Are Corporate Life Insurance Proceeds Taxable?

When most people think of life insurance, they automatically imagine a policy taken by a person to replace a source of income or cover certain costs after the insured’s death. But it’s beyond that. Businesses and corporations also take life insurance policies on individuals, and they do so for various reasons. Since individual life insurance is tax-free, one might wonder if the same applies to corporate life insurance.

The tax implication of corporate life insurance is quite complex. While it’s generally tax-free, there are instances where the authorities will impose taxes on the proceeds of corporate life insurance.

However, these instances are more of exceptions rather than the norm. Suppose you’re thinking of taking out a life insurance policy in your organization. In that case, you should know all about tax liabilities on proceeds from a corporate life insurance policy to minimize your company’s tax liability. This article discusses corporate life insurance and the tax implications that could apply to its proceeds.

What is a Corporate Life Insurance?

Corporate life insurance is an insurance policy taken by an organization on its personnel. In this case, the company will pay the premiums, and upon the insured person’s death, the corporation claims the proceeds. It is usually taken on the senior officers, significant shareholders, and company owners whose deaths could lead to serious financial issues. But it can also be taken out on junior level employees.

Why Companies Take Out Corporate life insurance Policies

You may wonder why corporations will choose to get life insurance on personnel. Here are some of the reasons:

Loan Collaterals

When a corporation secures loans for its operations, some lenders require that the company owners and major shareholders guarantee the loan personally as this offers a better chance of repayment. Lenders may also require that these shareholders have life insurance for the loan duration. By taking insurance on its personnel and significant officers, a company stands a better chance of getting the loan they need, and proceeds from the life insurance can cover outstanding debts.

Buy-sell Contracts

Private corporations can also use the proceeds of life insurance policies for buy-sell transactions resulting from the death of a shareholder. For example, suppose upon the death of shareholders, the beneficiaries decide to divest their interest in the company. In that case, the corporation can use the proceeds from the life insurance to buy the shares held by the deceased shareholders.

Funding Deferred Compensation Arrangements

Corporations also take out life insurance policies to fund a supplemental executive retirement plan for their top executives. This is a particular retirement plan offered selectively by the company to critical officers, which promises them certain benefits after retirement as long as they meet some conditions.

Tax Implications of Corporate Life Insurance Proceeds

Generally, there will be no tax on life insurance proceeds since the insurance premiums are deducted on income after tax. However, with a corporation, the net proceeds of the policy, the gross proceeds minus the adjudged cost basis of the premium, are added to the capital dividends account (CDA). In the CDA, the proceeds are not taxable.

But there are stringent rules to prevent companies from evading tax through corporate life insurance. Due to the several companies using corporate life insurance to reduce their tax liabilities and accumulate passive wealth, there were changes to the tax legislation related to life insurance policies. The changes reduced the long-term tax-free savings possible for those policies and reduced the capital dividend account, limiting corporate fund extractions.

Instances where Proceeds of Corporate Life Insurance Can Be Taxed

Here are some situations where corporate life insurance will be taxed:

Where a subsidiary company makes holding company beneficiary

The proceeds from corporate life insurance will be taxable if the subsidiary company makes its holding company the policy’s beneficiary. The holding company will pay tax on the proceeds. Also, where the parent company owns the policy, but the subsidiary company pays the premiums, the parent company will declare the premium paid on its behalf as income.

Where a company is to be sold

If the company is to be sold, there will be tax implications on all company assets, including the life insurance policies. Since such insurance policies might increase the company’s valuation, a higher selling price also means more sales taxes. For proceeds of corporate life insurance to not be taxable, you can transfer the policy through a dividend.

Payments of proceeds into a taxable estate

The proceeds of life insurance are usually paid to the beneficiaries of the deceased, in which case they’re tax-free. But if no beneficiary is named, it’ll go to the deceased’s estate, and in that case, it becomes taxable with the rest of the estate.

When the policy expires with a loan against it

The company may also face taxation if it takes a loan against a cash-value life insurance policy and expires during the loan term. Even though the loan won’t be taxed while the policy is in force, it becomes taxable as soon as the policy expires, and the taxable amount will be a surplus of the loan over the policy basis. One way to avoid taxes is to only withdraw the amount on a policy basis.

When the insurance policy is surrendered

In a situation where the company terminates the insurance policy, the insurance provider will cancel the coverage and deduct the surrender charge before refunding what’s left to the company. The company will be taxed on any amount received that exceeds the basis of the policy.

Bottom Line

Proceeds from corporate life insurance are not directly taxable except in the case of the subsidiary and parent companies. But the proceeds can still become taxable in certain situations. So, you must be aware of these instances and all the relevant rules guiding corporate life insurance. You can also contact a registered brokerage service for more information and guidance – we’d like to recommend Insurance Direct Canada.