The primary reason for corporately owned life insurance is to protect your business and family.
With permanent life insurance, the policy can build up money that your corporation can use if needed.1 This cash value can grow tax-free within the policy, subject to government limits.
Your corporation can access cash value of its policy in several ways:
1 Withdraw cash value.
2 Borrow from your policy.
3 Use it as collateral for a third-party loan
1) Withdraw your policy’s cash value Your corporation’s policy guarantees that the owner (your corporation) can withdraw some or all of the cash value, adjusted for any loans or fees. Known as the cash surrender value, withdrawals reduce your coverage and may be taxable. The policy ends if the corporation withdraws all of the cash value.
2) Borrow from your policy The policy guarantees that the owner (your corporation) can borrow from its cash value and pay it back over time, with interest. You can take advantage of the policy loan if the cash value is large enough and isn’t securing another loan. The loan’s tax-free, up to the policy’s adjusted cost basis (generally, the amount the corporation has paid into the policy that hasn’t yet been used to pay for coverage). The loan doesn’t reduce coverage. However, if the loan isn’t repaid, then its balance, including interest, is deducted from the amount paid out at death.
3) Use your policy as collateral for a loan or line of credit The corporation may borrow from banks or other third-party lenders against the policy’s cash value. Known as a collateral loan, it’s also not taxable but the corporation pays interest to the lender. A collateral loan doesn’t reduce your coverage and capital dividend account credit. If the loan isn’t repaid, the balance, including interest, is deducted from the amount paid out at death. Depending on the lender, a collateral loan may be available at a lower interest rate. You shouldn’t purchase life insurance just because of the future possibility of obtaining a collateral loan.
Loan repayment Once the loan is repaid, you may have a capital dividend account balance higher than your remaining insurance payout (also known as a death benefit). This extra room can provide your business with the flexibility to release other assets to shareholders as tax-free capital dividend. There’s no guarantee a third-party lender will offer your corporation a loan. You have to negotiate that with the lender, subject to their financial underwriting and requirements. Because it involves greater risks, you shouldn’t consider a collateral loan unless you’re a sophisticated investor with a high tolerance for risk. The corporation also needs enough income and capital to cover the interest and repay the loan, in addition to its life insurance payments. Depending on the loan arrangement, a shareholder borrowing personally using a corporately owned life insurance policy as security may result in a taxable benefit. Also based on the terms of the loan documents, the loan advanced by the third-party lender may still be considered a loan advanced by the corporation and may result in income inclusion.