Corporate Life Insurance

Case Study Preserving The Small Business Tax Rate

Let’s look at a simplified case study showing the benefits of using corporate-owned insurance for Dr. John Jones (composite; not real person) practicing in British Columbia. Dr. Jones’ is 45 years old and is expecting to work and earn active business income for another 20 years. His income and investment earnings range from $500,000 to $625,000 per year, which includes investment income held in his medical professional corporation (MPC). His corporation is generating a significant amount of excess cash flow each year and he retains a considerable portion of business profits within his corporation. Over the years, he has been able to accumulate over two million dollars in savings in his corporate account, currently invested in traditional investments including GICs, bonds, dividend-paying stocks, preferred and common shares. Every year his MPC pays the applicable tax on income generated from these passive investments (interest and foreign dividends are taxed at 50.67%, capital gains at 25.34% and dividends at 38.33%).

Although a substantial portion of this tax is ultimately refundable to his company if he pays out dividends to himself (or his spouse if possible), the extra personal taxes that Dr. Jones might have to pay make this option unappealing. As a result, he figures he will never use up all of his corporate cash during his lifetime and decides to purchase an insurance plan from his corporation with an annual investment of $250,000 for 10 years.

By moving $250,000 every year for 10 years from his taxable investments to an insurance plan (the portion he allocated to the policy would have otherwise gone to conservative interest paying investments averaging a 5% annual rate of return), Dr. Jones reduces the amount of taxable passive income his corporation is earning by $100,000 (assuming his income is all dividend or interest income. Diverting $250,000 per year into the policy reduces passive income by $12,500 per year at 5% interest only, assuming none of the income is reinvested to compound).

The insurance plan consists of a savings element (policy cash values) and a death benefit. As mentioned, there is no tax payable on the growth of the policy’s cash value as long as it remains in the policy. This helps reduce his corporate tax payable, resulting in greater asset growth. On death, the full amount of the death benefit, less the life insurance policy’s adjusted cost basis, creates a credit to his MPC’s capital dividend account (CDA), which can be used to create tax-free capital dividends. If Dr. Jones lives to a ripe old age, it’s possible that the entire insurance payment at death can be paid out of the company tax-free to his estate or other shareholders.

(The CDA credit is unique to corporate-owned life insurance. This is a notional account and appears on a company’s financial statement, which will have a significant benefit for owners of Canadian controlled private corporations. The balance in the CDA can be paid out to shareholders as a capital dividend and thus be exempt from tax. The death benefit of a corporate-owned life insurance policy is one item that can be credited to the CDA tax-free).

Using his conservative assets Dr. Jones is able to preserve his corporate estate and pass on his corporate assets back to his corporation tax-free eventually passing his assets over to his family.