When a private Canadian corporation receives life insurance proceeds after an insured person dies, the proceeds can increase its Capital Dividend Account or CDA. The CDA credit is generally the death benefit received less the policy’s adjusted cost basis immediately before death.
The corporation may then use its available CDA balance to pay a capital dividend that is generally tax-free to Canadian resident shareholders, provided it makes a valid election.
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How Does Life Insurance Create a Capital Dividend Account Credit?
Life insurance creates a CDA credit when a private corporation receives policy proceeds because an insured person dies. The corporation’s CDA increases by the net life insurance proceeds which generally means the death benefit less the policy’s adjusted cost basis immediately before death.
The corporation must receive the proceeds as the policy beneficiary or in another manner that meets the applicable tax rules. A policy owned personally by a shareholder does not create a CDA credit for the corporation simply because the shareholder owned the business.
What Is the Formula for a Life Insurance CDA Credit?
The life insurance CDA credit is generally calculated as:
CDA credit = Life insurance death benefit − Adjusted cost basis immediately before death
For example, a corporation receives a $1,000,000 life insurance death benefit. The policy’s adjusted cost basis immediately before death is $40,000.
$1,000,000−$40,000=$960,000
The corporation may add $960,000 to its CDA, subject to the applicable tax rules.
What Is Adjusted Cost Basis in Life Insurance?
Adjusted cost basis or ACB is a tax value assigned to a life insurance policy. It is not the policy’s cash value, surrender value or death benefit.
The ACB immediately before death reduces the amount of life insurance proceeds that can be added to the corporation’s CDA. As the policy ages, its ACB may decrease. The insurer can provide the policy’s ACB and other annual tax information.
Does the Corporation Pay Tax on Life Insurance Proceeds?
No. A life insurance death benefit received by a corporation is generally not taxable income to the corporation.
The proceeds can increase the corporation’s CDA. This can create a tax efficient path for the corporation to distribute available funds to Canadian resident shareholders through a properly elected capital dividend.
This differs from a regular dividend. A regular dividend is generally taxable to the shareholder.
How Can a Corporation Pay Out Life Insurance Proceeds Tax-Free?
A private corporation can pay out life insurance proceeds through a capital dividend if it has enough CDA balance and files a valid capital dividend election with the Canada Revenue Agency.
The corporation files Form T2054, Election for a Capital Dividend Under Subsection 83(2). The election must be filed by the earlier of the day the dividend becomes payable or the day any part of the dividend is paid. The filing includes a calculation of the corporation’s CDA balance immediately before the dividend.
A properly elected capital dividend is generally tax-free to Canadian resident shareholders.
Does the Corporation Need to Own the Life Insurance Policy?
No. The corporation does not always need to be the policyowner to receive a CDA credit. The important question is whether the corporation receives life insurance proceeds as a beneficiary after the insured person dies and whether the applicable tax rules are met.
In many business planning arrangements, the corporation owns the policy, pays the premiums and is named as beneficiary. This is commonly called corporate owned life insurance.
Can a Corporation Pay a Capital Dividend Before Receiving the Death Benefit?
No. A corporation cannot add life insurance proceeds to its CDA until it receives the proceeds.
The CDA credit arises when the corporation receives the life insurance death benefit. The corporation should calculate its CDA balance immediately before declaring a capital dividend and should not assume that an expected insurance payment is already available for distribution.
What Happens If a Corporation Pays More Than Its CDA Balance?
A corporation that pays a capital dividend greater than its available CDA balance may be subject to a penalty tax on the excess amount.
The corporation may have limited options to correct an excessive capital dividend, including treating some or all of the excess as a taxable dividend. The rules, conditions and deadlines are strict.
The corporation should confirm its CDA balance before declaring the dividend and before filing Form T2054.
