The Role of Life Insurance in Estate and Tax Planning

The best way to increase the value of your estate is to minimize the tax implications arising on your death. On that basis, because of the potential tax savings, life insurance policies are useful estate planning tools that ought to be considered when planning your estate.

TAX BENEFITS
One of the greatest benefi ts of life insurance is that, upon the death of the insured individual, it provides a tax-free lump sum payment directly to the designated beneficiary(ies), tax free. Consequently, the insured individual knows that he or she provided protection and financial security to his or her surviving spouse or his or her surviving dependents.

Another reason to consider life insurance in the context of estate planning is estate preservation. The Income Tax Act provides that a deceased taxpayer is deemed to have disposed of each capital property owned by him or her  immediately before death for proceeds equal to the fair market value at that time. For tax purposes, that signifies a deemed a capital gain will be realized upon death.

In this context, life insurance may be purchased to provide the necessary funds to pay the capital gain, thereby  preventing the beneficiary(ies) of the estate from having to sell some of the assets to pay for the taxes.

Since the proceeds of the life insurance are paid directly to the designated beneficiary(ies), they do not form part of the estate and, as a result, probate tax is saved on that amount. It may be advantageous to transfer cash into life insurance and designate a beneficiary(ies) to avoid probate tax being levied on the value of these assets in the estate.

Life insurance should be considered a valuable estate planning tool as it can be cost efficient and will allow the insurance proceeds to be received tax-free by the designated beneficiary(ies).

TRUSTS
Th ere has been much debate as to whether one’s life insurance proceeds should be paid to their estate or to designated individual beneficiaries. Fundamentally, the issue is whether the proceeds are to be paid to a designated beneficiary,  thus avoiding probate tax, or paid to the estate in order to take full advantage of the graduated tax rates available to testamentary trusts on the income generated after death by the insurance proceeds.

The testamentary insurance trust may ultimately be the solution to that debate as it allows for funding of a trust using insurance proceeds such that the trust will also qualify as a testamentary trust for tax purposes. It is important to ensure
that the parameters of the testamentary insurance trust have been established prior to death in the deceased’s will in a manner intended to avoid probate tax. Also, care must be taken to ensure such trust meets the defi nition of a  testamentary trust and that it comes into eff ect in such a way so as to avoid probate tax.

If structured properly, the estate will avoid paying probate tax on the proceeds of the life insurance while the beneficiaries will benefit from the graduated tax rates of the testamentary trust on the income generated by the insurance proceeds. Th is arrangement may translate into considerable taxsavings for the beneficiaries.
THE ROLE OF LIFE INSURANCE IN A BUSINESS SUCCESSION PLAN
When developing a business succession plan, consider the use of life insurance as a source of funding to provide for the needs of the business upon the death of the business owner, a key executive, or shareholder. There are several key
tax advantages in using life insurance proceeds.

One of the main tax advantages is arranging for the life insurance proceeds to be payable to the corporation on a tax-free basis. As a result, the proceeds of the life insurance (over the adjusted cost base of the policy) will increase the capital dividend account of the corporation thereby allowing for the payment of tax-free capital dividends to the shareholders of the corporation or to the estate of the deceased shareholder. Depending on the Will of the deceased shareholder, the surviving spouse may receive tax-free capital dividends in a spousal testamentary trust allowing for income splitting.

Life insurance can also be an efficient means of funding the obligations under a buy/sell agreement found in a  shareholder agreement. The life insurance proceeds would be paid to the corporation thereby increasing the capital dividend account allowing for tax-free capital dividends to be available for purchase by the surviving shareholders from the deceased shareholder. If the shareholder  agreement provides for such a buy/sell agreement, the estate may also be entitled to claim the capital gain exemption on the sale of the shares to the surviving shareholders.

In order for this to occur, the shares must meet the definition of “qualified small business corporation shares” as defined in the Income Tax Act. If so, the estate would be eligible to receive up to $750,000 in tax-free shares. The business succession options set out above must be carefully implemented otherwise the business owner or the corporation might be assessed a taxable shareholder benefit by the Canada Revenue Agency.

It is not uncommon for a business owner to own the shares of a holding company which in turn own shares of the operating company. In those situations, there are a number of factual and tax considerations that must be considered in determining who will be the owner and beneficiary of the insurance policy; and which entity must pay the insurance premiums.

Life insurance may be used for reasons other than estate and business succession. Indeed, it may be possible to use some life insurance to fund the business owner’s retirement or for the company to offer some form of “supplementary executive retirement plan” to an executive person.

The success of your estate planning relies on a clear understanding of the rules of taxation upon death and the rules of taxation of life insurance. Seek professional advice when planning your estate, especially if you are considering implementing a business or succession plan with the use of life insurance, because an error could result in adverse tax consequences.

If you have any questions concerning estate or tax planning, please do not hesitate to contact me directly.

Sébastien Desmarais
LL.B., LL.L., J.D.
Associate, Tierney Stauffer LLP

This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship. 

Taxation of Damages – What a Difference It Can Make

At the conclusion of a long litigation matter, two questions sure to arise – how much was awarded and whether or not that award is taxable. Everyone agrees that a tax-free award is most desirable to the plaintiff . Whether or not a particular award of damages is to be received on a tax-free basis depends upon the characteristics of the action, the pleadings, the methodology used by the trial judge and the actual calculation of the damages.

Lawyers and their clients would be well advised to consider the tax implications of the damages sought from the outset. In some instances, the nature of the action clearly determines whether the damages will be taxable by rule of law.

In other cases, there may be the possibility of framing the cause of action for tax purposes; whether the damages are deemed income and, if so, are they capital gains or income.

Damages Related to Personal Injury or Death
Th e characterization of damages awarded in the context of an injured individual is key to determining whether the award may be received on a tax-free basis. Damages awarded in respect to a personal injury or death are to be
received by the injured party, or by the dependant of a deceased party, on a tax-free basis as long as the damages are special damages, general damages or pre-judgment damages.

Special damages in the context of personal injury relate to compensation such as out-of-pocket expenses (for medical and/or hospital expenses) and accrued or future loss of earning.  However, an amount which can reasonably be considered to be income from employment rather than an award of damages will not be excluded from income.

General damages in the context of personal injury relate to compensation for pain and suff ering, loss of amenities of life, loss of earning capacity, the shortened expectation of life and the loss of financial support caused by the death of the
supporting individual (a parent for example).

Furthermore, damages that are awarded to be paid over a period of time by periodic installments are also to be received on a taxfree basis by the injured party; notwithstanding that it appears to be an annuity. The CRA confi rmed in its IT Bulletin 365 that damages for personal injury or death that are ordered to be paid in periodic payments are not, despite such periodic payments, considered to be an annuity contract and the periodic payments themselves are not considered to be annuity payments.

An annuity contract purchased by a taxpayer or a taxpayer’s representative with proceeds of a lump  sum award received for damages for personal injury or death will be considered an annuity contract and will likely be taxable, with
some limited exceptions.

Business Related Damages

Determining the characterization of damages awarded on business matters and the resulting tax treatment can be difficult. The general principle is that damages in lieu of receipts that would have been taxable as income remain taxable.
Determining whether those damages are deemed income or nontaxable receipts depends on the nature of the legal right at issue.

One must carefully review the facts and determine the purpose of the remedy; i.e., for what do the damages compensate?
If the damages awarded are for loss of income, then the general principle is that they will be considered business income  and therefore taxable.

If the damages awarded relate to the loss of an income-producing asset, it will be considered to be a capital receipt and non-taxable. As one can imagine, the difference between loss of income and the loss of an income producing asset can be nuanced and there exists no bright-line test to diff erentiate the two; it is always a question of fact. Essentially, if the damages received are for the failure to receive a sum of money that would have been income had it been received, the
damages are likely deemed income receipt and taxable. Also, if the damages awarded are essentially a surrogatum for future profits surrendered, the damages will likely be treated as revenue receipts, not a capital receipt, and be taxable.

Employment Related Damages 

In most instances, employment related damages are awarded as compensation for a loss of employment and are specifically dealt within the Income Tax Act as “retiring allowances.” Under the  Income Tax Act, retiring allowances
are fully taxable as income.

As a result, damages for wrongful dismissal, damages for compensation for lost earnings or damages on account of a  contractually agreed settlement (such as a signing bonus) will all be taxable in the  hand of the recipient. Damages awarded by the Workers’ Compensation Board for illness, injury or death ought to be included as income but the recipient is entitled to a deduction which essentially off sets the inclusion by excluding the damages award.

Also, damages awarded in context of a human rights violation, personal injuries (e.g. defamation or harassment) or tortuous conduct by an employer are usually viewed as general damages unrelated to the loss of employment and are therefore non-taxable. Once again, the determination is a factual one.

Conclusion

Th e taxation of damages awarded will inevitably aff ect the ultimate cost of recovery or indemnity. In some instances, the Income Tax Act will clearly dictate whether the damages are taxable. In other cases, a proper determination can only be made sometime aft er the commencement of the litigation process.

Ultimately, the only certainty is that some damages are taxable while others are not, that the analysis is a factual one and that the framing of the cause of action and the pleadings may formulate the determination.

Tierney Stauff er LLP, you can be sure that lawyers litigate with their clients’ best interest in mind and that always includes making informed decisions with respect to taxation.

If you have any questions concerning the taxation of damages, please do not hesitate to contact me directly at 613.288.3220

 

This article is provided  as an information resource and is not intended to replace advice from a quaified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter  referenced in this document before making decisions. Any use of this document does not constitute a lawyer-client relationship. 

Minimize Tax Implications and Increase Estate Value with Life Insurance

The best way to increase the value of your estate is to minimize the tax implications arising on your death. On that basis, because of the potential tax savings, life insurance policies are useful estate planning tools that ought to be considered when planning your estate. 

Tax Benefits

One of the greatest benefits of life insurance is that, upon the death of the insured individual, it provides a tax-free lump sum payment directly to the designated beneficiary(ies), tax free.  Consequently, the insured individual knows that he or she provided protection and financial security to his or her surviving spouse or his or her surviving dependents.

Another reason to consider life insurance in the context of estate planning is estate preservation.

The Income Tax Act provides that a deceased taxpayer is deemed to have disposed of each capital property owned by him or her immediately before death for proceeds equal to the fair market value at that time.  For tax purposes, that signifies a deemed a capital gain will be realized upon death. In this context, life insurance may be purchased to provide the necessary funds to pay the capital gain, thereby preventing the beneficiary(ies) of the estate from having to sell some of the assets to pay for the taxes.  

Since the proceeds of the life insurance are paid directly to the designated beneficiary(ies), they do not form part of the estate and, as a result, probate tax is saved on that amount. It may be advantageous to transfer cash into life insurance and designate a beneficiary(ies) to avoid probate tax being levied on the value of these assets in the estate.

Life insurance should be considered a valuable estate planning tool as it can be cost efficient and will allow the insurance proceeds to be received tax-free by the designated beneficiary(ies).

Testamentary Insurance Trusts

There has been much debate as to whether one’s life insurance proceeds should be paid to their estate or to designated individual beneficiaries.  Fundamentally, the issue is whether the proceeds are to be paid to a designated beneficiary, thus avoiding probate tax, or paid to the estate in order to take full advantage of the graduated tax rates available to testamentary trusts on the income generated after death by the insurance proceeds.

The testamentary insurance trust may ultimately be the solution to that debate as it allows for funding of a trust using insurance proceeds such that the trust will also qualify as a testamentary trust for tax purposes.  It is important to ensure that the parameters of the testamentary insurance trust have been established prior to death in the deceased’s will in a manner intended to avoid probate tax. Also, care must be taken to ensure such trust meets the definition of a testamentary trust and that it comes into effect in such a way so as to avoid probate tax.

If structured properly, the estate will avoid paying probate tax on the proceeds of the life insurance while the beneficiaries will benefit from the graduated tax rates of the testamentary trust on the income generated by the insurance proceeds. This arrangement may translate into considerable tax-savings for the beneficiaries.

Sebastien Desmarais

Lawyer