A corporate life insurance policy refers to a life insurance policy taken out by a corporation. It is taken out for one or more critical employees, and the company receives all proceeds from the death benefit, in the event the insured employee passes away. There are many reasons why corporations opt to own a life insurance policy. The life insurance policy covers the expenses associated with hiring a new employee after the insured passes away. It works in favour of the company. It protects against financial losses due to losing a critical employee, which may be caused by the cancellation of economic projects the critical employee was running; it is also a great way of funding deferred compensation plans. Further, it ensures that the control of company shares remains with the owners.
Special tax exemption is granted to life insurance policy products, thus reducing the corporation’s tax burden and increasing after-tax net income, which could be used to finance employee benefits. These aspects of corporate life insurance policy make it essential for financial planning. Most amounts received as proceeds from life insurance are not subject to tax. Taxation of corporate-owned life insurance is mainly brought about by the variety in usage, resulting in certain tax consequences. Click here to learn more.
Business purpose and economic substance
Some companies use corporate life insurance policies to exploit tax grey areas. Stricter corporate-owned life insurance tax considerations have been put in place to reduce these tax loopholes exploitation. A business purpose is the first consideration in determining the validity of corporate-owned life insurance. The insurance must have an economic substance as well as a valid business reason. Economic substance means that a transaction, apart from tax deductions, will also produce economic benefits from a logical observation. If the transactions are purely for tax purposes, there will be taxation of the corporate-owned insurance policy.
Death benefit
Proceeds from death benefits are exempted from taxable income. For this to happen, corporate-owned life insurance must meet certain conditions. The insurance can only cover a certain number of people, and the corporation must also obtain the consent of covered employees. Failure to adhere to these conditions makes the corporation ineligible to enjoy the tax exemptions, and it can be hit with an income tax on the proceeds of the death benefit.
Taxable death benefit
The corporation still gets its money back free of income tax if the death benefit proceeds from corporate life insurance are taxable. The corporation can only exclude an amount restricted to the number of premiums it paid for the policy by the total amount of dividends paid. If the corporation settled $8000 in premiums, but only $3000 was spent in dividends, the corporation will exclude $3000 of the death benefit from taxable income.
Loan interest deduction
One of the benefits of a corporate life insurance policy is securing a loan against the policy. Borrowing against the policy is attractive as the interest rate is typically lower than loans taken from banks. Even after the loan has been paid out, the remaining cash value continues to gain interest. And the interest the corporation pays goes to a policy that the corporation owns. The corporation uses the policy as collateral, and therefore it can access financing with ease and without a lengthy process. There is also no fee involved, and corporations are at liberty to borrow for more than once. The downside to this is that if the corporation continues to borrow and it becomes too much, the policy might lapse, and it might owe taxes in excess.
If the loan is not paid back, the cash value reduces due to the loan’s interest. To some degree, the interest on the remaining cash value can be used to pay for the loan’s interest. Still, if the loan is not paid for long enough, the policy may be lost and may lead to the company-owned life insurance policy’s taxation.
Premium deduction
In some cases, the corporation can deduct premiums paid on the corporate-owned life insurance policy. The corporation can deduct premiums to compensate itself if it receives nothing from the proceeds of the corporate-owned life insurance policy. Although it cannot deduct the premiums’ cost, it will recover the cost from the proceeds free of income tax.
Life insurance as a corporate asset
When a corporation owns a life insurance policy, it is an asset, impacting the corporation’s financial statements. The market value of shares of a corporation is affected by the corporate-owned insurance policy. If the company were to be sold, the corporate-owned insurance policy would be considered one of its assets. A corporate life insurance policy is regarded as a passive asset, which means that the corporate-owned insurance policy’s value could be used to determine whether the corporation qualifies for the lifetime capital gains exemption for small business corporations. Valuation of the life insurance policy is determined by factors such as the insured’s health, cash value, and death benefit of the policy qualify for these exemptions. All their assets must be principally in active business. Having a corporate-owned life insurance policy could make it hard for the corporation to pass this test.
