As I fall deeper down the rabbit hole of technical corporate estate planning, I enjoy discovering how many clients are taking the journey with me. I know that most of it is just my eyes opening to a new level of reality, but I can’t help to be grateful for any coincidence there may be.
In the last couple of months I’ve had the opportunity to speak in-depth to several multi-layer entrepreneurs, where their main operating company is owned by a holding company (or two), which itself is then owned by a family trust. Some have been set up this way for years, and others are just getting into the thick of it. To me, these conversations are not just amazing compliment to my text-book knowledge, they’re fascinating. But I understand that this topic isn’t a tea party for everyone, so if you didn’t follow this first bit, I won’t blame you for checking out now.
This Matryoshka (Russian nesting dolls) corporate strategy isn’t something that an entrepreneur comes by easily. It first takes many decades of hard work building a business, and turning an income problem into a tax problem. And then, once the tax problem is solidly developed, the challenge matures into an estate problem.
When you have an estate problem, and a tax problem, and even some days still an income problem, one of the most cost effective solutions is to purchase a life insurance policy within the corporation. The life insurance can have many purposes including helping the business run smother after the loss of one of one of the key members, making the estate more equitable for heirs who aren’t active in the business, covering future taxes owing to the CRA, funding a buy/sell agreement, and tax efficient sheltering and distribution of corporate savings.
If the business is small enough and the successors are expected to be able to buy out a less-active owner over time, then term insurance can be a good solution. For companies that have grown substantially larger to the point where life insurance is the only way to fund a buyout, then permanent insurance is probably a better fit.
When these corporate matroyshka structures exist, the question is often which entity should own the life insurance policy. Should it be the operating company, since that’s where the operating costs are focused? Should it be a holding company, so the family can retain the policy if the owner gets bought out? Or should it be the trust, so that the funds have a more direct route to the family?
An operating company is one of the least favorite choices for corporate planning professionals. While the premiums could be paid using less-expensive corporate dollars, the additional cash value would be exposed to corporate creditors, and the policy would be considered a passive corporate asset, so any future change of owner of the policy could have an impact on the corporation’s small business tax rates.
A holding company may be more desirable owner for the policy, since holding companies don’t normally have the same exposure to creditors. In addition, since many entrepreneurs choose to save inside of a holding company instead of through more conventional vehicles such as an RRSP, a life insurance policy is an excellent vehicle for the tax deferral of investment income, which can add significant benefit given the high rates of corporate tax on passive income. Of course, internal rates of return, liquidity needs, and investment flexibility would all need to be taken into consideration as well.
Additionally, when investment savings in a corporation are held outside of a life insurance policy they are potentially subject to double taxation on death both through the a deemed disposition of the shares, and again when the investments are actually sold – potentially triggering capital gains. Since the investments held within a life insurance policy are considered as part of the death benefit, they are received tax-free by the corporate beneficiary, eliminating that second layer of tax.
This is important even when the owner of the holding company is a trust and not a natural person. Whereas natural persons have a disposition on death, trusts have a scheduled deemed disposition every 21 years. If the trust assets aren’t distributed to the beneficiaries before that time, the increased value of the holding company due to the ownership of the life insurance could raise a significant taxation issue.
Instead, the trust itself may be a more suitable owner for the policy. Not only does this allow the holding company to be able to be wound up without triggering a disposition on the change of owner of the policy, but more significantly life insurance policies are exception to the 21 year deemed disposition rule. Life insurance held directly by a trust, including the investment component within, survives the 21 year deemed disposition unscathed, thus preserving the life insurance as a true estate asset.
Insurance can be used inside a corporation to help with many future planning challenges, including the ongoing income after the loss of a key shareholder, tax owing on the disposition of the shares, buy/sell funding, and estate equalization. When your corporate organization chart starts to resemble a family of matryoshka nesting dolls, then the appropriate structure of the policy should always be considered with the assistance of a financial planner with an advanced knowledge of corporate tax and estate planning.
If you have questions on tax effective distribution of corporate assets, or for more information on insurance policies within multi-layered corporations, speak with a Certified Financial Planner today.
Written by Meagan S. Balaneski, CFP, R.F.P.
Meagan S. Balaneski, CFP, R.F.P CERTIFIED FINANCIAL PLANNER® Advantage Insurance & Investment Advisors Investment Funds Representative Manulife Securities Investment Services Inc.
The opinions expressed are those of Meagan S. Balaneski and may not necessarily reflect the views of Manulife Securities Investment Services Inc.