Every business owner is familiar with the old saying, cash is king. When you have it on hand, cash provides stability and the capacity for growth when opportunities arise. Since cash is the lifeblood of any business, shareholders struggle when it isn’t close by. Frankly, many view the purchase of life insurance as a threat to that cash flow, even when an accountant recommends it. However, there is a way to have your cake and eat it too using an insurance strategy called the immediate financing arrangement or IFA for short.
What is the Immediate Financing Arrangement?
In a nutshell, IFA allows a business to finance a life insurance premium on behalf of a shareholder, create tax deductions and ultimately transfer assets tax free from the business to the shareholder’s estate. It uses a life insurance policy with a cash accumulation component.
How does the Immediate Financing Arrangement Work?
It is important to know that a business can purchase an insurance policy on the life of a shareholder. Accountants usually recommend this since premiums can be paid with lower-taxed corporate dollars compared to higher-taxed personal dollars. The tax savings become significant when purchasing an insurance policy that builds cash value. Put simply, cash value is like equity in owning real estate in that it is more expensive than renting but provides you with longer term value.
Unfortunately, there is still a tax loss in this scenario since premiums are paid post corporate tax unless some planning is done to recover cash flow. The solution involves borrowing money from a bank or financial institution and using the insurance policy as collateral for a loan. Then, the loan can be invested into the business or other investments if the business does not require all of the cash flow for operations immediately.
Here are the key implementation steps of an IFA strategy:
- The business buys an insurance policy on the shareholder.
- Obtain a loan from a bank or financial institution using the insurance policy as collateral
- Invest the loan into the business or other investments
How can an Immediate Financing Arrangement be Structured?
If you already have an insurance policy with cash value, you may be able to use it instead of taking out a brand new one. Please note that a term life insurance policy does not accumulate cash and thus cannot be used for this strategy. You should also remember that to obtain an insurance policy, the insurance company may require medical evidence and will always require financial evidence.
There are three main ways to design an IFA. Let’s have a look at them in detail.
The first is to provide the loan based on the cash value of the insurance policy. It is common for the loan to range from 75%-90% of the cash value, but some lenders will go up to 100%.
Often, the cash value is initially less than the premium paid by the business, so there is still a cash outlay. Therefore, the second approach is to lend the entire premium to the business. However, this will require additional collateral for the loan, which can be investments, real estate, or other assets.
The third approach does not actually have any cash flow leakage at all as the premium and yearly net interest costs are advanced. Thus, your internal rate of return is limitless. It’s also possible to structure a personal IFA, but is typically done within a business structure.
Banks and financial institutions have different documentation requirements, rates, and terms. Some are very streamlined and can do smaller cases where premiums are as low as $10K per year. On the flip side, larger cases where the premium is $250K or more can take a bit longer to arrange, but can secure rates lower than Banker’s Acceptance (BA) rates. If the business does not want a floating rate, it can also structure a fixed rate loan, although this is less common.
IFA: What are the Perks to a Business Owner?
We had previously mentioned the business paying premiums with lower-taxed corporate dollars. Additionally, there are two potential tax deductions provided when properly structuring the plan that ultimately help reduce the overall costs of the insurance.
- Loan interest charges: The first tax deduction is the loan interest charged by a financial institution. It is important to note that for this to happen, the replacement funds from the financing company must be invested into an income generating business or investment. Some examples of investment into the business are purchasing equipment, property, or inventory.
- Collateral insurance deduction: The second write off is a collateral insurance deduction related to the insurance policy itself. It is calculated as the lesser of premiums and the net cost of pure insurance (NCPI), which is a calculation of the true mortality cost of the insurance policy. This deduction is only available when the policy holder and borrower is the same entity or person. The NCPI amount is low in the initial years but does eventually become a significant part of the policy over time. Therefore, it should not be disregarded at first glance.
Immediate Financing Arrangement Risks – What Should I Know?
As with all investment strategies, there is a list of potential scenarios to consider. Not all of them will be realized but they should be understood by you and your accountant, and properly disclosed. This way you can determine if the strategy remains relevant and appropriate for the right reasons.
- Rate changes: First and foremost, rate changes need to be considered by the business owner. Financial institutions can adjust the floating rate of their interest rate charged based on the markets and also based on the credibility of the client.
The second rate change can be the dividend rate that is credited to the cash value of the policy. Each company has different sensitivity to interest rate changes and significant swings on policies cash values can result. It is worth looking at the alternative scenarios of an insurance illustration that show how it reacts when the rates are lower than the current rate.
If the loan rate is higher than the credited rate, extra collateral may be required by the bank or financial institution. If extra collateral cannot be provided, the bank may require a withdrawal of a portion of the cash value, which will trigger a taxable gain that is included into income at 100%. The taxable gain is calculated as the amount of cash value that is over the adjusted costs basis or ACB. The insurance company will provide the ACB at any point in time.
- Tax deductions: Tax deductions have the greatest impact when applied to highly taxed income. A question to ask is if the business will be able to utilize the deductions into the retirement years of the shareholder.
- Personal loan: A unique spin on the IFA is to have the shareholder use the corporate owned policy as collateral for a personal loan as a shareholder. There is potential for this to be classified as a shareholder benefit issue, which comes with the highest level of tax. This may be avoided with a guarantee fee that is paid by the shareholder to the corporation. The guarantee fee generally needs to be reasonable and generally ranges between one and three percent (1%-3%).
- Death: Even with shareholder benefit issues covered while alive, these risks pop up again at death unless there is proper planning. If the loan to the lender is paid directly at the time of death, the shareholder would be receiving a benefit from the corporation that is taxed at the highest rate possible. However, the shareholder can avoid this by providing directions to pay through will and estate planning documents that involve the coordination between the corporation, lender, and the shareholders estate. Those documents will lay out the particular sequence of transactions to avoid being classified as a shareholder benefit.
- Hybrid strategy: Earlier in the article I mentioned how you can also do this strategy individually but there is also a hybrid method where the shareholder uses a corporate asset to obtain the loan. This structure creates shareholder benefit issues while alive, so a common method to mitigate this is for the corporation to charge a guarantee fee to the shareholder for the use of this asset.
Is There any Flexibility in This Strategy?
Yes, there is actually a lot of flexibility in terms of the policy, the loan, and your commitment to it. It is important for businesses to be able to pivot when challenges arise.
My favorite part is designing the policy itself. Of course, there is always a base amount of premium required but you can also create the capacity for additional deposits, which help you achieve higher cash values in the early years. Additional deposits build the cash value dollar for dollar right away, resulting in less collateral security requirements from the bank or financial institution. However, since the additional deposits are optional, the business can tailor the premium stream to match the evolving business.
The loan itself is usually not set in stone. If desired the loan can be paid down at a faster rate through regular payments, lump sums, or even in full as cash becomes available. There is no penalty to pay off floating rate loans or they can be switched into fixed terms if requested.
What Happens When I Die?
As mentioned earlier, the shareholder should document, in advance, the direction of pay procedures to ensure that there are no shareholder benefit issues.
After the loan is paid, there may still be some residual insurance proceeds. These funds can remain within the business or be paid out tax free to the shareholder’s estate. The mechanism that allows this tax-free payment is called the capital dividend account (CDA). The CDA balance is calculated as the death benefit minus the adjusted costs basis. The remaining CDA balance within the business after paying off the loan can be distributed to the deceased shareholder’s estate or the remaining shareholders while alive by using other business assets.
The true value of this is substantial and should not be underestimated. It can be measured by combining the yearly tax savings of the asset if it had remained within the business and the tax cost to normally move an asset from the business to an individual. The IFA strategy can be designed specifically to optimize the release of trapped retained earnings and business assets tax free.
The remaining insurance proceeds can also be used to fund buy/sell agreements, replace the shareholder, redeem shares, or pay off business debt.
The immediate financing arrangement can lower the net cost of life insurance premiums for a business owner so that cash is kept on hand. The overall rates of return on the strategy are potentially infinite as cash flow is not hampered. There is a way to have your cake and eat it too, and the best part is that you don’t have to share any with Canada Revenue Agency.
Interested in talking about life insurance solutions that can help you and your organization? Our insurance professionals look forward to hearing from you.
Steve Meldrum is a contrarian by nature. He is the corporate insurance specialist at Swell Private Wealth, a boutique firm specializing in corporate tax strategies for medical and dental professionals. His advisory practice also supports quarterly training for national and regional accounting firms, lawyers, and private bankers on advanced insurance strategies. Established as a thought leader for the dual advisor approach, he consults other financial advisors in collaborative planning. He loves the challenge of solving complex problems in creative ways with a mantra that simplicity brings clarity.