Building Insurance into Your Client’s Estate Plan

Kevin Wark, LLB, CFP

CIFPS Annual

National Conference

Your client, Ron is 65 years old Married to Lisa (62) – second marriage Ron has two children, Mary (32) and

Richard (27) both from first marriage Currently 2 grandchildren – uncertain if

there will be more in the future

Case Study

Case Study

Ron started a manufacturing company 20 years ago, currently valued at $3 million and drawing salary/bonus of $200,000 per year

Mary is involved in the business as VP Marketing

Richard currently traveling in Europe Commercial property acquired for

$400,000 in 1996, currently valued at $600,000 – rented to business for $40,000 pa. and has UCC of $200,000

Case Study

Ron’s other main assets consist of personal residence, $300,000 in RRSPs, $200,000 in shareholder loans

Ron has personally guaranteed $1 million loan to business

Ron is President of local hospital board Home (valued at $400,000) has no

mortgage and no other major debts

Ron’s Estate Objectives

Ensure Lisa has income of at least $200,000 per year (before-tax) if he predeceases her

Pass on business to daughter (Mary) Treat son (Richard) “fairly” on his death Minimize impact of taxes on his estate

Ron’s Estate Objectives

Provide gifts to grandchildren for post secondary education and other significant obligations

Creditor protect his estate Large gift to the hospital on death

Some Observations

Value of estate assets (before tax) is approximately $4.5 million

Taxes could reduce estate by approx. 20% ($900,000)

Major asset (representing almost 75% of aggregate estate) going to daughter

Conflicting Demands on the Estate Plan

Ron wants major estate asset to go to the daughter – impact on income to Lisa and ability to be “fair” to Richard

Significant tax and other liabilities may impact viability of estate plan

How to fund gifts to grandchildren and charity from estate??

Family law implications

Planning Idea #1– Collateral Insurance

Corporation acquires $1 million term or permanent policy on Ron’s life

Corporation assigns or hypothecates policy to bank as collateral for loan

Corporation can deduct lesser of premium and “net cost of pure insurance”

Planning Idea #1 – Collateral Insurance

Insurance proceeds would repay loan on Ron’s death and corporation would receive credit to its capital dividend account (CDA)

CDA could be used to flow tax-free dividends to Lisa to provide required level of income (subject to availability of cash in the corporation) or convert to secured shareholder loan

Removes significant liability from corporation and Ron’s estate

Planning Idea #2 – Creditor Protection/Capital Growth

Ron has significant wealth tied up in his business

Ron also has $200,000 shareholder loan account subject to business risks

Corporation could repay shareholder loan and replace with conventional bank debt

Split dollar arrangement between corporation and Ron for $1 million exempt UL contract

Planning Idea #2 – Creditor Protection/Capital Growth

Under a split dollar arrangement the Corporation owns death benefit and pays term costs of policy

Ron owns the cash value and funds with proceeds from the repaid shareholder loan

Corporation assigns its interest to the bank and can deduct lesser of premium and net cost of insurance

On Ron’s death the corporate debt is repaid by insurance proceeds and cash values flow to Lisa on tax-free basis outside of estate

Planning Idea #2 – Creditor Protection/Capital Growth

Corporation pays $31,000 per year for insurance coverage of $1 million

Ron pays $24,000 per year for 10 years and owns tax-deferred cash values

Assuming death at age 85, corporation receives $1 million (full credit to CDA) and Ron’s estate receives over $700,000

Represents a total return of 5.5% (after-tax) and 10% (before-tax) on Ron’s deposits

Planning Idea #3 – Estate Freeze/ Buy-Sell with Mary

Ron converts common shares into two classes of shares redeemable for $500,000 and $2.5 million respectively (total of $3 million)

As part of this transaction Ron also completes an estate freeze and increases cost base of first class of preference shares to $500,000

Deferred tax liability on shares of approximately $600,000

New common shares issued to Mary

Planning Idea #3 – Estate Freeze/Buy-Sell with Mary

Buy-sell agreement between Ron, Lisa, Richard and Mary funded by corporate owned insurance

Corporation acquires $3 million permanent insurance policy on Ron’s life

Under Ron’s will $2.5 million low ACB shares are transferred to Lisa and $500,000 high ACB shares to Richard

Lisa’s shares are redeemed by the Corporation – no gain or loss on redemption as funded by capital dividend arising from insurance proceeds

Planning Idea #3 – Estate Freeze/Buy-Sell with Mary

Mary buys Richard’s shares for $500,000 with a promissory note

Remainder of insurance proceeds flowed out to Mary to repay promissory note

Lisa receives $2.5 million tax-free, Richard $500,000 tax-free and Mary has all common shares (worth at least $3 million) with $500,000 ACB

Planning Idea #4 - Estate Equalization

Ron wants to ensure Richard and Mary are treated “equitably” on his death

Mary will be sole owner of a corporation worth between $3-4 million

Assume Richard has received $500,000 tax-free on sale of preferred shares to Mary

Still significant disparity in values being received by children upon Ron’s death

Planning Idea #4 – Estate Equalization

Simplest and most cost effective approach would be to purchase joint second to die insurance on lives of Ron and Lisa

Make Richard beneficiary of policy On death of surviving parent Richard will

receive a tax-free gift outside of the estate

Cost of $500,000 UL policy - $6,600 p.a.

Planning Idea #5 - Estate Equalization

Another option would be for Ron to transfer the commercial property to his Corporation on a rollover basis

Ron would take back redeemable preference shares with redemption value of $600,000 and ACB of $200,000

Mary would enter into agreement with Ron to purchase shares on Ron’s death

Planning Idea #5 - Estate Equalization

Mary would acquire a $600,000 policy on Ron’s life to fund purchase of shares

Taxable gain in Ron’s estate on shares Ron’s will would provide for after-tax sale

proceeds to flow to Richard Mary would own preference shares with

full cost base

Charitable Gifting

Number of ways to cost effectively structure major gifts on death

Can be funded through personal or corporate dollars

Can structure to receive tax credit for premium payments or death benefit

Planning Idea #6 – Personal Charitable Gift while Alive

Ron could purchase $200,000 insurance policy and gift to the hospital

Ron would be able to claim a tax credit for premiums paid on policy after transfer

10 Year Direction to hold would exclude gift from charity’s disbursement quota

Planning Idea #7 – Personal Charitable Gift on Death

Ron acquires $200,000 insurance policy and designates hospital as beneficiary

No charitable credit for premiums paid On Ron’s death estate can claim entire

death benefit as charitable gift Gift bypasses estate and potential

creditors Tax credit available to offset gains on

death (i.e. from sale of preference shares to Mary)

Planning Idea #8 – Corporate Charitable Gift

Ron’s Corporation could purchase $200,000 policy on his life

On Ron’s death life insurance proceeds could be gifted to the hospital (cannot designate hospital as direct beneficiary)

Corporation can claim deduction for donation

Corporation also receives $200,000 credit to the capital dividend account – tax free dividends

Planning Idea #9 – Gifts to Grandchildren

Complicated by fact these are not natural grandchildren of Ron’s wife

Ron will want to take steps to “protect their inheritance”

Purchase insurance to provide gifts on death

Could establish life insurance trusts to hold benefits for grandchildren

Benefits include bypassing the estate and management of funds while grand children are minors

Three years later…

Ron has incorporated a holding company, sold the operating business and invested after-tax proceeds in the holding company

Planning Idea #10 – Corporate Insured Annuities

Objectives of Program Increase corporate investment yield

and cash flow Increase value of estate by

reducing taxes Facilitate distribution of corporate

assets on tax effective basis

Corporate Insured Annuities - Process

Corporation applies for $4 million joint first to die UL on Ron and Lisa’s life

Corporation liquidates $4 million of investments to purchase a “life 0” annuity with payments to the first death of Ron and Lisa

Corporation borrows $4 million to replace investment portfolio

Corporation assigns both contracts to bank as security for loan and pays interest annually

Corporate Insured Annuities – Cash Flow

Annuity payments used to: Pay insurance premium ($177,500 pa) Pay loan interest ($340,000) @ 8.5% Pay taxes on annuity (non-prescribed)

* $36,600 in year 1

* $80,600 in year 2 and declines

every year thereafter

Corporate Insured Annuities – Cash Flow

Corporate Income Taxes Reduced by: Loan interest expense ($340,000) NCPI deduction ($146,000 in year 1 and

increases to equal total premium in year 3)

Loan is repaid with insurance proceeds on Ron’s death

Corporate Insured Annuities – Cash Flow in Year 1

Inflow Outflow

Annuity $367,000

Insurance $177,500

Loan Interest 340,000

Tax on Annuity* 36,600

Tax Savings* $243,000

Net Cash Flow $60,000

* Assuming 50% corporate rate

Corporate Insured Annuities – Cash Flow in Year 2

Inflow Outflow

Annuity $367,000Insurance $177,500Loan Interest 340,000Tax on Annuity* 80,600 Tax Savings* $259,000 Net Cash flow $30,000* Assuming 50% corporate tax rate

Corporate Insured Annuities –Impact while Ron is Alive

No reduction in corporate investments (except for any tax payable on disposition)

Loan fully secured (other security may be required)

Positive cash flow as a result of tax deductions

Corporate Insured Annuities – Tax consequences on Death

Corporate shares deemed disposed of at FMV – insured annuity has no value for tax purposes

Corporate value reduced by bank loan of $4 million (tax savings of up to $1 million)

CDA credit of $4 million less ACB of policy (allowing corporate investments to be extracted on tax-free basis)

Corporate Insured Annuity - Risks

Liquidation of corporate assets may have tax consequence and/or penalties for early termination

Interest rate fluctuations – borrowing rates may rise but annuity rates are fixed

No commutation value for annuity Separate insurers should be used for life

insurance and annuity contracts

Corporate Insured Annuities - Risks

General anti-avoidance rule (has value of company really been reduced?)

Interest deductibility (new REOP proposals requires annual testing)

Financial strength of insurance companies backing the arrangement

Other Planning Tips

Joint second to die insurance if Ron is substandard/uninsurable or for corporate back to back scenario

Use of holding companies for corporate-owned insurance (creditor proofing, avoids transfer on sale of operating business, valuation issues)

Having other family members or business partners share in costs of insurance

Discussion…