A practical look at corporate insured retirement plans

For many successful business owners, the question eventually changes. It is no longer simply, “How do I build wealth?” It becomes, “What do I want the wealth I have built to do?”

Years of hard work may have created a successful company, significant retained earnings and corporate assets well beyond what is required for day-to-day operations. The owner may also have a legitimate need for permanent life insurance while beginning to think about something that still seems a long way off: eventually stepping back from the business. I deliberately hesitate to call that retirement.

For many entrepreneurs, retirement is not a date circled on a calendar. They may gradually reduce their hours, transition ownership to children or management, sell part of the company, remain involved as a consultant or simply reach a point where work becomes a choice rather than a necessity.

I prefer to think about transition. How much capital does the business need today? What should remain readily accessible? What will the owner eventually need personally? What happens if the business is not sold when anticipated, or for the amount expected? What needs to be protected for the family? And ultimately, what is the accumulated wealth intended to accomplish?

A Corporate Insured Retirement Plan, commonly referred to as a CIRP, may form part of that conversation. The concept can be sophisticated. The explanation does not have to be.

At its simplest, a corporation purchases permanent life insurance on the life of a shareholder. The insurance addresses a legitimate need today while also accumulating cash value over time. In later years, that value may potentially be used as collateral to obtain financing from a third-party lender. The same corporate dollars may therefore perform different jobs at different stages of the client's life.

But before discussing how the strategy works, we need to ask a more important question. Why are we considering the insurance in the first place? Start with the need!

Insurance should solve a problem. Before recommending a CIRP, an advisor should be able to clearly identify the permanent insurance need. Perhaps there is a key-person exposure, an estate tax liability, a shareholder or succession planning need, estate equalization or a requirement for liquidity at death. Whatever the reason, the insurance need should make sense independently of the future borrowing strategy.

If the only reason for purchasing the policy is the prospect of accessing its cash value decades later, I would question whether we have started the conversation in the right place. The insurance is the foundation. The potential access to capital later is another planning opportunity. That distinction matters.

Put a person behind the strategy

Sometimes the easiest way to understand a concept is to put a person behind it.

Consider a 42-year-old business owner who has spent the past 15 years building a successful company.

The business is profitable. Cash flow is strong. Retained earnings have accumulated beyond what is reasonably required for operations, emergencies and anticipated expansion. At 42, retirement is hardly the immediate conversation. Risk is.

The owner remains instrumental to the success of the company. If something happened unexpectedly, the business would need capital to manage the disruption, recruit or retain key people and give the company and family time to determine what comes next. There is a legitimate key-person insurance need today.

But there is another conversation worth having. The corporation also has surplus capital that is accumulating and being invested. Rather than viewing all of those dollars as one pool of money, the owner and their advisory team consider whether a portion could be allocated differently. Some remains liquid. Some continues to be invested conventionally. And a portion is directed toward a permanent life insurance policy owned by the corporation.

The objective is not to replace the company's investment portfolio. It is to introduce another corporate asset with a different purpose. The insurance immediately addresses the key-person exposure. At the same time, values within the policy have the opportunity to accumulate on a tax-advantaged basis, subject to the rules governing exempt life insurance policies. Then we allow time to do some of the work.

Move the clock forward. At 55, 60 or 65, perhaps our business owner is ready to work four days a week rather than six. Children may be becoming involved in the company. A management team may be assuming greater responsibility. The business may be preparing for sale. Or perhaps the owner simply wants the freedom to spend less time working without being forced to sell the company to fund the next chapter. By then, the insurance policy may represent a meaningful corporate asset. And the owner has choices.

Where does the money actually come from? This may be one of the most misunderstood aspects of an insured retirement strategy. We sometimes hear these arrangements described as creating “tax-free retirement income.” I think we need to be careful with those words. The insurance company is not paying the shareholder a retirement income.

Depending upon the structure and circumstances at the time, the accumulated cash value of the policy may instead be pledged as collateral to a financial institution. The lender advances the money. The loan is separate from the insurance contract.

Future borrowing is therefore not guaranteed simply because an insurance policy exists. Interest rates, lending practices, the percentage of policy value a lender is prepared to advance, credit requirements and other conditions will be determined at that time. There is also an important tax distinction. A loan is generally not income simply because money has been borrowed. But when a corporation owns the policy, we still need to ask: Who is borrowing? Who owns the collateral? Who receives the money? And how does that money ultimately get into the shareholder's hands?

Under one approach, the corporation may borrow using the policy as collateral. If those funds are subsequently distributed to the shareholder as a dividend, that dividend would generally be taxable personally.

Legal and tax considerations

Other structures may contemplate the shareholder borrowing personally, supported by the corporate-owned policy. That introduces additional legal and tax considerations, including potential shareholder-benefit issues. The structure matters. This is precisely why the client's accountant, tax specialist, lawyer and lender belong in the conversation.

Our role as insurance advisors is not to practise tax law. Our role is to understand the strategy sufficiently to recognize where it may fit, explain it clearly, identify the questions that need to be answered and bring the appropriate professionals to the table.

Before deciding where surplus corporate capital should be allocated, I believe there is a better question than simply asking which option may produce the highest return. What does the money need to do? Does the business need it for expansion or an acquisition? Is it working capital? Will the shareholder eventually spend it? Is it intended to help fund a gradual transition from the business? Will it ultimately pass to children or grandchildren? Is there a tax liability that will need to be funded at death? How much liquidity needs to remain readily available?

Only after answering those questions can we begin deciding where the money belongs. Permanent life insurance should not replace the corporate chequing account, nor should it absorb capital that could reasonably be required for operations, emergencies or foreseeable business opportunities.

But where there is true surplus, a long planning horizon and an existing permanent insurance need, allocating a portion of corporate capital to permanent life insurance may deserve consideration. That is not simply an investment decision. It is an allocation decision.

We are asking whether one asset can help solve several different problems over time. Why not simply invest the money? It is a fair question. For many business owners, conventional investments will remain an important part of the answer.

A CIRP does not suggest that life insurance is a replacement for equities, fixed income, real estate or other investments. The liquidity, risk, tax treatment and purpose are different. Corporate investment income is generally taxable, and significant passive investment income can also affect a Canadian-controlled private corporation's access to the small business deduction. That does not make permanent insurance the automatic alternative. It simply means we need to understand what is accumulating inside the corporation, why it is there and what the owner ultimately wants those assets to accomplish.

Rather than asking only: “Where can we get the best return?” Perhaps we should also ask: “What are we asking this money to do?” That creates a much better planning conversation. A business is not necessarily a retirement plan.

Many entrepreneurs spend most of their working lives reinvesting in their companies. Ask about retirement and we often hear: “My business is my retirement plan.” Perhaps. But at what value? And on what date? A future sale price is not guaranteed. Neither is the timing.

Children may not want the business. Partners may have different objectives. Industries change. Markets change. Health changes. And the owner may simply decide at 60 that selling the company is the last thing they want to do.

The business may certainly form an important part of retirement planning. It just should not necessarily be the only plan. Good planning creates options. A CIRP may create another one.

Then there is the estate. The value of the strategy does not necessarily end when borrowing begins. At death, life insurance proceeds are generally received by the corporate beneficiary without income tax. Any outstanding collateral loan and accumulated interest can then be addressed according to the lending arrangement.

Capital Dividend Account

Corporate-owned life insurance may also create a credit to the corporation's Capital Dividend Account. Generally speaking, this is based upon the insurance proceeds received less the policy's adjusted cost basis immediately before death, subject to the applicable tax rules. The terminology can quickly lose a client, so I prefer to explain the concept more simply.

The Capital Dividend Account is essentially a mechanism that can allow certain amounts received tax-free by a private corporation to ultimately be distributed to Canadian-resident shareholders as capital dividends without personal income tax. But clients rarely wake up thinking: “I need to increase my future Capital Dividend Account.” They wonder: Will my family be okay? What happens to my company? Will assets have to be sold? Can I enjoy some of what I have built while I am alive? Can I still leave something meaningful behind?

Those are the questions we need to answer. The tax mechanics support the planning. They should not become the planning.

Who would be a good candidate for a CIRP?

So, who might be a good candidate? Not every successful business owner with retained earnings should consider a CIRP. A stronger candidate will generally have an established, profitable corporation with surplus capital that is not required for foreseeable operations, a genuine permanent insurance need, a long planning horizon and adequate liquidity outside the strategy.

Traditional retirement planning opportunities should also be considered. And then there is a question that may never appear on an insurance illustration: How does the client feel about debt?

We can model borrowing beautifully. We can show potential policy values, loan balances and estate values decades into the future. But our 42-year-old business owner may feel very differently about borrowing at 62. If that client eventually says, “I don't want to owe anybody money,” the policy still needs to make sense without the loan. Suitability is not merely financial. It is behavioural. Ask “what if?”

Sophisticated strategies tend to look their best when every assumption cooperates. Our responsibility is also to discuss what happens when they don't. What if interest rates are considerably higher when the owner wants to borrow? What if a lender is prepared to advance less against the policy than anticipated? What if policy values are lower than illustrated? What if the company needs the capital earlier? What if the business is sold? What if the owner no longer wants to borrow? What if tax legislation changes? And finally, what if the client dies much earlier than expected?

That brings us back to where we started. There should still be a genuine insurance need. Asking “what if?” does not weaken the strategy. It strengthens the advice.

CIRP and IFA: similar ingredients, different objectives

Corporate Insured Retirement Plans and Immediate Financing Arrangements are sometimes confused because both may involve permanent life insurance, corporate ownership and collateral lending. But their objectives are quite different. With an Immediate Financing Arrangement, borrowing generally occurs shortly after the insurance is funded. The objective is often to replace capital committed to the policy so borrowed funds can continue to be deployed in the business or in income-producing investments.

With a CIRP, borrowing generally comes much later. The corporation first funds the insurance and allows policy values to accumulate. Borrowing may then be considered years later when additional liquidity is wanted. Put simply: An IFA is generally about accessing capital today. A CIRP is generally about creating the potential to access capital tomorrow. But I would apply the same principle to both:

The financing should support the planning. The financing should never be the reason for the planning.

Don't forget the second sale

There is another component that can easily get lost in the financial modelling. The client still has to qualify for the insurance. A beautifully designed corporate strategy does little good if the proposed insured cannot obtain the required coverage on reasonable terms. Age, health, lifestyle, financial justification and the amount of coverage requested can all affect whether the strategy is viable. Where there may be underwriting concerns, I would rather understand them early.

Before an application is submitted, understand the person behind it. What is the medical history? What has changed? What is the financial story? Why this amount of insurance? Why now? The first sale may be to the client. The second sale is to the underwriter. Both matter.

Collaboration is not optional.  No advisor owns every part of this conversation. The insurance advisor understands insurance design and field underwriting. The accountant understands the corporation and its tax circumstances. The tax professional can advise on the proposed borrowing structure. The lawyer understands ownership, shareholder agreements, succession and estate considerations. And the lender determines whether it is prepared to lend, how much and on what terms. Each professional sees the strategy through a different lens. That is not a weakness. That is good planning.

I have long believed that the quality of advice is directly related to the quality of the conversations we are willing to have. A strategy expected to survive several decades deserves more than one conversation and certainly more than one advisor.

Protect today. Create choices for tomorrow. Let's return one last time to our 42-year-old business owner. We did not ask that person to predict exactly what life would look like at 62. We addressed a risk that existed at 42. We protected the business against the loss of someone critical to its success. We identified corporate capital that was genuinely surplus and allocated only a portion of it to a long-term strategy.

In doing so, we began building an asset that could potentially provide additional choices many years later. Perhaps the owner will borrow against it. Perhaps not. Perhaps the company will be sold. Perhaps it will pass to the next generation. Perhaps the owner will gradually step away while continuing to receive income from the business. And perhaps life will look completely different from anything we could predict today. That is precisely the point. Good planning should not require us to predict the future perfectly. It should prepare our clients for more than one version of it.

A Corporate Insured Retirement Plan is not simply a permanent insurance policy with a future loan attached. It sits at the intersection of business, retirement, tax, lending, insurance and estate planning. For the right client, it may allow the same corporate dollars to accomplish several objectives over time: protect today, accumulate for tomorrow, potentially provide another source of liquidity later and ultimately create estate value.

For the wrong client, it can introduce unnecessary complexity, reduced liquidity and risks the client never needed to assume. That is why the conversation should never begin with an illustration. Start with the person. Understand the business. Identify the need. Determine what the corporation needs to retain. Ask what the owner will eventually need personally. Understand what the accumulated wealth is ultimately intended to accomplish. Bring the right professionals into the conversation.

And always ask: “What if things don't go according to plan?” Because the objective is not to sell a CIRP. The objective is to help clients build, protect and eventually transition what they have spent a lifetime creating, while preserving as many appropriate choices as possible along the way. At 42, that may mean protecting the business. At 62, it may mean having the freedom to slow down. And eventually, it may mean transitioning wealth to the people who matter most.

The strategy may change over time. The value is having the choice.