Small business owners are always looking for a way to save money these days. One of the ways this can be accomplished is by using all available deductions at tax time.
However, many of these deductions can be complex. Although deductions provide tremendous benefits to businesses and business owners – they can lead to huge headaches if done improperly.
In addition to this, many business owners will overlook some deductions that can provide great cost savings for the business.
A frequently overlooked deduction is the cost of life insurance. This may be due to businesses not knowing that in some circumstances, you can use premiums as a deduction. Since life insurance is personal in nature, it isn’t typically thought of at tax time. Or, it may be due to the fact that some find the explanation in the Canadian Income Tax Act a bit technical.
First, let’s explain what life insurance is.
Life insurance is a contract between an individual and an insurer, where the individual pays premiums in exchange for insurance coverage – just like your car or home insurance. Upon your death, the insurer pays out a sum of money to those that are listed as beneficiaries. This is really to provide benefit and security to your family in the unlikely case of death.
There are two types of life insurance that people typically look at.
1. Term insurance
Term insurance is a type of life insurance that provides coverage for a certain period of time or term. Term insurance is typically less expensive than permanent insurance and it has no cash value. The value of the policy is the guaranteed death benefit from the policy.
2. Permanent insurance
Permanent insurance on the other hand does not expire and it combines a savings component as well as a death benefit.
When discussing life insurance in relation to your corporation, we are saying that life insurance premiums may be used as a deduction at tax time, specifically, as collateral for a business loan in certain circumstances. However, this is only in specific circumstances.
Using life insurance as collateral
Life insurance can first and foremost be used as collateral for businesses in a variety of circumstances. These circumstances can include when an individual is applying for a loan, and they are responsible for the sustainability of the business.
This could also include if the person in question is the owner or operator of a business; or, if the individual is offering a professional service such as an accountant, and is either the only employee or a member of a small business team.
Essentially, life insurance can be used as collateral for any key person whose demise could cause the business to fail and make the business unable to repay the loan – whether a business owner or high-level employee.
Take for example that someone opens a small agricultural business in Canada. They are the sole owner, operator of the business, and are responsible for the continuity and success of the business. When they apply for a loan to purchase their machinery and start the business, the financial institution may require them to take out a life insurance policy equal to, or greater than the loan.
In this situation, the lender is requiring the financial institution to be listed as the beneficiary in order to get the loan in the first place. This is what is considered a form of collateral.
In order to be used as a deduction, there are even more criteria that have to be met that are stated in Canada’s Income Tax Act, paragraph 20(1)(e.2). To start, the life insurance policyholder must be the borrower listed on the loan, or the person taking out the loan in the first place. Other criteria stated in this article include:
- That the interest in the life insurance policy be assigned to a “ restricted financial institution”. This means that you must be taking the loan out from a restricted financial institution as defined under the Income Tax Act. This would include banks, credit unions or trust companies, or insurance companies.
- That the interest payable on the borrowing, but for subsections 18(2) and 18(3.1) be deductible in computing the policyholder’s income in the year (meaning, the borrowed funds are used to earn income from a business or property).
- The assignment noted in #1 must be required by the lender as collateral for the loan, or what is being borrowed. This should be clearly stated in the loan document so that there is no question at tax time. It is important to remember that if it is not required by the lending institution, you will not be able to deduct the insurance premiums.
As life insurance is typically used for personal reasons, the Act also imposes a cap on how much of this premium can be used as a deduction, provided they meet the above criteria. This is noted in paragraph 20(1)(e.2) of the Income Tax Act. Regardless, the premium amount that can be deducted from annual business income includes the lowest of the three following values:
- The policy premiums actually paid for the year on the insurance,
- The ‘net cost of pure insurance’, meaning any premium paid less any savings component, like in permanent insurance, or
- The portion of the premium that would be associated with the outstanding balance of the loan.
Again, whichever of these three values is the smallest is the amount that a business can deduct based on their life insurance when used as collateral on a loan.
Paragraph 18(1)(a) of this act also states that no deduction should be made unless it was incurred by the taxpayer for the purpose of getting an income from the business. That means that if the life insurance isn’t used as a loan or way to generate income for the business (for example, if it’s just used to provide security for the business or its owner), it cannot be deducted.
The CRA has some additional notes relating to the collateral insurance deduction. These include:
- If the policyholder’s tax year is different than the policy year, the premiums under the policy should be determined for that tax year.
- If a policy has required contractual premium payment, a deduction may be taken (being the collateral insurance policy).
- If the lives of more than one individual are required by the institution as security (for example, if two shareholders are borrowing money and both are required to take out collateral life insurance policies), a separate deduction is available for each policy as long as the other criteria is met.
- A corporation is entitled to a credit to its capital dividend account for the insurance death benefit, even where a collateral insurance deduction has been claimed in respect to that policy.
To summarize this information, it can be understood that life insurance deductions are quite complex, and only happen in certain instances. However, if you think you qualify, it’s important to speak with your accountant or tax expert to learn more.
Other exceptions
Aside from those listed above, there are even more exceptions that can be made to life insurance deductions in business.
As an individual, you are not able to write off your life insurance premium. As a business owner, if you pay the premiums for the employee’s group life insurance, this expense may be a deductible. Once again, however, speak with your accounting and tax professional for more insight.
Group term life insurance is when the employer provides life insurance for its employees, with each covered employee having a certificate of coverage.
The conditions that must be met for this to be a deduction include:
- that the employer may deduct these premiums against business income, if the premium payments are a reasonable business expense,
- the employee must include the premium payment as part of their income,
- the employee’s beneficiary receives the death benefit tax-free.
As a further expansion on the Canada Revenue Agency point above, it is possible for a corporation to pay the premiums for a life insurance policy belonging to a shareholder as long as it is the corporation who collects the proceeds upon the covered individuals passing. The proceeds would not be taxable to the corporation and would simply be added to the company’s capital dividend account.
Again, it is important to remember that if your life insurance policy is not required as collateral of a loan, the premiums would not be able to be deducted.
Need help from an expert?
As taxes and allowable deductions can frequently be confusing, let one of our experts at Valley Business Centre help. For over 30 years, Valley Business Centre has been providing comprehensive bookkeeping, payroll, and tax services to our clients in Whistler, Squamish, the Sea to Sky Corridor, and Metro Vancouver B.C. areas. Valley Business Centre provides reliable and effective services to all clients.
Disclaimer
This article is written for informational purposes only. It is current at the date of posting and changes to laws and regulations may result in the information becoming outdated. It is not intended to provide legal, tax, or financial advice. It is recommended that readers get advice from a tax professional before making any final decisions.
