Another Policy Matter

National Post

2010-07-27


In certain conditions, you can sell your life insurance to your firm for tax-free funds

If you're a business owner who personally owns a life insurance policy, you may be able to extract surplus funds from your company, tax-free. The strategy involves transferring your personally owned policy to your company, but be aware that the tax rules regarding the transfer are different from other asset transfers.

While normally you can transfer an asset from personal name into corporate name using a tax-deferred "rollover," the section of the Tax Act that generally permits such a transfer is not applicable to the transfer of life insurance policies. Instead, the transfer of your policy to your company is considered to be a disposition for tax purposes. Special rules govern the taxation of this transfer when it's between non-arm's length parties, such as a shareholder and a corporation.

Under the Act, your proceeds of disposition as the shareholder are deemed to be equal to the "cash surrender value" of the policy. The cash surrender value is the amount of cash in a life insurance policy that the insurance company will pay the policyholder if he or she surrenders the policy back to the company.

The opportunity to extract surplus cash arises if the life insurance policy has a fair market value -- as determined by an actuarial valuation -- which is higher than the cash surrender value, if any. The most common reason for the fair market value to be high occurs where the cost of buying a new policy today would greatly exceed the cost of continuing to pay the premiums on the old policy, due to advanced age, poor health or decreased life expectancy.

So, to extract the cash from your company when the fair market value is greater than the cash surrender value, your company would simply pay you cash (or a promissory note) equal to this fair market value. The excess over the cash surrender value is yours to keep, tax-free. Only the difference between the cash surrender value, if any, and the adjusted cost basis of the policy will be taxable.

When the company buys the policy, its new adjusted cost basis is deemed to be the cash surrender value, not the fair market value. This is beneficial because upon death, the death benefit proceeds, less the adjusted cost basis of the policy, can generally be paid out tax-free as a capital dividend.

But take note: While the CRA is well aware of this strategy and agrees with the technical tax result, it has stated "it is not clear that the above result is intended in terms of tax policy… (and it has) brought this situation to the attention of the Department of Finance."