When you work your entire life to build your business, it may be your most valuable asset. You may want to pass the business on to your children or spouse should you pass away.
While hard work and growth can result in a substantial increase in equity, this increase also creates a liability. As the business owner, tax may have to be paid on capital gains when you die.
Capital gains tax can be a substantial amount; however, there are options available when it comes to paying. One strong strategy is for business owners to plan for life insurance benefits to pay the tax. The insurance premiums are typically much less than what the tax owed would be, and the equity in the business is preserved for the heirs.
Let’s look at this in a little more depth.
If you sell (or are considered to have sold) all or part of your company for more than the adjusted cost base plus outlays and expenses associated with the sale, you incur a capital gain. In Canada, tax is paid on 50% of the gain.
The amount of tax owed if a business owner dies can potentially be substantial. For example, a capital gain of $4 million means capital gains tax will be paid on $2 million at the owner's marginal tax rate at time of death.
As a business owner your future capital gains tax owed can be estimated based on a professional business valuation. Life insurance benefits can then be calculated to cover the tax in the event you pass away, and the premiums over your expected lifetime can also be determined.
Because the insurance premiums over your expected lifetime are often much less than the future capital gains tax owed, purchasing insurance can potentially save your estate a substantial amount of money.
If you're the owner of an incorporated business, the company can pay the life insurance premiums and receive the insurance benefits tax-free.
Using insurance benefits to pay the tax protects your heirs from having to sell the business or other property in order to come up with the necessary funds. Being forced to liquidate assets to pay the tax bill is not a good situation to be in. Market conditions may be poor and a buyer may not be available. The value attained for the assets can be significantly less than may be expected.
For your heirs, dealing with the loss of a loved one is difficult enough without having to simultaneously make these kinds of highly stressful decisions.
The strategy for using life insurance benefits to pay for future capital gains tax will vary depending on your situation. While the basic premise is consistent, there are also investment options to consider that may help offset the cost of the premiums.
"Many business owners choose to keep assets – including real estate holdings – under corporate ownership," Andre Guillemette, an insurance advisor with BlueShore Financial, explained. "This often creates a future capital gains tax liability.
"Not only will life insurance cover these taxes in the event of unexpected death, you can also build an investment component into the insurance strategy," he added. "Over time, the value accrued through the investments can equal the insurance premiums paid. If the policy is terminated before it's needed – that is, before the owner dies – the cost of the insurance can potentially be covered by the increase in the value of the investments."
Making decisions regarding insurance strategies for covering future capital gains tax liabilities can be a complicated process. Every situation is different and your company's liquidity needs to be considered.
While your accountant can develop a structure for you, advice is typically required when it comes to implementation. A team approach where a business advisor and an insurance advisor partner and work with you to create a solution is the ideal approach.
Remember: a well-developed strategy can protect your hard-earned net worth from tax. It is worth the time to explore your options.
