There is a distinction between an Incorporated Business which virtually anyone can do, and a Professional Corporation which is restricted to designated professionals, who’s designation and conduct, are governed by a regulating organization. i.e., Lawyers are subject to the rules and regulations of the Canadian Bar Association and in Ontario, The Law Society of Upper Canada. For the purposes of this following discussion, we will focus upon Professional Corporation.

The ability to incorporate raises both planning issues and opportunities. This includes using life insurance for tax and estate planning purposes. We will focus on how life insurance has a role to play for the incorporated professional.

Understanding who can incorporate

Traditionally, professionals and business owners have carried out their practices as either sole proprietors or in partnerships. While there are many positive tax and non-tax reasons for carrying on a business in one of these business structures, tax planning may be more limited under the current tax regime. Professional organizations have successfully lobbied governments to allow for the ability to organize themselves as professional corporations. Though professionals in all provinces can incorporate, some jurisdictions limit this right to only a few professionals. For a list of professional disciplines which can incorporate in each provincial jurisdiction see attached spreadsheet.

Insurance planning opportunities

Life insurance owned by a professional corporation allows for cheaper after-tax dollars to be used to purchase the policy as compared to a sole proprietorship or partnership. These cheaper corporate dollars may be enticing. However, even though the use of cheaper corporate dollars is attractive, there are many reasons to consider before placing the insurance in the corporation. Even if there is a real funding need, and the insurance makes sense, one must be mindful of changing corporate status. Dynamic share ownership: whether the corporation will soon be wound up or sold; variability or stability of corporate earnings, might be some of the issues to consider before buying corporate owned insurance. Placing the insurance in the corporation when these events are likely to occur may not make sense from a tax and overall planning perspective. Your legal counsellor will need to understand not only your vision for a structure; they will also need to understand the future delineation of control and contemplated timing for any changes. Trusts and Holdco may play an important role in any incorporation process.

In order to retain the benefit of the small business deduction, it is common practice to retain corporate income up to the small business limit inside the corporation. This income gives rise to several planning options using life insurance.

1.  a) Personal and corporate insurance planning

Salary, bonuses, or dividends paid to a shareholder/employee can be used for personal financial planning including the purchase of personal life insurance. However, for high income earners this income is taxed at the highest marginal rates. Further, tax at source remittances reduce the amount of disposable cash available for personal tax and investment planning. Retained Corporate Earnings while beneficial in that they initially attract a comparatively low tax rate, create some complications and the low tax rate is short lived. Corporate owned investments are subject to a relatively high rate of corporate tax. As these corporate investments grow, they could jeopardize the small business corporate tax limits and thus defeat the very reason why a professional may establish a professional corporation. Passive income inside a Canadian Controlled Private Corporation is taxed at approximately 50%. That’s a lot of tax leakage!

An alternative to investing in taxable investments, would be to put the excess profits into an exempt life insurance policy. The funds in the policy in excess of the amount needed to fund policy charges can grow on a tax-exempt basis during the life of the insured. When the professional shareholder dies, a dividend may be paid out to the deceased shareholder’s estate or holding company tax-free by way of the corporation’s capital dividend account.

A corporation may also use life insurance for various other business needs including:

• Key Person Insurance;
• Business Loan Protection;
• Buy-sell Funding;
• Funding Capital Gains Tax on a Business at Death; and
• Executive Compensation. 

A Split Dollar arrangement may also be considered in the professional corporation context. A split dollar arrangement recognizes that separate interests can be identified within a single life insurance policy. The particular interests in the policy can be matched to the parties that most require the benefits provided by the interest.

A Split Dollar arrangement can be used as a cost-effective means to provide buy-sell or key person funding while also providing a tax-deferred investment vehicle. The corporation and the professional shareholder, with the shareholder as the life insured, jointly purchase a life insurance policy. The corporation pays for and owns a level death benefit sufficient to fund the corporate insurance need. The shareholder pays for and owns the remaining interest in the policy (generally the cash surrender value).

It is important that the portion of the premium paid by the shareholder is a reasonable amount for the benefit received. If a reasonable amount is not paid, the Canada Revenue Agency (“CRA”) could assess a shareholder benefit under subsection 15(1) of the Act.

By using the Split Dollar arrangement, the professional corporation is provided with the insurance funding that it needs, and the shareholder is provided with access to a tax-deferred investment vehicle that can ultimately be received tax-free if held until death.

1. b) Types of investments

Any type of investment held by a professional corporation should be reviewed to determine if there is a concern over the holding of that investment by the professional governing body. This may include life insurance. Provincial business corporation legislation in the common law provinces (e.g. Ontario Business Corporation Act) indicates that the corporation may not carry on a business other than the practice of the profession and the corporation is not prevented from carrying on activities related to or ancillary to the practice of the profession, including the investment of surplus funds earned by the corporation. The “investment of surplus funds” may be defined or included in the professional governing body legislation and some governing bodies have limited the types of investments that a corporation can make. Some will include that the professional corporation cannot engage in investment and business activities which are not related to the professional practice.

There is no case law on point in relation to this issue and therefore it boils down to a review of the governing bodies regulations and determining if the investment is permissible or not. This may require interpretation of that governing bodies legislation to make that determination.

1. c) Retirement and pension planning

Traditionally, professionals have been confined to pension planning utilizing RRSPs. As a result, professionals have only been able to contribute to their own pension planning by making contributions up to the maximum permissible for RRSPs thus limiting potential sources of income for professionals at retirement. The ability to incorporate now provides other options to better plan for their retirement. A cash accumulation option similar to an RRSP is an Individual Pension Plan (IPP).

Professional corporations may now consider purchasing an exempt life insurance policy with the intent of accessing the policy’s cash value by collaterally assigning the policy to a bank at a later date. Accessing the cash value allows for a number of options, including using the funds to make bonus payments, to redeem shares thereby providing funds at retirement to the shareholder, personal borrowing for the shareholder or providing for a living buyout using personal borrowing.

As discussed previously, a split dollar arrangement may be used to enable the corporation to cover buy-sell funding needs and the shareholder to invest in the policy’s cash value for this type of planning. Where the shareholder owns the cash value and wishes to use it to secure the loan the proceeds from the loan can then be used to provide additional cash flow in retirement.

A professional corporation may make tax-deductible contribution to an individual pension plan (IPP) or it may set up a retirement compensation arrangement (“RCA”) to increase a professional’s retirement savings. However, the decrease in corporate tax rates for active business income in recent years has significantly changed the landscape. RCAs for owner-managers compared to paying tax and retaining funds at the corporate level have become tax disadvantaged. Contributions to an RCA are subject to a 50% tax, which is refundable to the RCA when it distributes funds to the beneficiary. Note should be taken of technical interpretation (#2005-011993 dated April 25, 2005) regarding whether it would be acceptable to include the period of time during which an individual operated his or her practice as a sole proprietor before incorporation when determining the amount of benefits which could be provided to the individual from a RCA to be funded by the corporation. CRA’s technical interpretation indicated that a partner or sole proprietor does not provide employment services to the partnership or sole proprietorship and therefore such periods would not be employment services for the purpose of determining the benefits that may be provided to the individual from an RCA.

When an RCA is funded with a life insurance policy, the policy is subject to the same taxation rules as if the policy was outside of an RCA. The funds accumulating in an exempt life insurance policy are not subject to the refundable tax. Therefore, the funds are allowed to grow tax-sheltered. Any policy gains on a full or partial disposition of the life insurance policy will be subject to the 50% refundable tax. Death benefits are received tax-free by the RCA trust, but subsequent distributions to either the employer or the beneficiary would be taxable in their hands. The employer corporation, if a residual beneficiary under the trust, would not be entitled to an increase in its capital dividend account (CDA) on distribution of the death benefit from the RCA trust to the corporation.

In order to pay the retirement benefits, the trustee of the RCA trust can use policy withdrawals or use the policy as collateral for a bank loan. As noted previously, policy withdrawals may cause a tax liability for the trust, but a subsequent distribution out of the RCA trust will generate a refund of the tax.

1. d) Buy-sell considerations

The same tax planning on buy-out can occur with a professional corporation as with any type of corporation. The outcome from a tax perspective for the individual shareholder and the surviving shareholders will be the same but for the consideration of the loss of status should a non-professional own the shares at death. This consideration may limit the structure options available to the professional and therefore limit their tax planning options

Conclusion

Life insurance has a role to play when a professional incorporates. It presents various options that should be considered in the professional’s overall financial and estate plan.

The foregoing general discussion introduces the possibilities that these various structures can play in your personal financial. Elsewhere in our website we enter more in-depth discussions and detail. Please feel free to continue to explore areas of interest. Or…

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