wealth transfer
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This article appears in the June 2021 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

Insurance-tracking shares are a powerful yet relatively unknown tax and estate planning tool for a business owner who is considering holding a whole life insurance policy in their corporation. These shares work in tandem with a life insurance policy to ensure a business is transferred to the next generation in a tax-efficient manner, to achieve estate equalization among heirs and to meet other estate planning goals.

When a business owner dies, if a tax-free rollover to a surviving spouse isn’t available, there is a deemed disposition of private corporation shares at fair market value (FMV), representing a potentially large tax liability to the estate. Business owners often acquire a life insurance policy for their corporation to cover this tax bill for their estate.

An insurance policy with a cash component, such as a whole life policy, may allow for tax-sheltered investment growth, which has become a bigger priority for business owners affected by tax changes in recent years, said Steve Meldrum, insurance specialist and founder of Swell Private Wealth in Medicine Hat, Alta.: “People are running out of ways to shelter their money [from taxes], so they’re putting [it] inside insurance policies.”

However, the cash value of a whole life policy is added to the FMV of private corporation shares, which increases the estate’s tax liability, a fact ”a lot of [financial] advisors are not really aware of,” Meldrum said.

To address this, the corporation may issue preferred shares that track the cash value of the insurance policy but don’t otherwise entitle the shareholder — typically, a child of the business owner — to dividends, proceeds on the sale of the business or voting rights. As the cash value of the policy increases, so does the value of the tracking shares. (Depending on the estate planning required, the shares could track both the cash value and death benefit of a policy, or even just the death benefit.)

“As the cash value [of an insurance policy] becomes greater, insurance-tracking shares become more useful,” said Jonah Mayles, partner, tax and estate planning, with Sterling Park Financial Group in Toronto.

If the tracking shares are issued before the policy is acquired, they can be given a nominal value of $1.

At the business owner’s death, the policy’s cash value is attributed to the insurance-tracking shares, not the business owner’s shares. “If you can split off [the cash value], there could be significant tax savings,” Meldrum said. The corporation redeems the insurance-tracking shares and the life policy proceeds flow from the corporation’s capital dividend account (CDA) to the shareholding child on a tax-free basis.

Insurance-tracking shares should be drafted carefully. A shareholder’s agreement can ensure that the strategy “actually gets enforced” and works as intended, Meldrum said.

While an insurance-tracking share strategy can be used when an estate freeze has already been implemented, the freeze may mitigate the need for such a strategy, “as the growth in the value of the business has already been deferred,” Mayles said.

One key pitfall of this strategy occurs when a child who has been issued tracking shares predeceases the business owner. In these cases, the FMV of the tracking shares will be added to the value of the deceased’s estate, triggering a taxable event without a corresponding distribution of assets to offset the tax liability.

One way to mitigate the risk arising from that kind of premature death is to create a family trust and issue the shares to the trust instead, said Jean Turcotte, director of the tax, insurance and wealth management group with Sun Life Financial Inc. in Montreal. The trust would then have a number of beneficiaries to whom the shares can be distributed.

Insurance-tracking shares also can be used to equalize an estate for heirs, particularly when some children are active in the business while others are not. The corporation could issue insurance-tracking shares to either the active or inactive children. In the former case, when the business owner dies, the active children use the share proceeds to buy the inactive siblings’ common shares. If the shares go to inactive children, those children would simply receive the proceeds when the business owner dies.

Finally, insurance-tracking shares can be used to distribute estate assets in a tax-efficient manner when a beneficiary isn’t a resident of Canada. Distributions from the CDA to a U.S. beneficiary, for example, would be subject both to Canadian withholding taxes and U.S. taxes, so “you may want to have the death benefit track to the Canadian-resident beneficiary and have the U.S. beneficiary receive other shares or assets from the estate,” Meldrum said.

Meldrum noted that insurance-tracking shares are not “baked into the tax act,” which he suggests is one of the reasons they may not be commonly used.

However, the Canada Revenue Agency (CRA) has given its blessing to insurance-tracking shares, most notably in a pair of 2005 technical interpretations. At a May 2021 Canadian Life and Health Insurance Association tax officers conference, CRA officials confirmed that the agency’s position hadn’t changed.