For many business owners and family enterprises, leverage is a regular part of operations. Bringing existing insurance policies into the lending program can enhance the overall return on investment. Specifically, consider the advantages of a collateral loan when the policy has a negative adjusted cost basis (ACB).
Most advisors are familiar with the investment definition of ACB — adjusted cost base. It’s basically the amount of money invested. When you eventually sell the investment, there’s either a capital gain or loss, as calculated by the sale price minus the ACB. Pretty simple.
The insurance ACB — adjusted cost basis — has a lot more moving parts and can trip up a lot of professionals. In Canada, the ACB formula differs depending on when a policy was issued and other triggering transactions.
(If you’re the type who likes to Google everything, it’s worth noting that there is no ACB calculation in U.S.-based policies, so make sure you stick to Canadian sources.)
The two biggest factors that go into calculating ACB are important to understand. The first is insurance premiums, which increase the ACB, and the second is the net cost of pure insurance (NCPI), which decreases the ACB. The NCPI is essentially the mortality costs of the insurance coverage. Again, there are many more factors that go into the overall calculation, but this gives you a rough cut.
It’s not widely known or discussed, but you can have a negative ACB. (You’ll never see ACB on insurance statements, so it can be an out-of-sight and out-of-mind topic. You need to request the value directly from the insurance company.) Simply put, over time the NCPI can grind down the ACB past zero, as the total mortality costs become greater than the deposited premiums.
This negative ACB can add value to a client relationship when the fact pattern aligns. Keys facts to identify are an older policy with a higher NCPI, the ability to make deposits into the policy and, of course, that the client has borrowed to invest or is contemplating doing so. Further, proper timing and record keeping are required to help advisors and other professionals support the tax advantages that will be created.
Let’s start with the assumption of having a policy with a negative ACB. We’ll add that this is a corporately owned policy with a corporate payor and beneficiary. The death benefit minus the ACB will be credited to the capital dividend account (CDA), from which dividends can be paid tax-free, so the CDA is a powerful tool that we want to retain.
Remember, deposited premiums increase ACB. Since we assumed the ACB is currently negative, the deposits will increase the ACB but not negatively affect the CDA until the deposits push ACB above zero.
If we use the policy as collateral for a loan to earn income from a business or property, we can create tax deductions. One deduction is for the amount of interest paid on the loan. The second deduction is based on the mortality cost of the insurance premium. The protocols to follow for the insurance deduction are in the Income Tax Act, subsection 20(1)(e.2). In a nutshell, it’s the lesser of the annual premiums paid or payable and the NCPI. Therefore, with proper timing you can match the premium deposit with the NCPI for the year and deduct that amount from income.
It’s beyond the scope of this article, but you can have a policy on offset, which means the premiums are paid from policy dividends, so the policy itself can create a collateral insurance deduction.
With the two tax deductions, you’re lowering the net cost of any investment you make, thereby increasing your overall return on the investment. That’s an immediate win, but don’t forget that since you didn’t go into positive ACB territory, the full CDA can be retained and paid out to the shareholders’ estate upon death. The tax deductions and retention of the CDA payout thus create a double win.
Steve Meldrum is a corporate insurance specialist and broker with Swell Private Wealth Ltd. in Medicine Hat, Alta.