This article is a mini course on liquidity contracts. It is a course explaining what a liquidity contract is and various types; why prior planning around certain liquidity contracts could expose them to one’s unsecured creditors; and sets the stage for a critical analysis as to how and why one should protect that investment.
As such, this mini course is dividend into four topics:
- What is a liquidity contract?
- What puts a liquidity contract at risk of loss?
- What are the barriers for replacing a liquidity contract, the concept of recovery?
- How do I protect my liquidity contract?
Lets get started!
Liquidity contracts, what are they?
- Contracts issued by financial institutions.
- The purpose of which is to create a cash injection on the happening of a “critical event”.
- Cash injection is often tax free
What are the common critical events that these contract cover?
- Permanent disability.
- Critical illness.
Why would one purchase liquidity contracts?
- Tax efficient cash injection for one’s business or family should a critical event happen
Why is that important?
- During a critical event one is no longer able to work on a full time basis, if at all.
- Possibility of a financial crunch to both one’s business and family.
What are the differences among the contracts?
Permanent disability or critical illness liquidity contracts are designed to:
- Help with cash flow for the business and family.
- Smooth out the potential financial crisis until you recover from the critical event.
Liquidity contracts covering death are slightly different. There is no possibility that one can recover from death. So, they are designed for:
- A cash injection for the family to pay off personal debt or tax obligations.
- To supplement the surviving spouse’s retirement capital.
- To pay off corporate debt; for example to facilitate a partner buyout.
- To replace the life insured’s economic value.
The remainder of this course will concentrate on liquidity contracts covering death (hereinafter referred to as the “liquidity contract™”). These contracts are often owned by a professional corporation, which opens them up to exposure and risk of loss to the corporation’s unsecured creditors.
Risk of Loss
Can one protect a liquidity contract™? Government policy and the law say yes:
- In the early 60’s provincial governments across Canada enacted legislation that protected a liquidity contract™ from unsecured creditors, in certain instances.
- The Supreme Court of Canada confirmed that policy as sound law.
- Such contracts are seen as a family necessity, serving to guarantee the family’s well being.
However, a liquidity contract™ is not automatically protected. Rather, positive steps have to be taken by the owner of the contract to take advantage of that protection. More on that later.
What is the common planning when purchasing a liquidity contract™? Why use a corporation and not an individual as the owner?
- The corporation’s tax rate is much lower then an individual’s.
- The corporation has more after-tax cash to pay for the premium.
Is that a problem?
- The liquidity contract™ is subject to attack and risk of loss from a corporation’s unsecured creditors.
- Corporate ownership blocks access to the government’s policy regarding protection for a liquidity contract™.
So what. Most corporations do not have unsecured creditors. That may be true but can that be said with 100% certainty? The risk of an attack from unsecured creditors is remote. But it is not zero.
It is now time to shift to the concept of recovery. Can I recover if I lose my liquidity contract™ to an unsecured creditor?
Barriers for Replacing a Liquidity Contract™
John Wordsworth, of the Lengvari organization, is a colleague of mine who has more then three decades of experience consulting on financial and tax planning around a liquidity contract™. The following is a summary from an interview that I had with John of the four most common barriers for replacing a liquidity contract™ should it be lost to an unsecured creditor.
- The pricing of the original contract is based on one’s age when acquired.
- The older one is the more expensive the premium becomes.
- It would be almost impossible to financially regain the lost cash values in an old contract (if lost to an unsecured creditor); it takes time to accumulate those lost cash values.
- Older contracts (contracts issued before March 2013) enjoy better tax sheltering opportunities.
- Over time one’s health will change, more likely not for the better.
- The prevalence in older ages of Type 2 Diabetes, Cancer and Cardiac events is a negative factor when applying for a new contract.
- Health changes could mean a significant cost or even the inability to obtain coverage.
- One’s financial circumstances have changed for the worse.
- One has been successfully sued, maybe even declared bankruptcy.
- Life insurance companies do not like financial disasters (financial uncertainty).
- Certain sporting activities can make one less attractive to life insurance companies; examples include scuba diving, back country skiing or bungee jumping.
- Smoking marijuana more than “occasionally” could result in up to a one third increase in the cost of a new contract.
- Driving infractions can result in higher costs; even distracted driving violations (cell phone usage well driving) can render one uninsurable.
Protecting a Liquidity Contract™
So, why should one want to protect a corporate-owned liquidity contract™? Particularly for contracts that are 20 years or older. The answer is rather simple.
- They are now close to maturity.
- They are very valuable, unique and not replaceable.
- They are worth a lot to a family’s financial well being.
However, protection is not automatic. One needs to take positive steps. What are those steps?
- The “family member” beneficiary designation.
- The “irrevocable beneficiary” designation.
Either one could potentially work and that depends on who the owner of the liquidity contract™ is and the life insured under the liquidity contract™.
Focusing on the corporate owned situation, there are some barriers to protecting a corporate owned liquidity contract™ to be aware of. They are?
- Creditor law.
- Tax law.
With respect to creditor law, creditors have some basic rights that need to be considered.
- Creditor’s rights under fraudulent preference legislation and the bankruptcy law.
- If one is facing a lawsuit, is insolvent or is preferring one creditor to another, the protection will fail.
The lesson, one cannot wait to the last moment to do the protection. Plan ahead. Be prepared.
With respect to tax law, one needs to be aware of:
- Shareholder taxable benefit rules.
- The capital dividend account.
Shareholder taxable benefit rules will apply in the situation where a corporation owns the liquidity contract™ and a shareholder is designated the beneficiary. The protection would happen (family member designation) but:
- CRA will impute a taxable benefit to the spouse.
- The tax laws are putting one into a situation that is equivalent to personal ownership of the liquidity contract™.
The capital dividend account is a notional tax account that allows for the tax-free flow of the contract’s death benefit to the family shareholders. A very important tax account that must always be considered:
- One does not want to go into a protection plan that blocks the use of the capital dividend account.
- That results in the death benefit being taxable when it is otherwise not.
The course has now come to an end. As with all of my courses I like to give the reader (attendee) some homework to do in there spare time. I also always try to conclude on a positive note. Lets start with the homework. The checklist that follows is a work sheet that I have clients complete when reviewing their liquidity contract™. It is one page offering a click, enter text and tab feature for ease of use. You will need to find your the information to complete the form. Once completed keep it with your wills and give a copy to your spouse, executor, accountant and lawyer. I would do this exercise at least every five years.
Send me an email at email@example.com if you would like a pdf format of the form.
On to the positive note. I have developed a bespoke solution for those who qualify to “capture” that government policy of protection of a corporate owned liquidity contract™ in a tax neutral manner. No taxable benefit and the capital dividend account is preserved. Offering peace of mind to your family that your investment in that liquidity contract™ all those years ago will be there when they need it most.
For more information to see if you qualify for this bespoke planning, or if you would like a pdf version of the checklist, my contact information is as follows: