Life insurance is often viewed as a pure risk management tool. Yet, consider that a permanent life insurance policy with a cash value component, such as universal life or whole life, may also act as a flexible planning tool to support tax planning, fund liquidity needs or facilitate business succession planning.

As the cash value component grows, it may be accessed while the policy continues to provide protection. Generally, this can be done in three ways: i) Withdraw the cash value; ii) Borrow from the insurance company based on the policy’s terms; or iii) Use the cash value as collateral for a third-party loan, through an immediate financing arrangement (IFA) strategy.

For high-net-worth individuals and business owners who are comfortable using leverage, an IFA has the potential to be a flexible financial planning tool. The IFA assigns the policy to a lender, such as a bank, as security for the loan, which typically can be between 50 and 100 percent of the cash value. The individual or business pays loan interest to the lender going forward. While the loan can be repaid at anytime, the intent is often for it to be repaid upon the death of the insured. Upon death, the life insurance death benefit proceeds would be used to repay the bank loan. Any insurance proceeds remaining after the loan repayment would be paid tax-free to a named beneficiary.

An IFA arrangement may provide various benefits, including:

Tax Planning — Compared to other ways of accessing a policy’s cash value, with an IFA income tax is not generally payable by the policyholder and loan proceeds are not considered as income for tax purposes. When the funds from the loan are invested in a business, investment or other income-producing activities, the loan interest may be tax deductible. Assuming the loan interest is deductible, an annual tax deduction is received for the interest paid and the collateral insurance deduction.

Funding Liquidity Needs — The bank loan replenishes the funds used to pay for the life insurance allowing the proceeds from the loan to be used for investment purposes or reinvested into a business. This can reduce net after-tax cash flow by allowing the business to claim tax deductions and keep more funds working within the business while still maintaining insurance protection for the insured.

Business Owner Succession Planning — Generally, when a life insurance policy is held within a corporation, the death benefit amount received less the policy’s adjusted cost-basis may be credited to the corporation’s capital dividend account, often allowing a tax-free dividend to be paid to the shareholders of the corporation. With an IFA, the corporation receives a credit to the CDA on the same basis, regardless of the loan amount, even when the death benefit is paid directly to the creditor. This may facilitate business succession planning by providing significant tax savings when distributing assets to shareholders.

Alongside the benefits, there are financial and tax risks associated with any planning strategy when leverage is involved. Depending on the arrangement, there may be tax consequences when the IFA is held within a corporate structure. Typically, proceeds from the loan are received by the policy owner; however, if the loan is made directly to the shareholder, instead of the policy owner, which would be the corporation, there may be additional tax risks. Due to current low borrowing rates, the IFA may appear favourable; yet, IFAs are intended to be long-term arrangements and future increases in interest rates can impact the arrangement. If the spread between the loan interest rate and policy interest rate widens and the accumulated loan balance increases faster than projected, the borrower may need to provide additional collateral, partially repay the loan or surrender the policy. Other risks include potential changes to debt servicing requirements, tax rules, loan requirements due to mortality risk, overall performance of the life insurance policy and the lending institution’s practices.

When considering this planning, seek legal and tax advice from professional advisors relating to your own particular situation.

Note: The terms and conditions noted in this article may not apply within the province ofQuebec. In Quebec, the use of a life insurance policy as collateral involves the use of a movable hypothec.

The views expressed are those of Wes Ashton, Director of Growth Strategy and Portfolio Manager, and not necessarily those of Harbourfront Wealth Management Inc., a member of the Canadian Investor Protection Fund.

Harbourfront Wealth Management was one of Wealth Professional Magazines 5 Star Brokerages for 2022. Wealth Professional is a free online information resource for all Canadian advice and planning professionals. This is not a paid award Harbourfront Wealth Management is not a sponsor.

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