What are insurance-tracking shares?

You’ve invested a lot into your business throughout your life. Life insurance, specifically whole life insurance policies, can be used to ensure that your loved ones get to share in your success after you pass away. 

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 whole life insurance?

Whole life insurance, implying that you are covered for your entire life, is sometimes loosely used to refer to all categories of permanent insurance. However, there are different types of permanent life insurance Canadians can choose from. Besides whole life insurance, many Canadian companies also offer universal life insurance and term-to-100 insurance. 

Unlike term life insurance which covers you for a specific duration or term (10, 20, or 30 years), with whole life insurance you are covered for your entire life. Since you are covered for such a long time, whole life insurance usually has a higher premium. 

Find out the cost of whole life insurance for your unique needs. 

The most important differences between the types of permanent life insurance products have to do with whether you want:

• To have an investment component and
• To actively manage the investment account or let the insurance company managers run with it

Many whole life insurance products have an investment or cash value component associated with most whole life policies. As you pay into a whole life policy over time, part of the premium is invested and generates cash value. This cash value may be accessed during the insured’s lifetime either by withdrawing or borrowing against it.

With some whole life insurance policies, part of the premium that the policyholder pays can go towards an investment account that receives dividends, which can accumulate within the policy on a tax-deferred basis. This portion of the insurance plan can drive its cash value to be higher or lower than otherwise expected, depending on how the investments turn out.

Tax benefits of business-owned life insurance

A corporation can be the owner of a life insurance policy. A corporation-owned life insurance (COLI) allows the corporation to pay the premiums for the policy. The corporation can also be the beneficiary of the COLI and thereby collect proceeds upon the death of the person covered under the insurance policy. In most cases, the premiums are not tax-deductible (unless used as collateral for a loan), but they can still be financed by corporate dollars. Since corporate tax rates are usually lower than personal tax rates, paying for a whole life policy with after-tax corporate dollars is usually more efficient than using after-tax personal dollars. Due to the lower corporate tax rate, you can buy a lot more insurance coverage with your corporate cash flow than with your personal cash flow. Many business owners, therefore, prefer to have their life insurance coverage be owned and paid for by the business.

​​Once the insured individual passes away, the insurance proceeds are received by the corporation as the beneficiary. The insurance proceeds are tax-free to the corporation and an equivalent amount (net of any adjusted cost basis) is credited to a notional account also called the company’s capital dividend account (CDA). The proceeds held from the capital dividend account can be paid-out tax paid out tax-free to shareholders as a capital dividend. The CDA can be paid out tax-free as needed – immediately or any time in the future. The adjusted cost basis of the policy is determined by the insurance company and is calculated by subtracting the annual pure cost of the life insurance from the premiums paid

There are other additional strategies to benefit a business through life insurance such as key person insurance, buy-sell agreements, estate tax equalization, etc. Read more about the benefits of business-owned life insurance to see if your business can employ these tactics to ensure long-term success.

How cash values can affect taxes

In addition to your death benefit, a whole life insurance policy accumulates a cash value. Usually, you can pay a surrender charge or fee to cancel your whole life policy before the death benefit payout and receive the policy’s cash surrender value. Cash surrender values are additionally crucial to corporations who hold a whole life policy because the cash surrender value may become part of the corporation’s fair market value (FMV). This draws significant tax implications. Upon the death of the business owner, they may want their business passed down to their loved ones. The transfer of assets to a spouse is tax-free; however, transferring these assets to children is not. The cash value of the policy contributes to an increase in the FMV of the business owners’ shares. Upon passing away of the owner, the shares are assumed to have been disposed of, creating additional tax liabilities for the beneficiary. This is where insurance-tracking shares become useful as they help reduce or eliminate the taxable impact of cash surrender values upon the death of the insured.

What is an insurance-tracking share or life insurance share?

Insurance-tracking shares, also known as life insurance shares are a special class of shares issued for the primary purpose of tax-efficiently distributing corporate life insurance proceeds to the heirs of the insured shareholder. These shares are issued to mitigate the tax liability arising from an increase in the fair market value of the life insurance policy, upon the death of the insured shareholder.

Insurance tracking shares are typically issued to the heirs of the owner or controlling shareholder of a corporation. These are issued as non-voting, non-participating, shares redeemable for a nominal value of $1 at the discretion of the corporation, with no entitlement to any value other than some or all of the life insurance proceeds.

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. 

If you’re a business owner, you can use insurance-tracking shares to protect your assets from taxes (such as the ones incurred when transferring assets to your children) upon death. Insurance-tracking shares use a whole life policy’s value to transfer a business to the next generation tax-efficiently.

How do insurance-tracking shares work?

The logistics of insurance tracking shares are somewhat complex and require the help of an estate and tax lawyer to implement. In the simplest terms, your corporation would issue these preferred (tracking) shares prior to purchasing a whole life insurance policy. The preferred shares will be issued to track a life insurance policy’s cash surrender value without any dividend entitlement. The corporation would then obtain a whole life insurance policy and is also named as beneficiary of the policy. The preferred shares then increase in value of the corporation alongside the cash surrender value of the policy. 

Upon the business owner’s death, the whole life policy’s cash surrender value is attributed to the insurance-tracking shares and not the shares of the business owner. The proceeds of the life insurance are paid to the corporation which receives them as a credit to the Capital Dividend Account (CDA). The Corporation would then redeem the life insurance shares using the CDA. The outcome is a tax-efficient transfer of the business or proceeds to the next generation. 

Additional uses for insurance-tracking shares 

The proceeds can also be used to facilitate estate equalization. Estate equalization is a strategy to transfer assets in a fair manner to one or more beneficiaries. 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.

Want to learn more?

Implementing insurance tracking shares into your business protection plan can be a complex process and should be done before purchasing the life insurance policy. PolicyAdvisor’s licensed insurance experts can help you better understand what insurance products may be best for your situation and business. Book some time with us below and see how you can use insurance to best plan for the future of your business.