What are Insurance-Tracking Shares?

You work hard to build a successful business. But now that you feel age is catching up with you, it’s time you start planning your transition plan.

The question, however, is: How can you pass the business to your children in the most tax-efficient manner? 

Insurance-tracking shares might just be the answer to your problem. 

Issued as preferred, non-voting, and non-participating shares, they help protect your assets from taxes after death. However, in order to use these shares to your advantage, you first must buy a corporate-owned whole life insurance policy. 

Follow along as we explain what insurance-tracking shares are and how you can use them to your advantage. 

What is whole life insurance?

Whole life insurance covers you for your entire life, provided you pay the premiums. With whole life, you can rest assured knowing that your beneficiaries will eventually receive the death benefit. 

Apart from the death benefit, whole life insurance includes a savings component — called the cash value. The cash value grows tax-deferred at a fixed rate set by the insurance company. This means all the interest earned on the cash value is tax-free, unless you withdraw the funds. You can access your policy’s cash value at any time and for any purpose. 

Keep in mind that when you pass, your beneficiaries will only receive the death benefit, not the cash value. The latter is for you to access during your lifetime. Because unlike term life insurance, whole life insurance lasts your entire lifetime and includes a savings component, it is significantly more expensive. 

Sometimes whole life insurance is used as an umbrella term for all types of permanent life insurance such as term-to-100 and universal life insurance. 

Though all types of permanent life insurance offer lifelong coverage, not all of them have cash value. For example, term-to-100 does not include a savings component while universal life does not offer a guaranteed rate of return on its cash value. 

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What are insurance-tracking shares?

Insurance tracking shares are preferred shares used for transferring the benefits associated with a corporate-owned whole life insurance policy (cash surrender value or the death benefit or both) to the heirs of a shareholder.  

Insurance tracking shares, also known as life insurance shares, lower your estate’s tax liability upon death. By tracking the cash value and/or death benefit, they let you transfer the family business to your children in a tax-efficient manner. Apart from helping with that, life insurance shares can also play a pivotal role in estate equalization. 

Insurance-tracking shares are non-voting and non-participating. Non-voting means the stockholders cannot vote on matters of corporate policy. Whereas, non-participating means the shareholders do not have the right to the remaining property of the company if it is dissolved. 

How do life insurance-tracking shares work?

Insurance tracking shares, also known as life insurance shares, are a potent estate planning tool for a business owner with a corporation-owned life insurance policy. These shares work together with a whole life insurance plan to ensure: 

• A tax-efficient business transition to the heirs after the death of the owner
• The owner’s estate is divided equitably among the deceased’s heirs
• A tax-efficient distribution of estate assets when a beneficiary is not a Canada resident

Tax-efficient business transition

If the tax-free rollover option is not available to the surviving spouse, the deemed disposition of the deceased’s shares is reported at fair market value (FMV). This, however, could mean a huge tax bill for the estate. To offset the expense, business owners often opt for a corporation-owned life insurance policy. 

Since whole life insurance provides lifelong protection, it is the insurance policy of choice for estate planning. You know for sure that your beneficiaries will receive a payout and be able to use it to offset taxes. For business owners, the cash value may be an added benefit, since you can use it to shelter their money from taxes.

However, your policy’s cash value gets added to the fair market value of the company shares owned by you when you pass. This can significantly increase your estate’s tax burden.

You might be wondering, “How can I reduce my estate’s tax liability and still use a whole life insurance policy to my advantage? 

The answer is by having your company issue insurance-tracking shares. 

Issued as preferred shares, they track your policy’s cash value, without giving the shareholders any voting rights. Nor would your heirs be eligible for dividends or receive any proceeds from the sale of the company if it is sold. 

Because insurance-tracking shares track the cash value of your policy, they grow in value as your policy’s cash value grows. Depending on your estate planning needs, the shares could track:

• Your life insurance policy’s cash value
• Your policy’s death benefit 
• Both the death benefit and cash value 

If issued before the purchase of the life insurance policy, insurance tracking shares can have a nominal value of $1. 

When you pass, your policy’s cash value is attributed not to your shares, but to the life insurance shares. This arrangement can lead to substantial tax savings. Your company redeems these shares and your shareholding children receive the life insurance proceeds tax-free from your company’s capital dividend account, or CDA.

Estate Equalization 

As most parents, you probably want to leave each child the same inheritance.

You might not want to divide ownership of your business equally among your children. Since businesses usually represent the largest part of any estate, you might not have the wherewithal to leave an equitable inheritance to the inactive children. 

So, how can you pass the business to the active children while ensuring others receive an equitable inheritance? 

Insurance tracking shares offer a way out. Your company could issue them to either the inactive or active children. If issued to the inactive children, the proceeds from the policy would ensure they receive a fair financial compensation. If given to the active children, they can use the money to buy out their inactive siblings.  

Here is a real-life example that shows how insurance-tracking shares work:

Mr. Miles Bakers fully owns VintageDreams Inc., which has a fair market value of $3 million. He has two sons — Joe and Mike — but only Mike is actively involved in day-to-day running of VintageDreams. 

To ensure both his children are treated fairly, Mr. Bakers gives the company’s common shares to Mike. And to his other son, he plans to leave a whole life insurance policy with a death benefit of $3 million. 

Rather than buying life insurance himself, Mr. Bakers buys a corporately-owned policy. This allows him to pay the premiums with lower after-tax dollars. He then directs his company to issue life insurance shares at a nominal value of $1 before the policy is purchased. Once the life insurance plan is in place, Joe buys these shares. As a result, he would receive a non-taxable dividend equal to $3 million after Mr. Bakers died. 

Thus, issuing insurance-tracking shares to Joe and gifting company’s shares to Mike allows Mr. Baker to divide his estate equitably between his children in a tax-efficient manner. 

Tax-efficient distribution of an estate when a beneficiary is not a Canadian resident

Insurance tracking shares can prove useful where some of the heirs are Canadian residents, while others are not. For example, if you distribute money to a resident in the USA from the capital dividend account, the latter would pay both US taxes and Canadian withholding taxes.

This means your heir would receive much less than what you intended him or her to receive. To address this problem, you could have your company issue life insurance shares to your Canadian beneficiary and pass other assets to the non-resident beneficiary. 

Why should I use insurance-tracking shares?

Most people use insurance-tracking shares for a tax-efficient transitioning of their family business to the next generation. However, these shares can be used for other purposes as well, such as estate equalization. 

If all of your children are not interested in inheriting the family business, you could issue life insurance shares to either the active or inactive children to achieve your goal of estate equalization. You may also consider using insurance-tracking shares if your family has cross-border connection. These shares can help ensure your estate is divided fairly among the Canadian heirs and non-residents family members. 

What are the tax benefits of owning business-owned life insurance?

There are three main advantages of owning a corporately-owned life insurance policy. 

1. Corporate tax rates are generally lower than personal tax rates

Unless you use a corporately-owned policy as loan collateral, the premiums do not count as a deductible expense. All the same, buying a life insurance policy by corporate dollars is more advantageous than purchasing one by personal dollars. This is because corporate tax rates are invariably lower than personal tax rates. 

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2. Part of all of the insurance proceeds can be passed tax-free to your family

If the company is both the owner and beneficiary (which is nearly always the case with corporately-owned policies), the insurance payout is issued to it tax-free. When the proceeds come into the company, a certain amount also gets credited into the CDA.  This amount is equal to the death benefit minus the policy’s adjusted cost basis. The company can pass this amount tax-free to anyone immediately or at a later date. 

Business owners can use the CDA to flow a part or potentially all of the insurance payout to their heirs or estate tax-free. 

3. To reduce the estate’s tax liability

By having your company issue life insurance shares, you can use a whole life insurance to reduce your estate’s tax liability after your death. Your company could issue these shares at a nominal rate of $1 before taking out a life insurance policy on your life. Your heirs would then purchase the insurance-tracking shares and eventually receive the proceeds from it tax-free. Depending on your needs, you can have these shares track your policy’s cash value or death benefit or both. 

Insurance-Tracking Shares and Whole Life Insurance

Life insurance shares track the cash value and/or death benefit of a whole life insurance policy. They can lower your estate’s tax liability upon death, pass your business to your heirs in a tax-efficient way, and ensure an equitable distribution of your assets among your heirs. 

Looking to learn more about ways to save on taxes with estate planning? Book a call with a Dundas Life licensed advisor today.