In my introductory accounting textbooks, it talks about how a corporation can not die. It also mentions that all corporations have one or more voting shareholders. The voting shareholder(s) appoint one or more directors to oversee the corporation. In a smaller professional corporation or business, the owner is often the sole voting shareholder and sole director. Although the owner of the business may die, the business does not.
In the absence of a detailed plan, or shareholder agreement, your executor would typically take control of the shares and appoint a new director that would make the decision on whether to maintain or wind down the corporation. Despite the corporation continuing to exist after the owner’s passing, the owner is still deemed to have disposed of the shares of the private company, for proceeds equal to their fair market value.
Surplus cash
The accumulated surplus cash within a corporation is often referred to as retained earnings. The retained earnings are essentially an accumulation of profits. The surplus cash is often used to purchase investments, such as fixed income, common shares, real estate and other passive investments. Typically, these types of investments will generate income (i.e. interest income, capital gains, dividend income, rental income) over time that is also taxable within the corporation. Essentially, profits on profits. Passive income within a corporation is subject to a higher level of taxation than active business income.
Tax liability upon death of owner
Upon death, all assets are deemed to be sold at their fair market value for tax purposes. These assets are not only exposed to tax at the corporate level, but also at a personal level when the dividends are paid out of the corporation which can result in a significant tax liability. An often-eye-opening exercise for any owner of a corporation is to ask their accountant what the combined tax liability would be if they were to pass away.
Excess surplus cash
Shifting back to surplus cash. As surplus cash gets built up, this becomes the nest egg for our client’s retirement. Often at times the surplus cash is more than our clients will ever require to live comfortably. The goals will shift to maximizing returns, minimizing taxes and ensuring that the greatest amount of wealth is available for transfer to the next generation.
The benefit of time
When we begin working with corporate clients, we will request the latest copy of the financial statements, financial plan, and have a conversation with our client’s accountant. If we see a substantial amount of surplus cash, we will have a discussion about what planning steps have been taken to reduce double taxation, or to avoid a significant tax bill in the future. The more years we have, the more time is available to implement a strategy, and the more likely we are to be effective in minimizing the tax liability.
Passive investments within a corporation
As noted in our column Investing Under a Corporate Umbrella, passive interest income is taxed at a combined 50.67 per cent (comprised of the Federal tax rate of 38.67 per cent plus the 12 per cent BC tax rate). Like individuals, a corporate investment account must determine the portion in cash, fixed income, and equities. The cash component may be the amount equal to the cash flow requirements for the next 12 months. With respect to fixed income within a corporation, we will highlight the above tax rates and the net potential return. Below we have outlined the fixed income returns.
Fixed income within a corporation
Fixed income rates are near historic lows. The main forms of fixed income are government bonds, corporate bonds, and guaranteed investment certificates (GIC). If an investor purchases a 10-year government bond, the yield is approximately 1.3 per cent. A basket of investment grade corporate bonds, with a duration up to 10 years, has a yield of approximately 3.1 per cent.
Bonds pay interest income. A one-year GIC has a yield of 0.91 per cent, stretching all the way to 1.92 per cent if a five-year GIC is purchased. If we average the durations between one to five-years, the average GIC yield is approximately 1.3 per cent.
Government bonds, corporate bonds, and GICs all pay interest income. The after-tax rate of return on government bonds is 0.64 per cent [1.30 per cent x (1 – 50.67 per cent)], on corporate bonds is 1.53 per cent [3.10 per cent x (1 – 50.67 per cent)], and on GICs is 0.95 per cent [1.92 per cent x (1 – 50.67 per cent)].
Fixed income alternative
Before exploring a fixed income alternative, we want our business clients to fully understand what their tax liability would be if they do no planning. We also spend time teaching our clients that the net returns on fixed income within a corporation are minimal, and in fact, are negative after income taxes, investment counsel fees, and inflation are factored in.
If our business owners are committed to an estate strategy that will enhance returns, we can map out a strategy that will enhance returns, reduce estate taxes, and greatly enhance the net estate value that passes onto the next generation. The way we explain this to our business clients is that instead of purchasing fixed income within the corporation, consider a corporate estate reallocation strategy.
Corporate estate reallocation strategy
The strategy involves the purchase of a permanent life insurance policy. The corporation would own the policy, pay the premiums and would also be the beneficiary of the life insurance policy. The policy could be structured on either a single or joint life basis.
Clients can choose an insurance product with guaranteed values or accept a product with some market risk, which may result in higher values. Premiums for the policy could be taken from the funds typically used to purchase fixed income, from funds used to purchase other passive investments, or from excess cash flow from operations not required by the corporation.
The policy could be structured as a “quick pay,” meaning the premium would be payable for a pre-determined number of years (i.e. 10 years), provided the policy performs as expected.
At death of the insured(s), the life insurance death benefit would pay out a tax-free death benefit directly to the corporation. The corporation would receive credit to its capital dividend account (CDA) for the insurance proceeds minus the insurance policy’s adjusted cost base (ACB). In our article Understanding Tax-free Capital Dividends, we outlined how capital dividends can be paid out tax-free to the business owner’s estate.
Ideal candidates for reallocation strategy
Clients who are over 45 years old that own a Canadian Controlled Private Corporation (CCPC). They have to be in good health to qualify for the insurance and have significant cash levels or passive investments in a holding company.
The individual would also like a fixed income alternative and are committed to long-term planning and slow growth. The corporate estate reallocation strategy looks to reduce corporate taxes and maximize the shareholder’s estate value at death.
Client illustration
Through the financial planning process, we had worked with a business owner with $3.6 million in a holding company. The company was owned by Mr. and Mrs. Smith, both aged 60. Currently the company has 20 per cent in cash (or $720,000) and 80 per cent invested in equities (or $2,880,000).
We compared the option of purchasing traditional fixed income investments with the option of using these funds for the Corporate Asset Transfer Strategy. For illustration purposes we first used a scenario where Mr. and Mrs. Smith put $72,000 into GICs every year for 10 years.
We did another scenario where they committed to putting $72,000 per year, for ten years, into a corporate owned permanent life insurance strategy. The initial death benefit of the policy is $948,800; however, we recommend that Mr. and Mrs. Smith overfund the policy to enhance the death benefit.
In order to illustrate the potential value to Mr. and Mrs. Smith’s holding company, we are going to use a conservative life insurance product called Participating Whole Life with the intent of paying more than the minimum annual premium over the next 10 years. Another appealing feature is that once a dividend is credited to the policy, it can not be errored due to market performance. This makes these types of plans ideal as a fixed income alternative.
To make our example, we are going to use a participating whole life product. Please note that we have partnerships with most of the major insurers in Canada, and select the insurer depending on each client’s individual situation.
The current dividend rate on the participating whole life product in our illustration is six per cent. To be conservative with our analysis, we are going to reduce the current dividend rate from six per cent to five per cent (Current less 1.0 per cent).
Comparing tax exempt insurance to GIC
We are going to assume that the Smiths are currently 60 years old. The illustration we have ran assumes premium payments of $72,000 are made for the first 10 years, and then no further premium payments are made. We have assumed the Smiths having a life expectancy (LE) to age 91.
If the Smith’s invested in a GIC for this 31-year period, they would have $853,051 within the corporation. If they were to pull this money out, through a dividend payment, they would net $478,273. This would be a non-eligible dividend payment (see Clarifying the confusion around eligible and ineligible dividends) and the tax rate would be 48.89 per cent.
Alternative investment option - GIC at 1.3 per cent
| Accumulation at age 91 — Net Investment Balance | Net Estate Value after withdrawing from corporation (after tax) |
|---|---|
| $853,051 | $478,273 |
As noted above, the current average yield for a mix of one to five-year GIC rates is currently 1.3 per cent. We have also done a stress test calculation illustrating GIC rates at 3.0 per cent and 5.0 per cent below:
Alternative investment option - GIC at 3.0 per cent
| Accumulation at age 91 — Net Investment Balance | Net Estate Value after withdrawing from corporation (after tax) |
|---|---|
| $1,063,628 | $652,814 |
Alternative investment option - GIC at 5.0 per cent
| Accumulation at age 91 — Net Investment Balance | Net Estate Value after withdrawing from corporation (after tax) |
|---|---|
| $1,376,626 | $912,247 |
The above figures are taken from illustrations we have run. Reach out to us today and we can provide additional information on the illustrations and walk through them with you.
Tax-exempt insurance strategy
As an alternative to the GIC option, let’s look at the tax-exempt insurance strategy, which we refer to as the Corporate Estate Bond.
The Corporate Estate Bond would have a cash surrender value of $1,705,779 and an after-tax estate value of $1,913,407.
The cash surrender value is the accumulated value of the policy as an asset within the corporation. The after-tax estate value is a combination of the death benefit which is paid tax free into the corporation and can be withdrawn from the corporation to the estate tax free to the extent that it can create a capital dividend account credit.
| Before Tax Redemption Value | Net Estate Value (After-Tax) |
|---|---|
| $1,705,779 | $1,913,407 |
This strategy is often overlooked by business owners as it appears overly complex.
To overcome the complexity, we will ask our insurance consultant to also be present to break the steps down. We find that using visual flow charts and comparing this strategy to alternatives makes the decision easier for clients. We have conversations with our clients’ accountants as well to ensure that they fully understand the benefits of this strategy.
Some clients also are not open to talking about insurance products if they feel they have more than enough capital to live comfortably for the rest of their lives. This strategy is to enhance the estate, so our clients can leave even more to the next generation. The strategy works as it takes advantage of moving a component of our client’s portfolio (the fixed income component) from a low yielding and fully tax-exposed environment to a tax-deferred environment.
Corporate estate bond with corporate borrowing
An extra layer of flexibility also exists with this strategy — using the insurance policy to borrow money. A policy holder can use the Cash Surrender Value built up within the policy as collateral to secure a series of loans. The corporation may then use the borrowed money to invest back in their business. If the loan is structured correctly, the corporation may be able to deduct the interest incurred on the bank loan against its taxable income. The tax savings on being able to deduct the interest costs helps offset the interest expense paid each year.
Asset mix within corporation
Our corporate clients with the Corporate Estate Bond would then have a portfolio that is more heavily weighted towards blue chip equities, and a portion in cash equivalents and short-term money market to meet their one to two-year cash flow needs if corporate borrowing is not utilized. There can be a lot of additional value to using a tax-exempt insurance plan as one’s fixed income alternative within a corporation. Provided our clients are committed to a long-term strategy, tax-exempt corporate owned insurance is worth exploring.
Kevin Greenard CPA CA FMA CFP CIM is a Portfolio Manager and Director, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. Insurance services are provided by Scotia Wealth Insurance Services Inc. His column appears every week at timescolonist.com. Call 250.389.2138, email greenard.group@scotiawealth.com or visit greenardgroup.com/secondopinion
