LIFE INSURANCE SHARES – WHY YOU WANT THEM
The use of Life Insurance Shares (“LI Shares”) for estate purposes, succession planning and flowing of income out to beneficiaries at highly tax efficient rates is a useful tool to use for planning should this be a viable option. To begin, an LI Share is typically a non-voting preferred share with nominal value assigned. LI Shares are a great tool for reducing capital gains tax that arises on the death of a common stock shareholder. They are also commonly used for estate equalization purposes.
An LI Share is usually created after the company is already in existence. Typically, an LI Share is issued to the heirs of a shareholder. LI Shares must be created before any life insurance policies are put in force and after any significant reorganization of the company has occurred. Initially, the shares will only have a nominal value. Going forward, the LI Shares can be structured such that their value tracks the cash surrender value (“CSV”) and/or death benefit of a life insurance policy.
Once the LI Share is created the value of one or more specific life policies are attached to the LI Share. On the death of the common stock shareholder the value of the CSV may not be attributed to the value of the shareholder’s common stock. This in turn means there is a lessening of capital gains tax in the common shareholder’s estate. In accordance with the correct documentation, the value of the life insurance policy is paid to the specified LI Share. Subsequently, a dividend is declared on that specific class of LI Share, distributing the proceeds of the specified life policy to the specified heir through the Capital Dividend Account (“CDA”) mechanism.
A potential risk in the use of LI Shares exists if the LI shareholder dies before the participating shareholder and the LI shareholder has no spouse to take advantage of spousal rollover provisions. In this instance, the deceased LI shareholder’s estate will be forced to add the FMV of the LI Share to the rest of their estate value. This in turn means an increase in the value of their estate, potentially creating an increased tax burden, with no actual funds being created to pay for the increased liability. An option to avoid this issue would be to create a family trust. The trust would own the LI Shares and would have more than one beneficiary for distribution of the LI Share proceeds.
Under the new TOSI rules, it would be assumed that the LI Shares refer to shares of a private corporation issued to non-active shareholders who are relatives to an active (or formerly active) shareholder and tracks the life insurance in the corporation on the active (or formerly active) shareholder’s life. It would then be assumed that there are other related shareholders at the time of the dividend (and after the death) that would cause the TOSI rules to apply.
With respect to capital dividends, the TOSI rules do not apply to capital dividends. It is assumed that most of the value of the LI Shares relates to the capital dividend account that will be paid on these shares. While taxable dividends may be subject to TOSI, an exception may be available under the reasonability rules, but no comments with respect to life insurance have been provided on these rules by the Department of Finance or the CRA. Thus, in summary, no TOSI risk exists where a capital dividend is paid. If the share is sold (other than on death), the gain may be subject to TOSI if it is not a QSBC share.
A shareholder’s agreement designating the payout of the CDA on the LI Shares is essential and would be used to ensure that the applicable proceeds are paid on the preferred LI Shares. Without this type of agreement, taxable dividends could be paid on the life insurance shares and TOSI could apply (This can occur easily after the death of a voting shareholder if the voting shares are transferred to a beneficiary who wants to keep the CDA versus paying it to the preferred shareholder).
If implemented correctly with the knowledge of the new TOSI rules and consideration for certain legal and estate items, LI Shares can be extremely powerful in achieving tax efficiencies and estate equalization.