Estate Planning With Permanent Life Insurance in Canada

Introduction

Canada has no estate tax. What it has instead is a deemed disposition on death, which for many estates produces a comparable result.

On death, a person is generally treated as having sold their capital property at fair market value. Accrued gains that were never realized during life become taxable in the final return. Registered plans are generally brought into income in full unless they pass to a surviving spouse.

The resulting liability falls due at a point when the estate may hold substantial value but little cash. This is the problem permanent life insurance is most often used to solve, and it is the problem worth understanding before considering the solution.

The Liquidity Problem

The difficulty is rarely the size of the estate. It is the composition.

An estate consisting of a private company, a rental property and a cottage can be worth a great deal while holding almost nothing that can be used to pay a tax bill.

The executor’s options in that situation are limited. Assets can be sold, often under time pressure and at a discount. The estate can borrow, assuming a lender can be found and the terms are acceptable. Or an instalment arrangement can be sought where the circumstances permit it.

Each of these is worse than having cash available. Insurance proceeds arrive at the moment of death, in cash, in the amount contracted for, which is why the structure appears so frequently in estate plans.

Matching the Coverage to the Liability

The starting point is an estimate of what the liability will actually be.

The components typically include:

• Accrued gains on real property other than a principal residence
• Accrued gains on private company shares
• Registered plan balances not passing to a spouse
• Probate or estate administration fees, depending on the province
• Outstanding debts and the costs of administering the estate

That estimate should be revisited periodically. Asset values move, and a policy sized against a calculation made fifteen years ago is unlikely to match the current position.

The common error is in both directions. Some estates are underinsured because asset values have grown. Others are overinsured because the plan assumed a liability that a spousal rollover or a subsequent sale has since removed.

The Spousal Rollover and Timing

Where assets pass to a surviving spouse, the liability is generally deferred rather than eliminated.

This changes what the insurance is for. Coverage on the first death may be unnecessary if everything passes to the spouse, while coverage on the second death is where the liability actually crystallizes.

Joint last-to-die coverage is designed for exactly this situation. It pays on the second death, which is when the funds are needed, and it generally costs less than individual coverage on either life because the insurer’s exposure is deferred.

For couples whose estate plan relies on a rollover to the survivor, this structure usually fits the need more precisely than individual policies do.

Equalizing Between Beneficiaries

A second use arises where the estate includes an asset that cannot be divided sensibly.

A family business that one child works in and others do not. A farm. A cottage that one branch of the family uses.

Dividing the asset itself is often impractical and sometimes destructive. Leaving it to one beneficiary and nothing comparable to the others creates a different problem.

Insurance proceeds can fund the difference, allowing the asset to pass intact to the beneficiary best placed to hold it while the others receive equivalent value.

This works well, but it requires the amount to be set deliberately and reviewed as the asset’s value changes. An equalization plan built around a business worth a certain amount a decade ago will not equalize anything today.

Ownership and Where the Proceeds Land

Who owns the policy determines where the money arrives, and that determines whether it can be used for the intended purpose.

A personally owned policy with a named beneficiary pays directly to that beneficiary, outside the estate and generally outside probate. This is efficient, but the proceeds belong to the beneficiary rather than to the estate, so they are not available to the executor to pay the estate’s tax liability unless that beneficiary chooses to make them available.

A policy payable to the estate is available to the executor but passes through the estate and may attract probate fees.

A corporately owned policy pays to the corporation, and the proceeds then have to be moved out to the estate or shareholders, which is achievable largely without tax but requires steps to be taken.

None of these is universally correct. The right structure depends on who needs the money and for what.

The Corporate Dimension

For business owners the picture is more involved, because the liability and the funding often sit in different places.

The tax arises on the shares personally. The capacity to fund premiums usually sits in the corporation. The proceeds, if the corporation owns the policy, arrive in the corporation rather than in the estate.

Moving those proceeds out to the estate without tax is possible and is one of the strongest features of corporate ownership, but it depends on the amount available to distribute, which is the proceeds reduced by the cost basis of the policy.

That available amount should be projected against the expected liability rather than assumed to cover it. The two figures are calculated differently and there is no reason they will match.

Reviewing the Plan

Insurance placed for estate purposes tends to be set up carefully and then left alone for decades.

The policy itself generally requires no attention, which is the problem. Nothing about it signals that the plan around it has gone out of date.

Asset values change. Beneficiaries change. Businesses are sold. Corporate structures are reorganized, and policies are easy to overlook in a reorganization. Marital circumstances change, which affects both beneficiary designations and the availability of a rollover.

A periodic review against the current position, rather than the position at the time of purchase, is the single most useful habit in this area.

Common Planning Mistakes

Several errors recur.

Sizing coverage against a liability estimate that is years out of date.

Naming a beneficiary directly when the funds were intended to be available to the executor.

Assuming corporate proceeds will fully cover a personal liability, without projecting the amount actually distributable.

Leaving ownership and beneficiary designations unreviewed after a corporate reorganization or a change in family circumstances.

Drawing on a policy during retirement that was purchased to fund the liability at death, without revisiting the plan it was supporting.

Conclusion

The deemed disposition on death can produce a substantial liability in an estate holding little cash, and permanent life insurance is the most direct way to provide that liquidity.

Coverage should be sized against a current estimate of the liability and revisited as asset values move, since errors occur in both directions.

Where assets pass to a surviving spouse the liability is generally deferred, which often makes joint last-to-die coverage the better fit.

Ownership determines where the proceeds arrive. A named beneficiary receives them directly but the executor cannot compel their use, a policy payable to the estate is available but passes through it, and a corporately owned policy requires steps to move the funds out.

The plan should be reviewed periodically against the current position, because nothing about the policy itself will indicate that the circumstances it was built for have changed.

Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.

This article is written for educational purposes.
 

Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at info@taxpartners.ca, or by visiting our website at www.taxpartners.ca.
 

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