Life Insurance Proceeds and the Capital Dividend Account

Introduction

When a private corporation receives the death benefit from a policy it owns, the proceeds arrive free of tax. That much is widely understood.

What is less understood is that the amount which then becomes available to distribute to shareholders without tax is not the full death benefit. It is the death benefit reduced by the adjusted cost basis of the policy.

For some policies that reduction is negligible. For others it removes a substantial portion of what the shareholders expected to receive. The difference is largely determined by decisions made years or decades earlier, and by the simple passage of time.

The Basic Mechanism

A private corporation maintains a notional account tracking amounts it has received that can be passed to Canadian resident shareholders without further tax.

Life insurance proceeds are one of the principal contributors to that account. Where the corporation owns a policy and receives the death benefit as a consequence of the death of the life insured, the amount credited is the proceeds less the adjusted cost basis of the policy to the corporation.

The corporation can then distribute that credited amount to shareholders as a capital dividend, free of tax in their hands, following the required election.

The structure produces an outcome available with few other corporate assets. Value moves from the corporation to the shareholder or the estate without the usual cost of extraction.

What Adjusted Cost Basis Represents

Adjusted cost basis is the tax cost of the policy. It is not the total of premiums paid, and the gap between the two is the source of most of the confusion in this area.

The figure is built from amounts that increase it, principally premiums paid and the cost of acquiring the interest, and amounts that reduce it, principally proceeds previously received and an annual deduction representing the mortality cost of the coverage.

That annual deduction is the key component. It is a prescribed amount determined by the insurer, and it increases as the insured ages.

The elements that drive the figure in most policies are:

• Premiums paid into the policy over time
• The annual deduction for the cost of providing the coverage
• Any amounts previously withdrawn or borrowed from the policy
• Non-deductible interest on any policy loans

Why the Credit Grows Over Time

Because the annual mortality deduction increases with age while premiums are often level or paid up after a period, the adjusted cost basis follows a predictable shape.

It rises in the early and middle years of a policy, as premiums outpace the deduction. It reaches a peak. It then declines, and in many long held policies it approaches nil.

The consequence for the capital dividend account is direct. A death occurring while the basis is near its peak produces a reduced credit. A death occurring decades later, with the basis close to nil, produces a credit approaching the full death benefit.

This is one of the few areas of tax planning where simply holding an asset longer improves the outcome, without any action required from the owner.

The Same Feature Works Against Lifetime Access

The declining basis is favourable at death and unfavourable during life.

A corporation accessing cash value through a surrender or a policy loan is taxed on the amount by which the proceeds exceed the basis. A lower basis means a larger taxable amount.

So a policy optimized for the death benefit outcome is, by the same mechanism, becoming progressively more expensive to access during life.

A corporation holding a policy for estate purposes and one holding it as an accessible reserve therefore want different things from the same number. Clarity about which objective is primary should come before the policy is purchased, not after.

Ownership and Beneficiary Structure

For the credit to arise in a particular corporation, that corporation must receive the proceeds.

This sounds obvious and is frequently where structures fail. Arrangements in which one corporation pays the premiums while another entity is named beneficiary can produce a credit in the wrong place, or a reduced credit, or shareholder benefit exposure.

Rules introduced in recent years tightened the treatment of several such structures, including cases where a beneficiary corporation had no cost basis in a policy another entity had funded.

Groups that have reorganized since their policies were issued should confirm that ownership and beneficiary designations still match the original intention. Policies are easy to overlook in a reorganization because nothing about them appears to change.

Policies Transferred Into a Corporation

Where a policy was moved into a corporation at some point in its history, additional reductions to the credit may apply.

These rules were introduced to address arrangements in which a shareholder transferred a personally held policy into a corporation for an amount exceeding its cash surrender value, extracting corporate funds with little tax cost, while the corporation later claimed a full credit on the death benefit.

The reductions can apply to transfers made well before the rules were announced, provided the death occurs afterward.

For any corporation holding a policy that was not originally issued to it, the transfer history should be documented and the effect on the expected credit confirmed in advance.

Estimating the Credit in Advance

The credit can be estimated at any time, and for planning purposes it should be.

The adjusted cost basis is maintained by the insurer. It should be requested in writing rather than estimated, and it should be requested periodically rather than once, because it changes every year.

With a current figure and the death benefit, the expected credit is straightforward to project. Where a plan depends on distributing a particular amount to an estate without tax, that projection is worth revisiting as part of an annual review.

Projections prepared when a policy was first issued will not reflect the current position, since the basis has moved considerably in the intervening years.

Where the Shortfall Is Felt

The practical consequence of underestimating the reduction appears at the worst time.

A shareholder dies. The corporation receives the death benefit. The estate expects to receive a specified amount without tax, often because that amount was built into a plan for funding the tax liability arising on death or for equalizing between beneficiaries.

If the available credit is smaller than assumed, the shortfall must be distributed as a taxable dividend instead, with the associated tax cost falling on the estate at a point when liquidity is already under pressure.

The remedy is arithmetic performed in advance, not a provision in the Act.

Common Planning Mistakes

Several errors recur in this area.

Projecting the credit on the full death benefit rather than the amount net of adjusted cost basis.

Using cumulative premiums paid as a proxy for the basis, which generally overstates it in a long held policy and understates the credit.

Leaving ownership and beneficiary designations unreviewed after a corporate reorganization.

Overlooking that a policy was transferred into the corporation at some point, and the reductions that may follow from it.

Preparing the estate plan around a figure calculated years earlier and never revisited.

Conclusion

Where a private corporation receives a death benefit under a policy it owns, the amount credited to its capital dividend account is the proceeds less the adjusted cost basis of the policy.

Adjusted cost basis is not premiums paid. It is reduced annually by a prescribed amount reflecting the cost of the coverage, which increases as the insured ages, so the basis typically rises, peaks and then declines toward nil over a long holding period.

A longer held policy therefore generally produces a larger credit, while the same declining basis makes lifetime access to the policy progressively more expensive.

Ownership and beneficiary structure determine whether the credit arises in the intended corporation, and policies transferred into a corporation may carry additional reductions.

The current figure should be obtained from the insurer and the expected credit revisited periodically, because an estate plan built on an outdated projection will discover the gap at the point it can least afford to.

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.
 

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