TAXATION OF LIFE INSURANCE & TAX STRATEGIES (P2) (Chapter 7)

Question 1

REVIEW

How do you calculate the Net Amount at Risk ?

Answer 1

Death Benefit – Investment Account Value

• (ex. Pratik owns a UL policy with a death benefit of $500,000 and an account value of $128,000. The current NAAR of his policy is $372,000, calculated as ($500,000 – $128,000).

Question 2

REVIEW

What are the calculations for a policy gain?

Answer 2

Policy gain = proceeds of disposition – adjusted cost basis (ACB)

(e.g., Brian surrendered his whole life insurance policy and received proceeds of $46,000. The insurance company advised him that his adjusted cost basis (ACB) was $20,000, so he had a policy gain of $26,000 and 100% of this was taxable. Policy gain = $46,000 – $20,000 = $26,000

Question 3

Adjusted Cost Basis Calculations

REVIEW

Last Acquired Polices (G1, G2, G3) (Participating & Non-Participating) before & after December 1st 1982 key points

Answer 3

Policies prior to Dec. 2nd 1982 (G1)

(Non-participating)
CSV — Premium = ACB

(Participating Policies)
Premium — Dividends = ACB
—————————————————————-

Policies post Dec. 1st 1982 (G2 & G3)

(Non-Participating)
Premiums — NCPI = ACB

(Participating)
Premiums — NCPI — dividends = ACB

Question 4

REVIEW

What are the calculations of a full surrender?

Answer 4

CSV — ACB = Policy Gain
($24,00 - $10,00 = $14,000)

Policy Gain x MTR = Tax Payable
(14,000 x 35% = $4,900)

CSV — MTR = After Tax Funds
$24,000 — $4,900 = $19,000

[Ref.7.3.1]

Question 5

REVIEW

What are the calculations for a PARTIAL surrender?

Answer 5

CSV = $24,000
ACB = $10,000
FA = $200,000

(Reducing $200,000 to $150,00 for example)

1. Face Amount — Reduced Coverage / Face amount = Percentage%
   ($200,000 — $150,000 / $200,000 = 25%)
2. Percentage% x ACB = Prorated ACB
   (25% x $10,000 = $2,500)
3. Percentage% x CSV = Prorated CSV
   (25% x $24,000 = $6,000)
4. Prorated CSV — Prorated ACB = Policy Gain
   ($6,000 — $2,500 = $3,500)
5. Policy Gain x MTR = Tax Payment
   ($3,500 x 35% = $1,225)
6. Policy Gain — Tax Payment = After Tax Gain
   ($3,500 — $1225 = $2,275)

[Ref.7.4.1]

Question 6

REVIEW

What are the calculations for a policy withdrawal?

Answer 6

FA = $200,000
ACB = $65,000
CSV = $80,000

1. Amount withdrawn ÷ CSV x ACB = Prorated ACB
   (($40,000 ÷ $80,000) x $6500) = $32,500
2. Amount withdrawn — Prorated ACB = Policy Gain
   $40,000 —32,500 = $7500
3. Policy Gain x MTR = Tax Payable
   $7,500 x 35% = $2,625
4. Policy Gain — Tax Payable = After Tax Funds
   $7,500 — $2,625 = $2875

[Ref. 7.4.2]

Question 7

REVIEW

TRUE OR FALSE?

If the policyholder takes out a policy loan that is less than the adjusted cost basis (ACB), he will not have a policy gain, but the ACB will be reduced by the amount of the loan.

Answer 7

TRUE

• (e.g., Alicia’s ACB is $10,000. If she only took out a policy loan of $4,000, the policy’s ACB would be reduced to $6,000.

New ACB = $10,000 – $4,000 = $6,000

(She would not have to report a policy gain)

Question 8

REVIEW

What happens when the policyholder takes out a policy loan that is greater than the policy’s ACB?

Answer 8

If a policyholder takes out a policy loan that is greater than the policy’s ACB, he will have a policy gain equal to the amount of the loan, minus the ACB. The ACB of the policy will be reduced to zero.

• *(e.g., Alicia’s ACB is $10,000.
• Suppose that she instead takes out a policy loan of $19,000. She would have a policy gain of $9,000 and $3,150 in tax payable)*.

(Policy gain = $19,000 – $10,000 = $9,000
Tax payable = $9,000 × 35%)

• Her policy would now have an ACB of $0.

Question 9

Life Insurance Terminology

Successor Policyholder

Answer 9

Someone who will receive ownership of the policy if the original applicant/ policyholder dies.

Question 10

REVIEW

What happens when you repay a policy loan?

Answer 10

If a policyholder repays a policy loan, he will be able to deduct the repayment from his taxable income, up to the amount of the policy gain he had to report when he took out the loan.

If he repays more than this amount, the excess will increase the policy’s ACB.

• (e.g., Alicia’s ACB is $10,000 Suppose that she repays $12,000 of her $19,000 policy loan. She would be able to claim a tax deduction of $9,000, which is the amount of the policy gain she had to include in her income as a result of the loan.
• The ACB of her policy would increase to $3,000.
• (ACB calculated as $12,000 – $9,000)).

Question 11

REVIEW

What is an exempt test, and it’s purpose?

Answer 11

Hypothetical rule that prevent taxpayers from taking unfair advantage of the favorable tax treatment of investment income that may be provided within an insurance policy.

Question 12

Life Insurance Terminology

Spousal Rollover

Answer 12

Rollover of a life insurance contract or property from one spouse to another, without triggering a taxable disposition.

Question 13

Life Insurance Terminology

Intergenerational Transfer

Answer 13

The rollover of an insurance policy to a child

Question 14

Chapter 7 (Part 2)

What is an Absolute Assignment?

Answer 14

When the policyholder can transfer ownership, control, and rights under a life insurance policy to another person.

Question 15

Name 3 situations of an absolute assignment

Answer 15

• A non-arm’s length party (other than the policyholder’s spouse or child);
• The policyholder’s spouse;
• The policyholder’s child or grandchild

Question 16

Explain the term Arms Length transfer

Answer 16

• Transferring policy to a stranger (not blood related)
• Transferring to sibling (brother, sister)
• Proceeds are deemed to be equal to the amount that the policyholder would have received if he surrendered the policy.
• (In other words; CSV becomes the successor’s ACB)

[Ref. hllqp 7.8 -12.7 assignment of policy p1]

Question 17

Explain the tax implications on the arms length transfer with a scenario.

Answer 17

Jack owns a policy on his wife Amanda, with face amount $200,000. Jack is also the beneficiary on the policy.

Jack decides one day that he wants to transfer the ownership to his brother Jim (the transfer also could of been a stranger, in other words he’s not transferring to his spouse or children.)

At the time of the assignment, the ACB is $34,000 and CSV is $61,000. After disposing the policy, Jack acquires a policy gain of $27,000 (CSV minus ACB)

He reports the gain on his MTR

Now that Jim owns the policy, his ACB is $61,000 because the tax has always been paid by Jack at his MTR up to the $61,000.

(If Jack was to pass away, Jim would still be the successor owner of the policy and the gain of the disposition will be to jack’s estate).

[Explain this scenario to the client using your own words and examples]

[Ref. hllqp 7.8 -12.7 assignment of policy p1]

Question 18

In simple terms what is a NON-arms Length transfer

Answer 18

• When policyholder assigns policy to spouse or child
• Rollover (intergenerational transfer) applies to the successor
• There is no deemed disposition
• Successor will acquires the same ACB as the policyholder

[Ref. hllqp 7.8 -12.7 assignment of policy p2]

Question 19

Non-Arm’s length is also known as…

Answer 19

Intergenerational Transfer

Question 20

Illustrate NON-arms length transfer between Policyholder & Spouse.

Answer 20

SPOUSE Non-Arms length transfer

Jack (Policyholder), Amanda (Spouse)
ACB = $34,00
CSV = $61,00

• Rollover applies
• No deemed disposition
• Amanda (Spouse) acquires policy at the same ACB ($34,00) as Jack (Policyholder)
• This transfer has income attribution ( Which means If policyholder is still alive after the transfer and chooses not to opt out of the rollover provision, any policy gains by the spouse will trigger tax implications for Jack the policyholder)
• Opting out of the rollover provision is optional however, there will be a deemed disposition (gain) of $27,000 at the policyholder’s MTR ($27,000 x 35%)
• Amanda (Spouse) will receive the ACB at $61,000 (only if Jack (Policyholder) opts out of the rollover provision if he doesn’t Amanda will receive the ACB at $34,000)

[Explain this scenario to the client using your own words and examples]

[Ref. hllqp 7.8 -12.7 assignment of policy p2]

Question 21

Illustrate NON-arms length transfer between Policyholder & CHILD.

Answer 21

CHILD Non-Arms length Transfer

Mary (Mother/Policyholder), Sarah (Child)
ACB = $16,00
CSV = $24,00

• No deemed disposition
• Has rollover provisions
• Sarah (Daughter) acquires policy at the same ACB ($16,00) as Mary (Policyholder/Mother)
• As the child became an adult (18), The CSV grew to $40,000. If Sarah withdraws, or surrenders the policy, there will be a policy gain (deemed disposition) of $24,000 on her MTR ($24,000 x 25%)
• However, If Sarah (daughter) is still a minor while withdrawing, or surrendering the policy, the gain (deemed disposition) will be taxed on Mary’s (Policyholder/Mother) MTR
• Policy can also be transferred to a Trust on behalf of the child
• However, If the policy gets transferred to the trust there is a deemed disposition and tax implications applied to the policyholder and there will be no rollover provision.
• Opting out of the rollover provision is optional however, there will be a deemed disposition at the policyholder’s MTR ($27,000 x 35%)

[Explain this scenario to the client using your own words and examples]

[Ref. hllqp 7.8 -12.7 assignment of policy p3]

Question 22

TRUE OR FALSE?

There is no deemed disposition in a rollover

Answer 22

TRUE

[Ref. hllqp 7.8 -12.7 assignment of policy p3]

Question 23

Why would a policyholder want to opt out of a rollover?

Answer 23

A policyholder might want to opt out of the
rollover if he has a lower marginal tax rate than his spouse.

• (i.e., Noah recently assigned a life insurance policy with a CSV of $85,000 and an ACB of $32,000 to his wife.
• Noah has a rental loss of $70,000 and no other taxable income. If he opts out
  of the automatic rollover, the policy assignment will result in a policy gain of $53,000. (Policy gain = $85,000 – $32,000 = $53,000)
• (However, this will be more than offset by his rental loss, so it will not result in him having to pay tax. Furthermore, by opting out of the rollover, Eve’s ACB for the policy becomes $85,000 rather than $32,000)

[Explain this scenario to the client using your own words and examples]

[Ref. 7.8.3.1]

Question 24

Explain Income Attribution Rule

Answer 24

Taxable income to the transferor spouse even if it is earned and legally belongs to the recipient spouse. Once the transferor spouse dies, the income attribution rules cease to apply.

• (i.e., Noah recently assigned a life insurance policy with a CSV of $85,000 and an ACB of $32,000 to his wife, Eve.
• Suppose that Noah did not opt out of the automatic rollover, and that Eve later
  surrendered the policy when its CSV was $94,000. As a result of the income
  attribution rules, Noah would have to report the resulting policy gain of $62,000.
  (Policy gain = $94,000 – $32,000 = $62,000)

[Explain this scenario to the client using your own words and examples]

Question 25

TRUE OR FALSE?

By opting out of the rollover, there is no deemed disposition and the ACB for the recipient spouse will be set to zero, after the transfer.

Answer 25

FALSE

By opting out of the rollover, the ACB for the recipient spouse will be higher, which in turn will reduce the policy gain when the recipient spouse later disposes of the policy.

Question 26

TRUE OR FALSE?

In a Non-Arms length transfer, any policy gain that is subsequently triggered when the transferee child disposes of the policy will be taxable to that child, as long as the child is at least 18 years old by the end of the year.

Answer 26

TRUE

Question 27

TRUE OR FALSE?

In a Non-Arms length transfer, If the
child is under 18, the income attribution rules doesn’t apply and the policy gain will be taxable to the child.

Answer 27

FALSE

If the child is under 18, the income attribution rules will apply and the policy gain will be taxable to the original policyholder.

Question 28

Define the definition of “Child” in a Non-arms length transfer.

Answer 28

For the purpose of this rollover provision, a “child” of the policyholder includes the policyholder’s child, grandchild or great-grandchild, regardless of whether that relationship is by blood or adoption.

Question 29

TRUE OR FALSE?

A policyholder could acquire a UL policy on the life of a child, and maximum fund it to build up the CSV as quickly as possible. He could then give the policy to that child, and the rollover provision would apply.

Answer 29

TRUE

Question 30

TRUE OR FALSE?

If a child surrenders non-arms length policy prior to age 18, income attribution rules would apply, meaning that the original policyholder would have to report the policy gain as income.

Answer 30

TRUE

Question 31

TRUE OR FALSE?

If the policyholder dies and he is not the life insured by that policy, then generally he is deemed to have disposed of that policy immediately prior to death.

Answer 31

TRUE

Question 32

TRUE OR FALSE?

Upon death, the policyholder will result
a policy gain on the final tax return, equal to the CSV minus its ACB.

Answer 32

TRUE

• (i.e., At the time of his death, John owned a $300,000 whole life insurance policy
  on the life of his wife, Jacinta. His will left all of his property to his estate.
• The policy had a CSV of $73,000 and an ACB of $20,400. This resulted in a policy gain of $52,600.(Policy gain = $73,000 – $20,400 = $52,600)
• This amount was reported on his final tax return and taxed at his marginal tax rate.
• If John had left the policy to his wife, Jacinta, his deemed proceeds would have been equal to the policy’s ACB of $20,400, and no policy gain would have been triggered by his death.
• Jacinta would have acquired the policy with an ACB of $20,400)

[Ref. 7.9.1]

Question 33

TRUE OR FALSE?

A policyholder is allowed to designate a contingent or successor policyholder on his life insurance policy, who will automatically receive ownership of the policy upon his death.

Answer 33

TRUE

Question 34

TRUE OR FALSE?

designating a contingent policyholder allows the policyholder to avoid the deemed
disposition rules upon death.

Answer 34

FALSE

Designating a contingent policyholder will not allow the policyholder to avoid the deemed disposition rules upon death, unless a rollover applies.

Question 35

What are some taxation STRATEGIES that could be used in life insurance?

Answer 35

• Using the policy for collateral, including borrowing for business use;
• Annuitizing the cash surrender value to create a steady income;
• Leveraging a life insurance policy to create a retirement income;
• Charitable giving

[Ref. 7.10]

Question 36

Taxation of Life Insurance strategies

How can you use a life insurance policy as a collateral?

Answer 36

• By using the policy’s cash value as collateral for a loan from a third party.
• The policyholder assigns the rights to the
  policy’s cash values and death benefit to the lender, which is called a collateral assignment.

Question 37

TRUE OR FALSE?

A collateral assignment can trigger a deemed disposition to the policyholder.

Answer 37

FALSE

• Unlike an absolute assignment, a collateral assignment is not a deemed disposition for tax purposes, so it will not trigger a policy gain.
• The full cash value stays in the policy, where it can continue to grow on a tax-sheltered basis.

Question 38

Taxation of Life Insurance strategies

What are the conditions on the premiums when a business loan is secured by a collateral assignment?

Answer 38

• The loan needs to be from an authorized lender;
• The lender requires a collateral assignment of an existing or new policy to secure the loan.

Question 39

What are the premium deduction calculations for a business expense on a collateral assignment?

Answer 39

Face Amount / Loan Amount = Percentage%
($500,000 / $200,000 = 40%)

Percentage x NCPI = Deduction
(40% × $3,200 = $1,280)

(That’s the deduction as a business expense when you acquire this loan)

Question 40

Illustrate an example of premium deductions on a collateral assignment.

Answer 40

• Heloise borrowed $200,000 from a financial institution to expand her business.
• The lender required the collateral assignment of her $500,000 universal
  life policy, which had an adjusted cost basis (ACB) of $160,000 and a cash surrender value (CSV) of $250,000. Heloise paid premiums of $12,000 annually, with a NCPI of $3,200.
• Because Heloise’s policy is for $500,000 but the loan is only for $200,000, she can only deduct 40% of the NCPI.
• (Percentage of NCPI deductible
  = $200,000 ÷ $500,000 = 40%)
• So, she can deduct $1,280 as a business expense. (Deduction = 40% × $3,200 = $1,280)

[The NCPI can be found in either the terms of the insurance contract or with the insurance company.]

[Ref. 7.10.1.2]

Question 41

How do you annuitize the cash surrender value (CSV) on your policy?

Answer 41

By using the CSV to buy an annuity that will provide an ongoing series of income payments, either for life, or for a fixed period of time.

Question 42

TRUE OR FALSE?

Annuitizing the CSV is similar to an absolute assignment as an Arms length transfer. The lender acquires the policy with the same ACB as the policyholder and the policyholder acquires a “Paid-up” annuity.

Answer 42

FALSE

Annuitizing the CSV is not an absolute assignment. By annuitizing the CSV, you are essentially cancelling the contract and surrendering the policy.

Question 43

TRUE OR FALSE?

Some tax relief is provided if the policyholder is totally and permanently disabled at the time he annuitizes the CSV

Answer 43

TRUE

• If this is the case, the policy gain will be spread out over the life of the annuity also result in the policy gain being taxed at a lower rate because the marginal tax rate over the annuitization period will likely be lower.

Question 44

How does a partial surrender apply in annuitizing your CSV?

Answer 44

By decreasing the coverage, and annuitizing only a portion of a policy’s CSV. (This will be treated as a partial surrender for tax purposes, with a prorated policy gain)

Question 45

Explain insured retirement strategy

Answer 45

• The policyholder negotiates a series of annual loans, where each loan is secured by the policy’s CSV. When the life insured dies, the lender recovers the amount of the cumulative loans from the death benefit, with the remainder going to the beneficiaries.
• This is just another way to leverage a life insurance policy for retired policyholders who are looking for a tax-free source of retirement.

[Ref. 7.10.3.1]

Question 46

Charitable Giving

There are a number of ways that a person can use life insurance to help meet his philanthropic
goals, what are they?

Answer 46

• Assigning a new life insurance policy to a charity;
• Assigning an existing life insurance policy to a charity; or
• Naming a charity as the beneficiary of a new or existing life insurance policy

Question 47

TRUE OR FALSE?

Methods of charitable giving has the potential to result in a municipal tax credit.

Answer 47

FALSE

Methods of charitable giving has the potential to result in a charitable donations tax credit.

[Ref. 7.10.4]

Question 48

Explain Charitable donations tax credit

Answer 48

A person who makes one or more donations to a registered charity can claim non-refundable federal and provincial charitable donations tax credits for the amount of those donations.

Question 49

Explain the Federal & Provincial tax credits for charitable giving

Answer 49

A federal credit rate of 15% is applied to the first $200 of donations claimed during the year, and a federal credit rate of 29% is applied to donations over $200.

(The provincial credit rates vary by jurisdiction)

[Ref. 7.10.4.1]

Question 50

TRUE OR FALSE?

The tax credit is non-refundable, which means that the donator can only use the tax credit to offset his income tax otherwise owing, but he cannot use it to generate a refund.

Answer 50

TRUE

Question 51

*Charitable Giving

FILL IN THE BLANK

A donator can carry unused tax credits forward ________, and use it to reduce his tax liability in one or more of those years.

a) after 6 years
b) until policy cease
c) as a rollover
d) up to 5 years

Answer 51

A donator can carry unused tax credits forward for up to five years and use it to reduce his tax liability in one or more of
those years.

Question 52

Charitable Giving

There is a limit on the amount of donations that can be claimed for the year. What is it?

Answer 52

This limit is normally set at 75% of net income.

• (When the donor dies, the limit is increased to 100% of net income for the year of death, and the immediately preceding year)

Question 53

Can you assign your policy to a charitable organization?

Answer 53

YES

• You can assign a new insurance policy to a charity
• You can assign an existing insurance policy to a charity

Question 54

Explain the rules and limits of assigning a NEW life insurance policy to a charitable organization.

Answer 54

• The assignment of the policy is not considered to be an immediate charitable donation, and the charity cannot issue a tax credit to the donor due to insufficient cash value of a new policy
• However, if the policyholder continues to pay the premiums on a life insurance policy (Term or Perm) after assigning it to the charity, the amount of those premiums would be eligible for the charitable donations tax credit.

Question 55

Explain the rules and limits of assigning a EXISTING life insurance policy to a charitable organization.

Answer 55

If the existing policy is a permanent insurance policy, the charity will issue a tax receipt to the policyholder.

The tax credit will be equal to the CSV or the fair market value of the policy at the time of the assignment.

[Ref. 7.10.4.3]

Question 56

TRUE OR FALSE?

The assignment of an existing term policy to a charity will result in a tax receipt for the former policyholder.

Answer 56

FALSE

Because term life insurance policies do not build up a cash surrender value, the assignment of an existing term policy to a charity will not result in a tax receipt.

Question 57

TRUE OR FALSE?

An absolute policy assignment is a deemed disposition for tax purposes, even when it takes the form of a charitable gift.

Answer 57

TRUE

Question 58

TRUE OR FALSE?

Assigning an existing life insurance policy will result in a policy gain to the extent that the policy’s CSV exceeds its ACB at the time of the assignment.

Answer 58

TRUE

• (This policy gain will be taxable at the donor’s marginal tax rate)

[Ref. 7.10.4.3]

Question 59

TRUE OR FALSE?

Regardless of whether the policyholder is assigning a new policy or an existing policy to a charity, if he continues to pay the premiums for that policy after the assignment, he will be able to claim the charitable donations tax credit on the cash value.

Answer 59

FALSE

Regardless of whether the policyholder is assigning a new policy or an existing policy to a charity, if he continues to pay the premiums for that policy after the assignment, he will be able to claim the charitable donations tax credit on those premiums.

[Ref. 7.10.4.3]

Question 60

Charitable Giving

TRUE OR FALSE?

The policyholder can also get a tax receipt if the charity is named as the beneficiary on the policy.

Answer 60

The policyholder will not get a tax receipt at the time he names the charity as the beneficiary, nor will he get a tax receipt for the premiums he pays.

Question 61

Explain Why the policyholder does not get a tax receipt if the charity is named beneficiary on the policy?

Answer 61

• The charity does not get ownership or control of the policy, and they cannot surrender the policy to receive the cash surrender value;
• There is no guarantee that the policyholder will not change the beneficiary at a later date (unless
  the beneficiary designation is made irrevocable);
• There is no guarantee that the policyholder will continue to pay the premiums and keep the policy in force; if he lets the policy lapse, the charity will not receive anything upon his death.

Question 62

Charitable Giving

If the charity is named beneficiary, can they issue a tax receipt to the policyholder for the amount of the death benefit paid out upon the death of the life insured?

Answer 62

YES

The charity will issue a tax receipt to the policyholder for the amount of the death benefit paid out upon the death of the life insured.

[Ref. 7.10.4.4]

Question 63

Business life insurance

What are the four primary taxes or fees that can burden an estate?

Answer 63

• Tax on capital gains;
• Tax resulting from the collapsing of registered plans (RRSP, RRIF, etc.);
• Taxes payable by the estate;
• Probate fees