Benefits of Corporate-Owned Life Insurance (COLI)
Life insurance receives unique and specialized tax treatment that makes it an effective tax and estate planning tool, especially for business owners.
Business owners can utilize whole life insurance, a form of permanent life insurance, in a variety of ways. They can protect their families, preserve their personal and business assets, and ensure the continued viability and profitability of their business.
So as a business owner, you’ve decided on a permanent life insurance policy. You’re into the idea of committing to a policy that can provide your business with benefits beyond the usual death benefit of a standard term policy. That’s great news!
Whole life is one of the most common life insurance products available. It comes in many forms and has many customizable options via riders to fit you and your loved one’s needs. Whole life insurance is commonly used in estate planning via a death benefit payout. But there are other, alternative benefits to whole life insurance.
Alongside policy dividends, business owners and high-net-worth individuals can use their life insurance policy to cover those high tax bills when their company shares and estate are passed along to their loved ones.
What is business life insurance?
A business owner can either buy a personal life insurance policy or purchase a policy in the business name. Business, or business-owned, life insurance is similar to personal life insurance in that it pays a death benefit and may provide an additional investment component. However, company-owned life insurance offers additional applications which function to support your business needs. For example, business life insurance can be used as loan collateral when you need cash for your business now. You can purchase this insurance as a term (10, 20, 30 years) or permanent (the entirety of the life of the owner) depending on your business’s financial needs.
Can a corporation own a life insurance policy on an employee?
A corporation or company can be the owner of a life insurance policy. Corporation-owned life insurance (COLI) allows the corporation to pay the premiums for the policy. Generally speaking, the corporation paying for the policy should also be a beneficiary of the COLI so the premiums do not become a taxable benefit. The corporation can thereby collect proceeds upon the death of the person covered under the insurance policy.
What are the advantages of corporate ownership of a life insurance policy?
A corporate-owned life insurance policy has several advantages:
- Reduced tax-cost of life insurance premiums: Paying premiums through a business allows for the use of after-tax dollars generated by the business. Since corporations have a favourable i.e. a lower tax rate than individuals, it is advantageous for a corporation to own a life insurance policy rather than a shareholder. For the same amount of premium dollars, a corporation can own a much larger policy on the shareholder, than if the shareholder was using their own income to pay for the policy. As life insurance premiums are payable for several years, including over the entire lifetime of the insured individual, such savings can become quite substantial over time.
- Equitable distribution of premiums: A corporation can pay for premiums for several shareholders / key persons regardless of the cost of premiums that may vary across the various individuals, due to their age or personal health situation. Each shareholder therefore proportionately assumes the cost of the premiums paid for by the corporation and the potential benefit thereon. This allows for a more equitable distribution of premiums rather than each shareholder individually paying for a policy.
- Easier management: Policies owned by a corporation on multiple individuals or shareholders can be easily managed centrally by the corporation including in making premium payments or in utilizing the cash values, validating the status of the policies or even in filing claims.
- Creditor protection: Policies owned by a corporation on an individual shareholder generally allow them to be shielded from creditors of an individual shareholder. Certain structures could be created where any death benefit proceeds received may also be shielded from the creditors of the business.
- Tax-preferred cash value accumulation: The cash surrender values on corporate-owned permanent insurance policies are treated as an asset of the corporation. Any unrealized gain in the cash surrender values would be exempt from taxes unless the policy is cashed in or the cash values are withdrawn. This allows the corporation to diversify its asset mix and avoid having to pay taxes otherwise payable on regular investment income.
- Tax-free death benefit: Should the insured person pass away, proceeds of corporate-owned life insurance received by the corporation can be paid through to the deceased’s individual’s estate or any other beneficiary with little or no tax through capital dividends. The amount of the tax-free payment is equal to the death benefit amount minus the adjusted cost basis (ACB) of the policy at the time of death. Typically, a policy held to life expectancy will result in nearly all or a very high proportion of the death benefit available for tax-free dividends.
How can life insurance policy be used for your business?
If you are a business owner, you may be worried about how the business will continue when you pass away. There are many ways in which life insurance can be used as part of a business continuation strategy to ensure that the business continues to thrive, even upon any future ownership transition.
Key person insurance is a life insurance policy owned and paid for by a business, covering the life of a key employee, deemed critically important to the company’s operations. If the covered key person passes away, the business receives a tax-free death benefit which can be used to meet expenses, repay debts or even hire a replacement. Key person protection is a cost-effective way to help ensure the continued viability and profitability of the business in the face of a specific risk. The proceeds from the life insurance can effectively be used as a buffer against any contingent reduction in sales or business growth that may occur as the company navigates the transition in its operations from the loss of life of a key employee or shareholder of the corporation.
Buy/Sell Agreement is a contract that stipulates the process in which shareholders or owners of a business may purchase shares of a deceased business owner or partner. A buy-sell agreement can be funded by a life insurance policy whereby the death benefit of the policy can be used to buy out the remaining shares of the deceased partner from their heirs. This agreement prevents the business partners from having to use personal funds or business assets to buy out the deceased business partner’s shares. In some cases, the business partners may choose to individually own a policy on the other partners. However, a better strategy is to have the whole life insurance owned by the business, so that it can be more efficiently managed and used to fund the purchase of the shares of the deceased partner.
Estate Equalization is a strategy to transfer assets in a fair manner to one or more beneficiaries of a shareholder. Whole life insurance becomes an effective tool to accomplish estate equalization in situations where the business owner has some beneficiaries who are involved in the business and some who are not. The members of the family with an interest in the estate inherit the family business or family assets, while other members are bequeathed an equivalent cash value to the estate from the tax-free proceeds of a life insurance policy.
Life Insurance Collateral Assignment is another benefit of business-owned insurance. The death payout of a life insurance policy is the main benefit that most people consider, but there are living benefits to life insurance as well. In addition to your death benefit, a whole life policy accumulates a cash value. If you need quick cash for your business, you can get a policy loan from your policy’s cash value or use the policy as collateral from the bank for secured funding. There may be restrictions on how much cash value your policy has to accumulate before you can start borrowing against it. Additionally, if you cannot make the loan payments and the collateral of the cash value has to be used, then the interest and the loan amount can cut into the policy’s death benefit.
What are the risks of corporate-owned life insurance?
Owning life insurance within a corporation has several advantages as discussed above. However, COLI can also have some unintended negative consequences.
When a shareholder of a corporation passes away, if they do not have a spouse to rollover their shares, they are deemed to have disposed of their shares of the corporation, immediately before death, at Fair Market Value (FMV). The cash surrender value (CSV) of the life insurance policy on the shareholder is included when computing the FMV of the shares. Thus, when a corporation owns a life insurance policy with a high CSV, the FMV of the shares of the deceased shareholder is also high. The deceased shareholder will therefore be subject to a large capital gain on the death and consequently, a significant tax liability.
To avoid this tax liability, there is a special kind of share called an insurance-tracking share. These shares are issued to the heirs of the estate (usually the business owner’s child). An insurance-tracking share tracks the cash value of a COLI insurance policy but doesn’t otherwise entitle the shareholder — typically, a child of the business owner — to dividends, proceeds on the sale of the business, or voting rights.
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The information provided herein is for general informational purposes only. It is not intended and should not be construed to constitute legal aid or financial advice.
- Business owners can use whole life insurance as a source of liquidity to achieve diverse estate planning goals
- A business owner may purchase life insurance personally or through his corporation
- A corporation may purchase life insurance policies to facilitate key man insurance, buy-sell agreements, or estate equalization
- While there are several benefits and flexible planning opportunities, there are also a number of additional complexities to consider for corporate-owned life insurance