Does your future estate face a hefty tax bill?
How one business-owner couple used a unique insurance strategy – an Immediate Financing Arrangement – to meet multiple objectives
Former professional road-bike racers John and Mary,1 both 45, have built a successful business in a field they’re passionate about. Well known within the community of elite racers and weekend enthusiasts – referred to endearingly as “MAMILs” or Middle-Aged Men in Lycra, typically seen biking in large groups on weekends throughout many Canadian cities – their popular and successful bike store chain earns a large annual surplus. Recently, they were considering options to boost their corporate investment portfolio, ultimately to augment their income during retirement.
Having approached a Richardson Wealth Advisor, who created a customized financial plan, it became clear that they would face a substantial tax liability when they pass away. Their Advisor suggested purchasing a corporately owned participating life insurance policy to offset the tax liability. While the couple saw value in purchasing the policy, they were also concerned that diverting funds to a policy would impede their ability to grow their investment portfolio.
The couple’s Advisor explained how an Immediate Financing Arrangement (IFA) can address this concern in addition to providing John and Mary with insurance protection.
An IFA explained
An IFA allows investors like John and Mary, who have strong cash flow and high net worth, to secure a line of credit from a financial institution using the cash surrender value (CSV) of a permanent life insurance policy as collateral. (The CSV is the sum of money an insurance company pays to a policyholder in the event that their policy is voluntarily terminated before its maturity or an insured event occurs.)
Essentially, John and Mary deposited funds into a policy and applied for the line of credit. That is, they can borrow back most or all of the deposit amount to redeploy into their business or investment portfolio. The process is repeated each year that they are making deposits. As a loan advance, these borrowed amounts are received tax-free.
A step-by-step approach
Here is a breakdown of the approach that John and Mary took, prudently guided by their Advisor: They applied for a Joint Last to Die policy with an annual deposit of $100,000, for 20 years. In addition, they obtained a line of credit, which will provide an advance equal to the deposit each year, with a negotiated interest rate of 5%. The advance is then invested in a balanced portfolio with a projected rate of return of 5%.
Using available tax deductions
John and Mary’s company pays interest on the loan balance, and is able to use available tax deductions since the funds are being invested to earn income. The impact is a substantial reduction in the net out-of-pocket costs for the insurance. At the second death, the policy proceeds retire the loan, and a portion of the balance is used to pay the tax liability.
The couple is able to pay interest on the loan each year, which can reduce the costs of funding the policy in two ways: by claiming an interest expense deduction (as long as the loan is used to generate income); and by claiming a collateral insurance deduction if the policyholder and borrower are the same person.
For a corporate-owned policy, the total death benefit, less the adjusted cost basis (ACB), will generate a credit to the corporation’s capital dividend account (CDA).
Like John and Mary, if you are considering an IFA, be aware that in addition to qualifying for the insurance, you must also qualify for the loan. Specifically, you must qualify for life insurance based on health as well as for underwriting based on income, net worth and your ability to pay the premiums. You also need to have sufficient income that is taxed at higher rates to utilize the available tax deductions most effectively.
Additional collateral is often required in the early years of the insurance policy, since it takes time to accumulate sufficient cash surrender value to support the loan at the ratio negotiated, which is usually 90%. If the policy CSV does not grow as quickly as projected, this additional collateral may need to remain in place for a longer period of time. Alternatively, many lenders offer the option of tying the loan balance directly to the CSV amount. This would result in lower advances in the policy’s early years, but eliminate the need for any additional collateral.
As is the case with any strategy that involves borrowing, among the risks to consider is a change in the interest rate, which could affect policy performance and interest expense over the term of the loan arrangement. If rate changes result in the loan’s outstanding amount exceeding the negotiated ratio to the policy’s cash value, you may have to post additional collateral or repay a portion of the loan.
Also, John and Mary were advised and weighed the risk that they may not be able to use the interest expense deduction fully over the life of the IFA if their corporate or personal income levels decline, which will diminish the IFA strategy’s tax benefits. It’s also worth noting that the couple applied for the line of credit just like any other lending product. They, like any applicant, were required to have enough income to service the loan.
For John and Mary, the Immediate Financing Arrangement allowed them to tackle numerous planning issues including insurance coverage, investment opportunities and tax-efficient estate planning – all carried out in a cost-effective manner. If you are interested in learning more about this strategy, please contact our team.
1Client confidentiality has not been compromised here. Details provided for illustrative purposes only.