a corporate loan is being used to earn income from a business or other investment, the interest on the tax-free loan may be tax deductible to the corporation. Additionally, a portion of the life insurance policy’s premiums may also be tax deductible when the lender requires the life insurance for a collateral loan
- The strategy will also provide liquidity for corporate life insurance needs, such as coverage for a key person, debts or to fund buy-sell agreements or dividend payments to shareholders. Death benefit proceeds can also be used to help fund tax liabilities, estate equalization or to leave a legacy to heirs or favourite charities
- The death benefit in excess of the policy’s adjusted cost basis will create a credit to the corporation’s Capital Dividend Account. Capital dividends may then be paid out to shareholders tax-free
Who It’s For
This strategy is best suited for healthy, financially stable clients who are 35 to 65 years of age. This may be appropriate for individuals as well as for business owners. The client will often be a shareholder of a successful business and will have a need for permanent life insurance. The client’s corporation will often generate a significant annual surplus or have large retained earnings sitting in taxable investments. Examples of life insurance needs for the corporation and its business owner include key person, funding a buy-sell agreement, funding capital gains liabilities and the permanent needs of the shareholder which could be the desire to leave a tax-efficient legacy to heirs or favourite charities. The client will also want access to funds to help grow their business or invest in other income producing assets.
CASE STUDY
Meet Jack
Jack is the owner of a successful, incorporated, family operated business. Although Jack is married with 2 children, only one of the children has shown a desire to continue the family business. Jack has built the business from the ground up and after meeting with his accountant, Jack understands he has significant permanent life insurance needs. Along with the life insurance needs, Jack also has a desire to re-invest into his business. Understanding his situation will require some financial planning, Jack decided to meet with his financial advisor.
What are Jack's objectives?
- Provide funds upon Jack’s death in the most efficient and economical way to cover estate equalization issues as well as future capital gains liabilities
- Have immediate access to cash to be able to re-invest into his business
Jack's Concerns
- Jack’s current, corporately owned passive investments (about $1M of GICs) are being heavily taxed. Jack has longer term concerns that the passive income may impact his small business tax rate if monies are invested where they could potentially earn a higher rate of return. Then there are the investment risks associated with doing that. There are potential capital gains liabilities and estate equalization issues that will need to be settled upon Jack’s death. Jack’s business requires some upgrades and reinvesting funds into his business is a priority. Accessing existing funds in his corporation for reinvestment into his business will leave little funding available for Jack’s longer term needs which may be permanent. Leaving the funds for the future leaves Jack with a shortfall of necessary cash required to reinvest into his business in the interim.
The solution needs to assure that funding is available upon Jack’s death in the most efficient and economical way to cover his long term needs without depleting existing cash surpluses in the corporation needed for reinvestment purposes today.
The Concept
- The Immediate Financing Arrangement strategy enables Jack to grow passive assets in the policy from corporate surplus on a tax deferred basis
- Creates sufficient permanent life insurance coverage for funding needs upon Jack’s death
- Provides a tax-efficient strategy to access the funds required for reinvestment into the business
The Advantages
Using assets from within the corporation to fund a permanent life insurance policy that has a growing cash value component provides a viable opportunity to:
- Provide tax-sheltering on the corporation’s surplus retained earnings
- Convert corporate assets into tax free benefits paid directly to the corporation. Dividends can be paid to Jack’s estate, tax free
- Enable tax-efficient funding required for reinvestment purposes
How It Works
- Re-allocate a portion of retained earnings from corporate surpluses into a life insurance contract owned by the corporation
- Take advantage of tax-sheltered growth inside a customized life insurance policy
- Provide tax-efficient collateral for a bank loan that can be used to help grow the business
- The corporation can make monthly or annual interest payments with the loan balance repayment deferred until Jack’s death (or collateralize the interest)
- Interest and a portion of premiums may be tax deductible to Jack’s corporation
- By making the corporation the beneficiary, the death benefit proceeds will be used to repay the loan with the remainder being paid to Jack’s corporation tax-free
- The Capital Dividend Account is credited with the total death benefit in excess of the policy’s adjusted cost basis, not simply the excess death benefit minus the loan amount. The net value in the Capital Dividend Account may be used to distribute other trapped surplus tax-free over and above the net life insurance proceeds paid out as a death benefit
What is a Capital Dividend Account (CDA)?
It is a notional tax account available only to Canadian Controlled Private Corporations. The Capital Dividend Account is comprised of tax-free amounts received by corporations including:
- Tax-free portion of capital gains
- Capital distributions from trusts
- Net death benefit proceeds of life insurance policies (excess of death benefits over policy’s adjusted cost basis (ACB))
- Capital dividends received from other corporations
Amounts credited to the Capital Dividend Account may be paid out as capital dividends tax-free to Canadian resident shareholders. The amount credited to the CDA from an insurance policy are: CDA credit = Insurance Policy Death Benefits - ACB
Note: ACB = policy premiums - net cost of pure insurance
Technically, as someone ages the annual "net cost of pure insurance" gets higher even though the premiums remain the same. This means over the years the ACB grinds down to zero.
The Numbers Behind The Strategy
The advisor has gathered that Jack's company can afford, due to retained earnings in the corporation, a yearly premium of $125 000. To maximize the growth of the cash surrender value (CSV), an 8 pay option was selected. This means the entire policy will be paid off in 8 years, after which no more deposits are needed. Using the insurance provider's online illustration software, this premium represents a total insured coverage of: $1 526 200.
Remember:
- The insurance coverage is calculated based on the yearly deposits (affordability)
- This type of insurance policy permits a collateral loan from an external loan provider: typically at 90% or higher of the CSV. The owner may have to pledge additional collateral for higher amounts borrowed.
- In our case, 100% of the CSV accumulated in the policy at the end of the policy year is advanced as a loan each year. If the owner wanted to access the full deposit amount as a loan in the first 6 years, additional collateral would have to be pledged.
- The interest may be collateralized. Since the CSV accumulates over time, the interest may also be covered by the death benefit. In this example, the Bank Loan interest is 5% and the owner chooses to collateralize the interest.
- The dividends are reinvested in the policy to increase the cash surrender value each year
- As the CSV grows, so does the death benefit
- When properly designed, this type of participating whole life policy will generate a death benefit that will exceed the loan balance
Questions?
If you have questions about business strategies, please feel free to reach out so we can have a quick conversation about the Immediate Financing Arrangement and see if this is right for you and your business. You may sync your calendar with mine for a short 15 min introduction at: https://calendly.com/chuckseguin/discovery-call-15-mins
Reference: the illustration software, numbers involved, and images are provided by Empire Life