Making Money from Philanthropy and Doing Good

On November 13, 2012, a report authored by CIBC?s deputy chief economist Benjamin Tal was released that stated that, within a decade, 550,000 Canadian business owners will exit their privately owned corporations. These businesses have a value of $3.7 trillion.?? The report also stated that most of these business owners have not designed an exit plan nor have they considered a philanthropy strategy as an option to reduce their taxes when they do exit.

Recently the executive director of a large philanthropic foundation approached me to provide a unique philanthropic tax solution which is underutilized. This would help select business owner donors make gifts in the most tax effective way.

I shared with him a situation where a woman that had been diagnosed as terminally ill with six months to live had decided to donate an insurance policy to a charity. She also was the owner of an active corporation. Regrettably she did not get around to it before she died.

If it is done properly donating a life insurance policy to a charity could have substantial tax benefits for an individual who is uninsurable and who owns an active corporation. The total gain can be more than the death benefit.

The way to maximize the benefit is a two step process.

The first step is to sell the policy to the active company. An actuary obtains an estimate of the individual?s life expectancy from a physician. ?The present value of the death benefit is then calculated using that life expectancy.? The present value of the future premiums is then subtracted from this value and this is the value of the policy.

There could however be a potential disadvantage to the transfer of the policy.? It forms part of the assets of the company and is subject to the claims of creditors.? Even if the company is financially sound, a large product liability claim or a large personally injury claim could bankrupt the company.

From a tax perspective the rules regarding the calculation of capital gains and capital losses in section 39 do not apply to transfers of insurance policies.? In addition, since a life insurance policy is not an eligible property for purposes of subsection 85(1.1)[iv] a section 85 rollover is not possible.

Subsection 148(1) provides that dispositions of insurance policies are taxable as ordinary income to the extent that the ?proceeds of the disposition? in connection with the policy exceeds the ?adjusted cost basis? of the policy.? There does not appear to be any provision that allows a taxpayer to claim a loss on a disposition of an insurance policy.

The terms proceeds of the disposition and adjusted cost basis are both defined.? According to subsection 148(7) the proceeds of the disposition from a non-arm?s length transfer of an interest in a policy is ?an amount equal to the value of the interest at the time of disposition?.? The value of the interest is defined in subsection 148(9) as either the cash surrender value (if applicable) or nothing.

In many cases, insurance policies will have no cash surrender value at all.? As a result, the transfer of such policies should be tax neutral.

For a policy that has a cash surrender value, the adjusted cost basis is used to calculate the tax.? The adjusted cost basis of a policy is the total premiums paid minus the cumulative net cost of pure insurance (?NCPI?).? In early years, when the NCPI is relatively low and cash values may be reduced by charges to surrender the policy, the adjusted cost basis will likely exceed the cash surrender value of the policy.? However, as the tax sheltered growth accumulates and the NCPI increases, at some point in time the policy?s cash surrender value will probably be greater than the adjusted cost basis.

The adjusted cost base of the policy to the corporation is equal to the value.? If there is no cash value this allows the total death benefit to be paid out by the company tax free using the capital dividend account.

At a Round Table discussion at the Conference for Advanced Life Underwriting on May 7, 2002 CRA confirmed this approach and also made the following comment.

The result of this transaction is that the shareholder is effectively receiving a distribution from the corporation on a tax-free basis.? Notwithstanding that the corporation will have a reduced adjusted cost basis in the policy it is not clear that the above result is intended in terms of tax policy.? We previously brought this situation to the attention of the Department of Finance and have been advised that it will be given consideration in the course of their review of policyholder taxation.

There have been no changes regarding this aspect of policy holder taxation and CRA?s approach has not changed.

The second step is a donation by the company to a charity.

The value of the policy has been established and this is the amount of the donation.

40% of the fair market value is a tax credit but the donation cannot exceed 75% of net income.

Charitable donations cannot be used to create or increase a loss but unused charitable donations can be carried forward and used in any of the five following tax years.

Let?s look at an example.

A term to 100 life insurance policy for $1,000,000 taken out on the life of a male non smoker at age 45. The annual premium is $6,390.

Assuming a life expectancy of 4 years and using a present value rate of 3%, the present value of the death benefit is $888,486 and the present value of the premiums is $23,752. So the fair market value of the policy and the amount paid to the shareholder is $864,734.

At a 46.41% tax rate the shareholder has saved 401,323 on the payout from the company and has reduced the capital gain by $864,734 for a tax saving of $200,662. In addition the company has received a 40% tax credit of $355,394.

The total gain is $957,380 and has a future value in 4 years of $1,077,540.

This is $77,540 more than the death benefit.

It is essential to work with professionals.

An experienced insurance agent who has facilitated the sale of a policy from an individual to a company previously can expedite the process.? He will have worked with and can recommend an actuary and a lawyer that are familiar with the process and structure.

Using an actuary for the policy valuation minimizes the risk of the valuation not being accepted by CRA and using a lawyer that will draw a binding legal agreement minimizes the probability of the sale of the policy being attacked on legal grounds.

Peter is a Trust and Estate Practitioner and President of MerrickWealth.com, a business exit planning firm in Toronto. He is also the author of three books: ASK- Advisor's Seeking Knowledge (LexisNexis, 2013), ?The TASK - The Trusted Advisor?s Survival Kit? (LexisNexis, 2009) and ?The Essential Individual Pension Plan Handbook? (LexisNexis, 2007).

Source: http://merrickwealth.com/making-money-from-philanthropy-and-doing-good/

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