DFK Tax Newsletter

The Potential Cost of Holding Life Insurance in a Corporation

When planning for your estate, corporately held life insurance is often an option that is considered to reduce the estate’s tax burden or for tax efficient succession planning for privately held corporations. There is often a misconception that life insurance held in a corporation can be withdrawn on a fully tax-free basis. This article considers circumstances where unintended tax consequences may arise on corporately held life insurance.

Double Taxation on Death

When an individual passes away holding shares of a privately held corporation, there is a deemed disposition at fair market value of the shares held on death, typically resulting in a capital gain which is taxed on their final tax return. When property is distributed from the corporation as part of winding it up, a deemed dividend is triggered which is taxable to the estate, and the estate has a capital loss on the shares that were cancelled or redeemed. Unless additional tax planning is implemented double taxation may result related to shares of a privately held corporation, because the estate’s capital loss cannot be used to reduce the estate’s dividend income. One strategy to avoid this double taxation involves making use of a provision in the Income Tax Act (Canada) (“the Act”) that allows capital losses in the first year of a qualifying estate  to be carried back to the deceased’s personal tax return to offset the original capital gain. The estate then pays tax on the deemed dividend and not on the capital gain from the deemed disposition on death. 

Holding Life Insurance in a Corporation on Death

Life insurance is a practical way to plan for the cash flow needs resulting from the tax liability incurred on death. Holding life insurance in a corporation has many benefits, especially if there are multiple key shareholders and the policy can be used to purchase the shares owned by a deceased shareholder’s estate. However, there are also scenarios where holding the policy in a corporation does not have the expected end results. It is important to consult with your tax advisor prior to purchasing life insurance through a corporation. We will look at a scenario below where using the entirety of corporately held insurance to fund the tax burden of the estate results in unintended consequences.  

As stated above, when an individual passes away they are deemed to dispose of their capital property, including shares of a corporation, for proceeds equal to the fair market value (“FMV”). The resulting capital gain (or loss) on the deemed disposition must be recognized on the deceased’s final personal income tax return.   

When the insurance policy is paid out to the corporation, there are generally no tax consequences to the corporation, however, some or all the death benefitis added to the corporation’s capital dividend account. The capital dividend rules effectively allow the corporation to pay out the balance of the capital dividend account as a tax-free dividend to the shareholder, which is now the estate. 

The expected result of paying out the corporation’s assets as a tax-free capital dividend is the elimination of tax by the estate on the deemed dividend and carrying back of the capital loss to offset taxes owing on the final personal tax return. However, when the deemed dividend is paid as a capital dividend from life insurance proceeds, close attention must be paid to the stop loss rules under subsection 112(3.2) of the Act.

The Unintended Consequences 

The stop-loss rule under subsection 112(3.2) of the Act prevents the transaction from being 100% tax-free. When a capital dividend is paid on the redemption of shares owned by the estate, the capital loss amount available for the loss carry back is reduced by a formula set out in the Act. In the case of the life insurance policy being the last remaining asset of the corporation on death, the result of the stop-loss rule is that there are taxes payable on the deceased’s final tax return. Therefore, the stop-loss rules do not allow for all the insurance proceeds to be withdrawn from the corporation tax free as intended. 

Conclusion 

Before purchasing life insurance, it is important to consider all the assets held by both the shareholder and the corporation as well as intentions for the life insurance proceeds. As each situation is unique, careful planning is required to ensure tax efficient flow of life insurance proceeds to the intended beneficiaries. 

1. Bill C-15 includes proposed rules to expand the eligibility period for 164(6) elections from one to three years effective for estates of individuals who die on or after August 12, 2024 

2.  Subject to certain rollover provisions such as the spousal rollover at tax cost.

3. The difference between the death benefit and the tax cost of the policy is added to the capital dividend account.