What is Corporate-Owned Life Insurance?
We all know that life insurance can help individuals cover debts and funeral costs and provide financial support for their families after they’re gone. But did you know that your corporation can also purchase life insurance to handle various issues that might come up after your death? It can be used to pay off corporate debts, strengthen operating capital, and buy out shareholders’ estates.
Business owners and decision-makers often depend on a few key people who are vital to the company’s success. If one of these crucial individuals were to pass away suddenly, it could have serious financial consequences. This is where Corporate-Owned Life Insurance steps in.
For Oracle RMS clients, especially those managing small—to medium-sized businesses, grasping the benefits of Corporate-Owned Life Insurance is essential.
What is COLI?
Corporate-Owned Life Insurance (COLI) is a life insurance policy that a company takes out on its key employees. The business owns the policy and is also the one that receives the payout if something happens to the insured employee.
If that employee passes away, the company gets a death benefit. COLI acts as a financial safety net, helping the company stay stable during tough times. It provides immediate cash flow that can be used to soften the blow of losing a key employee. This money can be used in different ways, like funding buy-sell agreements, covering the cost of finding a replacement or paying off company debts.
When the company receives the insurance proceeds, they aren’t taxed. Instead, the amount (minus any adjusted cost basis) is added to the company’s capital dividend account. This can then be distributed to shareholders as a tax-free capital dividend. The adjusted cost basis, determined by the insurance company, is calculated by subtracting the annual pure cost of the life insurance from the premiums paid.
Why Would a Company Get Corporate-Owned Life Insurance?
There are several business reasons why it might make sense for a company to own a life insurance policy. When done correctly, a corporate-owned policy can offer clear financial, tax, and legal benefits.
Lower premiums
One benefit of corporate-owned life insurance is that the premiums are paid with after-tax corporate dollars, which are taxed at a much lower rate than an individual shareholder’s personal income. In Ontario, the corporate tax rate on active business income is around 15%, and for investment income, it’s about 50%. Meanwhile, the top personal tax rate in Ontario is roughly 53.5%. So, using corporate dollars to pay for the premiums can be much more cost-effective.
Reduced taxes
Upon death, an individual’s property is considered to be sold at its fair market value. When it comes to shares in a corporation that owns a life insurance policy, the Income Tax Act requires the life insurance policy to be valued at its cash surrender value right before death. This amount is usually much lower than the policy’s payout after death and also less than the value of the property the corporation might have accumulated if it hadn’t bought the insurance.
As a result, purchasing life insurance can help reduce the taxes owed on shares of a private corporation upon death, since it typically results in a lower valuation of the corporate shares compared to if no life insurance had been bought.
Key person protection
Key person protection is crucial for a business because the death of a shareholder or key employee can create significant financial stress. Replacing a key person is often challenging, and even when a replacement is found, it may take months or years for them to reach the same level of effectiveness. This disruption can impact a small business’s efficiency and profitability.
Life insurance can help by providing the necessary cash flow to stabilize working capital, pay off debts, or cover the costs of hiring and training a replacement if a key executive passes away.
Loan protection
In small businesses, it’s common for lenders to ask the owner to personally guarantee loans. Sometimes, they may also require life insurance on key individuals for the length of the loan. Even if it’s not required, having life insurance is a smart move. A personal guarantee can become a liability for the owner’s estate, meaning the estate might be responsible for any business debts that aren’t paid off. Plus, having life insurance can make it easier for the business to secure financing.
Equal distribution
Estate taxes and equalizing inheritances can be tricky, especially when a family-owned business makes up the bulk of someone’s estate, and not all beneficiaries are involved in the company. Typically, the shares of the family business go to those involved in running it, while the rest of the estate is divided among the other family members.
The challenge is that there might not be enough cash available to cover the taxes on the deemed disposition of the shares or to provide equal value to the uninvolved beneficiaries. Corporate-owned life insurance can help by paying out proceeds to the estate through a capital dividend, which can be used to cover tax liabilities and ensure that all beneficiaries receive an equivalent share.
Shareholder buyouts
Private companies often rely on life insurance to fund buy-sell agreements that kick in when a shareholder passes away. The life insurance proceeds can be used to buy out the shares owned by the deceased shareholder’s estate or beneficiaries. This approach ensures the business can continue without disruption while providing cash to the deceased’s beneficiaries.
In many situations, the remaining shareholders may not want the deceased partner’s family involved in the business, and the family might prefer to receive the estate proceeds rather than stay involved. Corporate-owned life insurance helps make this transition smooth for everyone involved.
Contact Oracle RMS today
At Oracle RMS, we’re committed to guiding our clients every step of the way, even after they’ve purchased their policy. Every client is personally matched with an Oracle licensed insurance broker who is dedicated to meeting their specific Corporate-Owned Life Insurance needs. Request a free financial services quote today.
