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Solving problems with life insurance

Life insurance, combined with fixed value corporate shares can solve succession problems

This month, I asked the experts a very direct question: “Can my incorporated farm business pay my personal life insurance premiums?”

The answer was reasonably clear:

Certainly, your farm corporation can pay your personal insurance premiums, but in general you will pay personal income tax on the premium amounts because they are a personal benefit to you.

That’s not to say there aren’t a few exceptions where a corporation can pay your life insurance premiums without personal tax consequences, but they are limited. One instance is where a bank or financial institution requires a corporation to take out life insurance on its principals to guarantee a bank debt.

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“If a farm corporation were to borrow $500,000 to buy land, and the bank made the farmer get a $500,000 life insurance policy to cover that bank debt, he or she could deduct the full amount of the premiums because in that case there’s a business reason for getting life insurance. Otherwise you can’t deduct the premiums against your taxable income,” says Matt Bolley, specialty tax business advisor at MNP.

The other instance is when the corporation is the beneficiary of the life insurance policy. “Let’s say a farmer takes out a life insurance policy for $500,000 and the beneficiary is named as the corporation. The corporation can make those payments out of the farm earnings, with no personal tax consequences to the farmer,” says Bolley.

Why it’s beneficial to do this is because corporations typically pay a much lower tax rate on income than individuals. “Farm corporations typically pay 10.5 per cent tax on income, and so the farmer is in essence keeping 89.5 cents on the dollar after the corporation pays tax on its earnings,” says Bolley. “An individual, who might have an average tax rate of 25 per cent, has only 75 cents on the dollar to pay that life insurance premium.”

The key point to keep in mind is the corporation has to be the beneficiary. You can’t take out a policy on yourself, make the kids the beneficiaries, and then have your business pay the insurance premiums without the tax man calling.

Life insurance as a transition tool

No matter who pays the premiums, life insurance isn’t just something you take out to make the bank happy or provide for loved ones in the event of your untimely demise, it can also be a valuable tool as part of a succession plan.

There are two main reasons why farmers might use life insurance as part of their transition planning, says Bolley. The first reason is tax issues. As an example, if farmers have assets that aren’t considered farm property, such as land they have rented out to neighbours, or other rental properties or assets that aren’t used in farming, these assets can’t pass on to the next generation without incurring tax. “What farmers will do is have life insurance available so that when they pass away, the life insurance is there to pay the tax, so it avoids the scenario where a beneficiary may have to go out and sell the asset in order to pay the tax on it,” says Bolley.

The second reason that farmers typically use life insurance is as a method to give funds to non-farming children. “The biggest dilemma in farm succession planning today is how to take care of the non-farming children without causing issues down the road for the farming children,” says Bolley.

Twenty years ago, the solution was pretty well always to split up the land and give some of that land to the non-farming kids so they had an asset, which they usually rented to the farming child. This gave non-farming kids a source of income from the land, and the farming child could keep using the land, and everybody felt they were fairly treated. The problem today is that this scenario doesn’t work very well when land can be worth $3,000 an acre or more.

“With the temptation of the large dollar amounts, for a lot of farm families it’s very difficult for the non-farming children to pass up the opportunity to cash in on the land value,” says Bolley. “If the farming sibling can’t come up with the money to buy the land, and if they don’t have the ability to get more credit from the bank, the land could end up being sold to pay the non-farming kids their share of its value.”

That uncertainty for kids who want to stay on the farm has steered some families away from using land as the equalizer, and instead using insurance, which the farm corporation can pay for from earnings, as long as the shareholder structure is set up correctly.

Typically parents decide on the amount of money they want the non-farming child to inherit and take out a life insurance policy for that amount through the farm corporation. Then they gift fixed valued corporate shares worth that amount to the child. Fixed value shares never increase or decrease in value, regardless of the farm’s performance. They are always worth the same amount as the day of issue. Once parents gift the shares, all parties usually sign a unanimous shareholders agreement, which binds all the shareholders. The non-farming child agrees not to touch the fixed value shares until Mom and Dad are both deceased. The farming child agrees to pay the insurance funds to the non-farming child as soon as the corporation receives them.

Using advisors

Because every farm is different, Bolley always advises clients to have as many people around the table as possible to make sure they choose the right kind of insurance that fits their situation. “Bring your accountant, lawyer, financial advisor and insurance broker to the table and decide what you want to happen when you pass away,” says Bolley.

Then you need to assess how much the farm is worth and based on that value, what you think is a fair amount to give to a non-farming child. Every family will doubtless have different opinions on what the number should be, but the main thing to remember is that in distributing cash and assets there can only be fairness, not equality. “The non-farming child is going to have a fixed valued asset when they walk away versus the farming child has something that could be hugely valuable,” says Bolley. “But as we’ve all seen in the farming sector, there can be tough times and the value of the farm asset itself, for farming children, is in so far as they can continue to make an income from it to support their family. In most cases they aren’t going to liquidate the asset for many years, if ever.”

Tax liability is also a consideration. In most cases when farm families pass farm assets on to immediate family there is zero or minimal tax liability for the next generation if they continue to farm. In this case parents don’t need to worry about life insurance to cover taxes.

But what happens if the succession plan involves a nephew or a niece? “The Income Tax Act doesn’t let you gift a farm to a niece or a nephew on your death,” says Bolley. “That person would have a bigger tax bill to pay, so whatever tax bill your assets would incur today, should be the starting point to get at least that amount of life insurance to help cover it.”

In reality, it comes down to deciding what the family is comfortable with. If Mom and Dad are comfortable giving away land to non-farming children, and the farming children are comfortable with that arrangement, they maybe don’t need any life insurance. If they want the whole farm, including land, to go to the farming child, then that’s where life insurance would come into play to provide cash for the non-farming children. But, says Bolley, don’t buy insurance without doing the share restructuring and putting written agreements in place. “You never want to assume the worst about a family dynamic, but there are lots of families that have had issues for one reason or another that came out of the blue,” says Bolley. “If you don’t protect yourself, then you could leave yourself open to not having anything to live off of down the road.”

There are definitely some tax advantages to life insurance, and it can be a sound and important part of an overall succession plan for sure, but probably the best advice is to buy early. The earlier that you buy life insurance, the less expensive the premiums will be on a whole life policy, and the sooner you can get insured. “We’ve run into issues with insurability when people put it off,” says Bolley. “I’ve had clients come into my office who are healthy people today, but who had a minor health condition five years ago, and the insurance company says based on your age and this condition, we won’t insure you. All of a sudden the plans go out the window.”

It’s crucial to get the right type of life insurance, adds Bolley. “I know some clients who have bought term life insurance and when they reach 70 it’s so expensive they have to give it up, and they’re back to the drawing board because they didn’t buy the right type of insurance to meet their objectives,” he says.

New tax rules coming soon

Finally, there are some new tax rules coming into effect January 1, 2017 that will reduce the amount of life insurance proceeds that can be paid out of a corporation tax free to redeem fixed value shares held by another family member. “Currently, most of the life insurance proceeds in this situation would come out of a corporation tax free as a capital dividend account, and just a small portion would be considered a taxable dividend to the person receiving the funds,” says Bolley. “Those rules are changing and the taxable portion is going to increase.”

The amount that will be taxable is based on a number of complex factors and circumstances, and will vary from policy to policy, so people should talk to their insurance company to find out how the current rules will compare to the new rules in relation to how it will affect their life insurance policy after the new year.

“I wouldn’t advise anyone to run out today and buy insurance if they have no need for it but if they think that life insurance is definitely part of their plan, or they’ve discussed it with their advisers and they’ve recommended insurance, now is the time to go buy it because it’s going to still be a good tool, but it’s a far more tax effective tool today than it will be after the end of this year,” says Bolley.

About the author

Contributor

Angela Lovell

Angela Lovell is a freelance writer based in Manitou, Manitoba. Visit her website at http://alovell.ca or follow her on Twitter @angelalovell10.

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