Life Insurance Decisions In The Face Of Tax And Estate Planning

In Alberta, a farmer we ll call Bill has been a grain producer for 57 years. His wife, who we ll call Elizabeth, passed away not long ago, leaving Bill, now 84, to manage 5,000 acres of land. He has two children, a daughter, 44, and a son, 42, both of whom have built lives of their own off the farm.

The farm is incorporated and is able to take advantage of low small business tax rates. In 2000, Bill bought a long term business succession and estate plan that includes a $600,000 term to 100 life insurance policy with the idea that it would pay various taxes due when he passes away.

Ten years have passed and Bill now has concerns about the life insurance policy.

The policy is a major investment that costs $18,000 a year in premiums. Yet the term policy is only rented coverage. Unlike a whole or ordinary life policy, it builds no cash value. In effect, Bill is renting life insurance. Worse, he has to declare the $18,000 per year as a taxable personal benefit of the company-owned life insurance policy. Bill figures the money going into the policy is a waste. He is considering canceling the coverage. The question is, is that wise?

Farm Financial Planner asked Don Forbes, head of Don Forbes &Associates/Armstrong &Quaile Associates Ltd. based at Carberry, Man., to work with Bill in order to figure out if the life insurance policy is good value for the money.

In Forbes s view, the policy is a fair deal, but not necessarily the best way to handle the problem of succession to children who don t want to farm. There is a lot more that has to be done, he says.

The insurance policy, viewed just as insurance, is not a bad deal, Forbes says. The death benefit is guaranteed, the monthly premium of $1,500 is fixed and cannot be raised before age 100, he says. Moreover, if the policy were issued today with the same age for the insured it would cost 30 per cent to 40 per cent more. Bill has a better investment than the life insurance company anticipated in 2000.

The essence of the coverage is that the policy will pay tax on accrued but unrealized gains on the farm and deferred taxes. But in retrospect, the policy may not cover all taxes due. Today, if the farm were sold for cash, the machinery sold at auction at market value and the assets of the family farm corporation were liquidated and paid out to shareholders in the same year, the combined tax bill would be $1,300,000 consisting of an $800,000 income tax liability for the corporation and $500,00 for the shareholders.

These are numbers worked out a decade ago. Values and taxes today would be much higher, Forbes says.

In a worst case scenario, the income tax payable on the disposition, would be $1.3 million consisting of $800,000 tax due by the corporation and $500,000 at the shareholder level. It was a massive and unexpected burden, Bill says.

This estimate, done in 2000, came on top of a massive, 70 per cent capital loss on technology investments. Quite understandably, Bill is not eager to put more money into the stock market.


If Bill were to take a $5 million outstanding offer for the farm, he could replace the land he would sell with 2,000 acres of farmland near a major urban area in Alberta with a $4 million price tag. His $4 million capital gain on existing farmland would be transferred to the replacement land. The tax payable would be deferred and new land would be carried on the company books at zero value, Forbes says.

The $1 million that could be paid out of the present farming corporation would be used to purchase $1 million of farmland adjacent to the new farm corporation land. The family farm corporation would have a long term lease on Bill s daughter s personally owned farmland and would pay rent to her.

A new plan for control and transfer of the farming corporation would be complex, but would accomplish to goal of transfer of assets with minimum tax cost. The plan would freeze s Bill s estate so that the $4.5 million of net equity in common shares that Bill owns would be converted to $3.9 million of Class A preferred shares and $600,000 of Class I preferred shares. The taxable part of commons shares would be transferred to the preferred shares on a tax-free basis. The preferred shares would be carried on the farm corporation s books at zero book value but with a $4 million capital gain attached to them. That gain would be taxable at redemption of the shares.

One hundred common shares would be sold to the son at a nominal value. All the farm s value is in the preferred shares, but the son would get full operational control of the farm.

To equalize the cash value between the son and daughter, a $600,000 term to 100 life insurance policy would be issued on Bill. The policy would be owned and paid for by the family farm corporation. As part of their shareholder agreement, the farm corporation would pay $600,000 to the daughter tax-free through the company s capital dividend account. The farming corporation would issue a promissory note to the daughter for $400,000 with a payout to take place over the next ten years.

In this elaborate shuffling of paper, the daughter would get an interest in $1 million of farmland that she leases to the family farm corporation. She would get rent every year from this investment. The family farm corporation will pay $40,000 on a $400,000 note for ten years.

There would be a commitment from shareholders that the daughter would get $600,000 on Bill s death with proceeds to come from the life policy. The son would get 100 per cent of common shares in the family farm corporation with a net worth of $4.5 million. That s $4 million in land and $500,000 in machinery.

The corporation, which would be the son s, would take a $1.3 million liability for income tax, though that sum could be eliminated by implementation of the estate plan.

The corporation would be responsible for a $400,000 note to the sister and a $600,000 commitment to the sister payable on Bill s passing. The corporation would still have to pay $18,000 per year of premiums on Bill s term life policy. The son would be able to farm actively, perhaps on a part time basis, or could hire a farm manager or even rent out the operation to someone interest in active farming. For now, the son has no interest in running the farm.

In this plan, Bill would have achieved an estate freeze of $4.5 million and a way for his son to run the farm or at least to have someone else keep it running. His daughter would receive about $2 million as her legacy.

The key to the income tax reduction strategy is the use of the $750,000 Qualifying Small Business Corporation Capital Gains Tax Exemption. It is similar to the Qualifying Farm Property Capital Gains Tax Exemption, but it excludes the sale of assets. Only the sale of qualified company shares are eligible. The son has an agreement to purchase the parents preferred shares at a fixed value so that they generate a tax-free capital gain of $750,000 for Bill.

If the life insurance policy were to be discarded, the son would have to borrow $600,000 for his sister s interest in the farm business and $240,000 for income tax payable on the purchase of Class I shares. The son has already paid $180,000 through the farming corporation on premiums on a life insurance policy that has no cash value.

All things considered, this is no time to ditch Bill s term life policy. It is a key component of the estate plan, Forbes says.

AndrewAllentuck slatestbook,WhenCanIRetire?PlanningYourFinancialLifeAfterWork,waspublishedbyPenguinCanadaearlierthisyear


A new plan for control of the farm corporation would be complex, but would accomplish a transfer of assets with a minimum tax cost

About the author


Andrew Allentuck’s book, “Cherished Fortune: Build Your Portfolio Like Your Own Business,” written with co-author Benoit Poliquin, was recently published by Dundurn Press.



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