Innovative uses of life insurance in estate planning
Life insurance can be used for a large number of innovative estate planning strategies that go far beyond the tax free death benefit provided by the insurance contract.
Universal life insurance can combines both elements of protection and investment. The investment portion of the contract enjoys certain tax preferences that makes life insurance a unique investment vehicle. Some of the more innovative strategies are described briefly below. The purpose of this summary is not to provide an exhaustive look at these strategies (nor to address all of the tax and financial issues relating to each individual strategy) but rather to introduce a sampling of the planning opportunities that are available using life insurance as part of the integrated overall estate plan.
1. Estate Maximization
Many affluent individuals, particularly retirees, own assets well in excess of that needed to maintain their lifestyle.
Many such individuals will retain and invest certain assets which they intend to gift to family members upon death. These assets may be invested in a variety of tax exposed vehicles including GICs, bonds, segregated funds and mutual funds. If a portion of these funds were allocated to an insurance contract, the investment returns could be greatly enhanced by virtue of the tax free accumulation within the insurance policy and tax free death benefits.
In other words, an exempt life insurance contract provides an investment opportunity through which it is possible to maximize estate values by providing a tax preferred investment vehicle.
The ability to accumulate wealth, tax free, within an insurance policy will compare favourably with alternative investments which do not enjoy the tax treatment available to life insurance.
Further, the insurance contract provides an element of creditor protection which is not available through conventional investments [Under subsection 196(2) of the Insurance Act R.S.O. 1990, c.1-8, "the rights and interests of the insured in the insurance money and in the contract are exempt from execution and seizure" when a spouse, child, grandchild or parent of the life insured is designated beneficiary of the contract.] as well as the opportunity to bypass probate fees as a result of the ability to designate a named beneficiary.
The concept of estate maximization can also be extremely attractive in the corporate context.
Maximum funding of a corporate owned life insurance policy provides several benefits.
In addition to accumulating wealth tax free within the corporation, the insurance proceeds will generate a CDA (Capital Dividend Account) credit.
Thus investments which would have been "trapped" in the company (from a tax perspective) can be converted into investments that (i) grow tax free and (ii) can ultimately be extracted from the company, in whole or in part, tax free through the CDA (Capital Dividend Account).
2. Leveraged Life Insurance
The ability to accumulate wealth tax free within an exempt insurance contract is clearly an attractive estate planning opportunity.
Traditionally, however, there have been limited means by which to access that wealth. The traditional methods of accessing the wealth within the insurance contract (aside from death of the life insured) were limited to partial cash withdrawals, policy loans or surrendering the policy.
Unfortunately, each of these traditional methods constituted a taxable disposition of the contract. More recently, a variety of strategies have been implemented whereby the cash/wealth within the contract is kept intact but the policy is collaterally assigned to a third party lender to support a loan, or a series of loans, the usual purpose of which is to supplement the policyholder's retirement income.
The collateral assignment of a life insurance policy is explicitly excluded from the definition of "disposition" of an interest in a life insurance policy at subsection 148(9).
Thus this method permits indirect access to the cash values without triggering a tax liability or encroaching on the accumulated wealth within the policy.
A typical leveraged life insurance strategy would operate as follows.
An individual (generally between the ages of 30 and 55) would acquire an exempt life insurance policy and maximum fund the policy for a number of years.
The excess deposits would accumulate tax sheltered within the contract.
At some point in the future, the policyholder has the option to collaterally assign the contract to a bank.
The bank will provide a loan or series of loans to the policyholder supported by the collateral assignment of the insurance policy. Interest on the loan will be capitalized.
A limit on the loan would be set as a maximum percentage of the cash surrender value of the policy (say, 75%). [If the loan grows to a point where it exceeds this maximum percentage the lender could demand partial repayment of the loan, the provision of alternative security or the lender could exercise its rights under the collateral assignment and surrender the policy.]
Upon the death of the life insured the lender will receive repayment of the outstanding loan out of the part of the insurance death benefit.
The balance of the death benefit will be paid to the policyholder's estate or named beneficiary.
A fairly typical leveraged life insurance strategy is outline in Table 2 below.
A 45 year old male non-smoker acquires a universal life insurance contract. (The example is based on Manulife Financial's InnoVision universal life insurance.)
The death benefit under the policy is face amount plus cash value.
The initial death benefit is $500,000.
The annual cost of insurance is $4,200.
The client, in fact, will contribute $20,000 per year to the contract for 15 years. The excess premium deposits are assumed to earn 6% within the contract.
At age 65 the client will commence a series of loans using the contract as collateral security. The borrowed amount will be $34,500 per annum. Interest on the loan will be capitalized.
At life expectancy of 81 years the outstanding loan is $1,220,000 and the total death benefit is $2,128,000.
The excess amount of $908,000 will go to the client's estate or named beneficiary.
TABLE 2
LEVERAGED LIFE INSURANCE
Client Male, 45, non-smoker
Face Amount of policy $500,000
Annual premium payment $20,000
Duration 15 years
Total deposits $300,000
Life insurance interest rate 6%
Annual loans commence Age 65
Annual loan amount $34,500
Bank loan interest rate 8%
Total advance $552,000
Total death benefit at age 81 $2,128,000
Loan balance at age 81 $1,220,000
Excess insurance proceeds $908,000
Leveraged life insurance strategies can also be implemented in the corporate context where a private corporation could maximum fund the contract and leverage the contract at some point in the future. The loan proceeds could be used in the operations of the corporation or distributed by way of salary or dividend to the owner/manager.
Clearly, there are a number of issues and risks, both tax and financial, which must be considered when contemplating a leveraged life insurance strategy.
Tax issues would include whether or not the interest is deductible for tax purpose; whether the loan be construed as a policy loan, whether the general anti-avoidance rule apply to the series of transactions and possible changes to the Tax Act which could impact long term planning.
In the corporate context it would also be necessary to consider if the arrangement could be characterized as a retirement compensation arrangement and therefore be subject to the stringent tax rules impacting such plans and whether there are any shareholder benefit concerns.
Financial considerations would include the rate of return within the contract and the rate of interest on the bank loan (which would not be linked). Other factors include the client living past life expectancy recognizing that the bank loan will continue to grow.
Leveraging strategies are certainly not for everyone and are not for the faint of heart.
Nevertheless, in the right circumstances leveraging can be an extremely attractive planning opportunity and a method of accessing the investments benefits associated with life insurance policies during the owner's lifetime rather than at death.
3. Generation Transfer
Many parents and grandparents wish to implement savings plans for their minor children and grandchildren.
The various attribution rules contained in the Tax Act thwart certain of the tax advantages associated with such savings plans.
An exempt life insurance policy can represent an attractive investment vehicle which, in the right circumstances, can achieve effective income splitting and can be transferred to the child on a tax rollover basis.
Normally, where a life insurance contract is gifted to a non-arm's length party the transferor is deemed to receive consideration equal to the cash surrender value of the contract. (Subsection 148(7).) However, under subsection 148(8), a rollover is available for certain intergenerational transfers of life insurance policies. Where the rollover is available, the transferor will be deemed to have received proceeds of disposition equal to the adjusted cost basis of the policy.
The rollover is available where:
1. A life insurance policy is transferred for no consideration to the policyholder's child [For purposes of the rollover, a "child" is defined as including a grandchild or great-grandchild of the transferor policyholder or an individual under 19 years of age who is wholly dependent of the policyholder for support]; and
2. The life insured is a child of the policyholder or a child of the transferee.
This rollover opportunity can be utilized to accomplish income splitting with minor children.
In its simplest form, a parent could take out a policy on the life of a minor child and maximum fund the contract.
The parent could transfer the policy to the child when the child reaches the age of majority.
It would also be possible for a grandparent to take out a policy on the life of a parent.
The grandparent could maximum fund the policy and subsequently transfer the policy to a grandchild on a rollover basis.
When the child (or grandchild as the case may be) reaches the age of majority, she could withdraw sums from the contract.
Those withdrawals would be taxable to the child or grandchild; but presumably the child/grandchild would be in a low tax bracket at the relevant time. Any withdrawals prior to the age of majority would result in income attribution back to the parent or grandparent transferor.
4. Insured Life Annuity
Many retirees own significant non-registered investments which they plan to use to supplement retirement income. Retirees are often conservative investors. These individuals are often classified as "GIC refugees" who are concerned with current low interest rates. Low interest rates could force these individuals to encroach on capital to maintain their lifestyle. However, they may also wish to maximize estate values and are concerned about encroaching on assets which they would like to gift to their heirs.
The insured annuity is a strategy designed for those seniors who wish to maximize cash flow without reducing the future value of their estate.
Under an insured annuity plan, a portion of the accumulated wealth would be used to purchase a life annuity (with or without a guaranteed term).
The annuity would be structured as a "prescribed annuity contract" (As defined at Regulation 304) thereby qualifying for level taxation.
The individual would also acquire a Term-to-100 life insurance policy with a death benefit equal to the amount used to purchase the annuity.
A portion of each annuity payment would be used to fund the insurance premium.
In many cases, the net after tax and after insurance premium payment received under the annuity will exceed the after tax yield on fixed income investments.
By way of example, consider a healthy 70-year-old male non-smoker.
This individual has $200,000 in a GIC paying 6%.
The individual is in a 50% tax bracket.
The after tax amount received from the GIC is $6,000.
This individual could use the $200,000 to acquire an annuity that would pay $21,325 per year for life.
The taxable portion would be $6,510.
The individual would also acquire a Term-to-100 life insurance policy with a $200,000 death benefit.
The annual premium would total $8,266 (Based on Manulife Financial's Signet Term-to-100 policy.).
The net after tax and after premium amount retained by the individual totals $9,804; which compares very favourably with the $6,000 available through the GIC.
An additional benefit of this strategy is the fact that the death benefit can be paid to a named beneficiary thereby avoiding probate.
One disadvantage of the strategy is that it is difficult to undo and could prove unattractive if interest rates spike upwards in the near term.
5. Planned Giving
The 1996 and 1997 Federal Budgets introduced significant proposals designed to encourage planned giving in favour of Canadian registered charities.
These enhanced gifting rules can be combined with the attributes of exempt life insurance to create attractive gifting strategies. Consider the following two examples.
A donor wishes to gift publicly traded securities to a charitable organization.
The securities have a fair market value of $500,000 and an adjusted cost base to the donor of $100,000.
The gift will result in a capital gain of $400,000 and a taxable capital gain of $150,000.
The net benefit of the gift is equal to the sum of (i) the adjusted cost base of the shares to the donor plus (ii) the tax-free portion of the capital gain ($100,000 + $250,000 = $350,000). It is assumed that the donor has sufficient income to claim the gift fully in the current year. Assuming a top marginal tax rate of 50%, the gift effectively results in a net tax saving of $175,000.
Assuming the donor is a 45 year old male non-smoker the tax savings could be invested in an exempt universal life insurance policy which could fully fund a death benefit in excess of $1,600,000 assuming an internal interest rate of 6%. Through the insurance contract the donor has provided his estate with replacement value well in excess of the value of the gifted property.
An alternative strategy takes advantage of the new rule permitting donations of 100% of net income in the year of death.
Consider a prospective donor who wishes to make a significant gift to charity by way of will.
The donor owns a registered retirement income fund ("RRIF") and is receiving minimum payments in respect thereof.
In the year of death the value of the RRIF will be included in the donor's income.
The donor could acquire a life insurance policy and name her estate as beneficiary. In her will she would provide for a gift of an amount equal to the value of the RRIF at the time of death.
The gift would be funded using the insurance proceeds. In the result the RRIF can be bequeathed to a named beneficiary and the insurance funded charitable gift effectively offsets the tax liability in the year of death otherwise associated with the RRIF.
6. Split Dollar
Split dollar or shared ownership is simply a creative method of owning and funding a life insurance policy.
Under a split dollar arrangement two parties are owners of interests in an insurance contract.
The death benefit under the contract is face amount (the level death benefit) plus account value.
One party pays for and is the beneficiary in respect of a level death benefit provided by an exempt life insurance contract.
The other party to the split dollar agreement pays for and is the beneficiary in respect of the account value portion of a contract. [Revenue Canada has indicated that the premium allocation in a split dollar insurance arrangement should be "reasonable" and reflect the costs the parties would pay for similar rights and benefits.
Thus the owner of the level face amount should pay an amount equal to the amount payable for "equivalent term coverage" and the account value owner pays the balance.]
Split dollar ownership allows a party who needs pure insurance protection to obtain that protection at a relatively low cost while at the same time providing a party who desires a tax preferred investment vehicle with a pure tax sheltered investment opportunity.
Split dollar ownership can be an attractive structure in a variety of circumstances.
For example, a corporation may need life insurance for key person protection or to fund the buy-sell provisions of a shareholder agreement.
At the same time the individual shareholders may have investment dollars available.
The shareholders and corporation could enter into a split dollar arrangement such that the corporation would pay for and own the level death benefit while the shareholders can use the contract as a tax preferred investment vehicle.
Split dollar funding can also be incorporated into executive compensation plans whereby a corporation and an executive will co-own an insurance policy and the executive can receive bonus payments the after tax amount of which can be invested in the policy.
At the time of retirement the executive could either leverage the policy or make withdrawals from the policy to supplement retirement income.
Properly structured, this approach can be implemented in a manner to avoid application of the retirement compensation arrangement rules at Part XI.3 of the Tax Act.
7. Trust Planning
The 1994 federal budget introduced two significant changes to the taxation of family trusts.
First, the budget restricted the availability of the preferred beneficiary election to disabled beneficiaries.
Secondly, the ability to defer the 21-year deemed disposition rule was eliminated.
The inability to defer the 21-year deemed disposition rule creates serious problems for many estate plans.
The most common solution to avoid application of the rule is simply to distribute the trust property to the beneficiaries on a rollover basis prior to the deemed disposition.
Unfortunately this may not always be possible (if it conflicts with the express terms of the trust) or desirable (if it conflicts with the settlor's overall objectives).
One possible solution to the 21 year deemed disposition rule is having the trust invest in an exempt life insurance policy.
The 21 year deemed disposition rule applies to capital property; however, life insurance is not capital property and the deemed disposition rule will not apply to life insurance.
A second attractive planning opportunity involving trusts and life insurance is the testamentary insurance trust.
Such a trust can be the designated beneficiary of a life insurance contract.
Properly structured, the insurance proceeds will not attract probate fees as the proceeds will be paid directly to the trust and would not flow through the estate.
Further, Revenue Canada has confirmed that such a trust, properly structured, will be treated as a testamentary trust for tax purposes. (See Revenue Canada Technical Interpretation 9605575 dated December 17, 1996.) As a testamentary trust any income earned by the trust will be taxed at graduated rates rather than the top marginal rate applicable to inter vivos trusts.
Conclusions
Life insurance can be a key component in a large number of estate planning strategies.
Modern life insurance products and planning strategies using those products have evolved greatly over the years.
Today, life insurance is more than just tax free proceeds on death.
Whether using traditional planning strategies or innovative strategies, life insurance represents a unique financial instrument and a unique planning tool.
Life insurance can provide pure insurance protection, tax preferred investment, creditor protection and probate relief.
It can be used to create an estate, preserve an estate, maximize an estate or equalize an estate. It can also be used as a tool for growing corporate assets tax free and ultimately extracting corporate values on a tax efficient basis.
Modern life insurance products can provide more than just insurance protection; they can represent a crucial component in designing the most tax effective solutions for complete estate planning.
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