When asked, many business owners, professionals, and high-net worth individuals prefer to invest in their business instead of using the cash to pay for life insurance premiums.
Is that true for you too?
If so, consider an immediate financing arrangement (IFA). It lets you enjoy the benefits that insurance offers, at a fraction of the cost. You're left with more money to grow your business. An immediate financing arrangement works with permanent life insurance (ie. whole or universal life insurance) as it involves borrowing money using your cash value as collateral.
Useful as an immediate financing arrangement is, it is not the right option for everyone. To qualify for this program, you must pass medical and financial underwriting.
Let's dive into how an IFA works and whether it's right for you.
What is an Immediate Financing Arrangement?
Immediate financing arrangements (IFA) are a financial planning tool that allows incorporated business owners and individuals to buy participating permanent life insurance without reducing cash for business or investment opportunities.
With IFAs, the cash surrender value of a life insurance plan is used as collateral for getting a loan or a line of credit from a life insurer or a Canadian bank. This means the IFA can help you get more credit. As the cash value of your life insurance policy increases, the amount of money you can borrow also goes up. Borrowing against your policy may be very helpful in many ways.
During the premium payment period, you can usually borrow back up to 80-90% of the cash surrender value. In some cases, the lender may let you borrow up to 100% of the cash surrender value.
You may spend the loan proceeds however you see fit. You can, for example, you can inject it into your business to boost cash flow, park it in various income-producing investment vehicles, or use it for other business purposes, such as successfully completing an acquisition.
For tax deductions, you may be able to deduct interest expense from total income to reduce your taxable income. Aside from the interest expense, part or all of the insurance premiums may be tax deductible when a life insurance policy is used as collateral for a loan.
When you pass away, the policy proceeds pay off the entire loan that the borrower took. If the insured is a corporation, the corporation will be the policy owner as well as the policy beneficiary.
How Does the Immediate Financing Arrangement Work?
A typical IFA works in the following way:
- A corporation takes out a participating permanent life insurance plan on the life of its owner or a key employee. For an IFA, permanent life policies that accumulate substantial cash value in the initial years are usually preferred.
- The corporation is both the owner and the beneficiary of the insurance plan.
- The cash surrender value of the policy is used as collateral by the corporation to obtain a line of credit from a lender, which can be a life insurance company or a Canadian bank.
- Since the corporation is listed as the policy owner, it pays the insurance premiums. It also pays the interest payment on the collateral loan.
- The corporation uses the loan proceeds, which can be up to 80-100% of the cash surrender value, to generate income. For example, it may use it for expanding the business, investing in income-generating investment vehicles, or buying real estate.
- Upon the insured’s death, the corporation receives the funds tax-free. A part of the life insurance proceeds are used for paying off the loan.
Benefits of an Immediate Financing Agreement loan
The main benefits of an Immediate Financing Agreement are:
- Allows business owners to meet their life insurance needs while preserving cash for business purposes
Let us say as a successful business owner, you need a sizable life insurance policy but are not prepared to take out a large amount of money from the business to cover the recurring premiums.
So, you decide to set up an IFA to borrow back 90% of your cash surrender value and invest this money to grow your business. As a result of this arrangement, the policy costs you only a fraction of its true premium cost.
- You may be able to claim interest expenses as tax deductions
The interest on a corporate loan used for generating income may be counted as part of your tax deductions. So, if you name your company as the policy owner on your life insurance policy and take out a business loan, you may be able to deduct the interest expenses in tax write-offs.
In addition to claiming the interest expenses as tax deductions, you may also be able to avoid paying tax on a part or all of the policy premiums.
- Makes it easier to meet corporate life insurance needs
Because an IFA reduces a company’s net cost of buying a life insurance policy, they can easily meet various life insurance coverage needs, like taking out a policy on a key employee or funding a buy-sell agreement.
Who can Benefit from an Immediate Financing Agreement?
Like any financial strategy, IFAs are not suitable for everybody. But they can be a good choice for certain business owners and individuals. Consider an IFA if you:
- own an incorporated business and want life insurance to protect your family’s future
- want a permanent life insurance policy but do not want to take money out of your business to pay the recurring insurance premiums
- are eligible for a medically-underwritten life insurance policy
- are a high-net-worth individual
- are an incorporated business owner and want to use life insurance to fund a buy sell agreement or buy key person life insurance without reducing the cash available for business or investment purposes.
How to Structure an Immediate Financing Agreement
An IFA can be set up in three ways:
- If you already have life insurance, you can use it for an IFA, provided your policy has cash value. Only full life insurance plans can be used for IFAs. Generally, you can borrow up to 80-90% of your policy’s cash value, though some financial institution may be willing to lend you 100%. Term life insurance, which does not accumulate wealth, is not suitable for this financial strategy.
- If you do not have a life insurance policy or only have a term life plan in your name, you can take out a permanent life insurance policy. Once your policy has built up a sizable cash value, you can use it as loan collateral on some financial institution. Different full life insurance plans build cash value differently. If you are interested in an IFA, consider a plan that accumulates cash value quickly during the first few years.
- If your policy does not have enough cash value, you can borrow an amount equaling 100% of the annual premium that has been paid. However, you will likely be required to use additional assets, like real estate or investments, as collateral.
Repaying the Immediate Financing Agreement Loan
Generally, the balance on the debt is paid after the insured's death. The insurer pays the outstanding loan directly to the lender from the policy proceeds, while the remaining death benefit is issued to the beneficiary. If desire, you can also pay off the entire loan while you are still alive.
What are the Perks of an IFA for a Business Owner?
The main benefit of an immediate financing arrangement is that it allows you to get the life insurance coverage you need without taking out cash from your business. Also, you can escape paying tax on the loan interest if you invest the loan proceeds into a business or investment portfolio.
Lastly, you may also be eligible for collateral insurance deduction. Generally, life insurance premiums are not tax deductible for income tax purposes. However, with collateral insurance deduction you may be able to claim a deduction if you collaterally assign the policy to secure a loan and use the latter to earn income from business or investment.
Risks to consider with an Immediate Financing Agreement
Immediate financing arrangement loans are a long-term arrangement and as such the biggest risk to consider is a change in the interest rate. The lender can change your interest rate based on the markets and/or any changes in your financial position.
A rate change can increase the interest expense and policy performance over the term of your IFA. If the rate increase leads to a situation in which your loan balance exceeds the negotiated ratio of the surrender cash value, you may be asked to repay a part of the owed amount or provide additional collateral security.
Who will be responsible for the interest payments?
The responsibility for the interest payment will depend on the type of loan and the agreement between the lender and the borrower. Generally, the borrower is responsible for making interest payments on any loan that they have taken out. This includes mortgages, student loans, auto loans, and personal loans. For mortgages, the borrower is typically responsible for making monthly payments to the lender that include both principal and interest.
What Happens When You Pass Away?
When you pass away, the insurance proceeds are first used for paying the amount you owed to the lender. The remaining death benefit goes to the beneficiary, which in the case of a business owner is the corporation.
The corporation can distribute the residual life insurance proceeds tax-free to your estate. Alternatively, it can use the payout to increase the cash flow or distribute it between the surviving shareholders.
An immediate financing arrangement is an option for all those who need life insurance but hate the idea of paying monthly premiums with money they can use to generate income. This financial strategy allows you to enjoy the benefits of life insurance without reducing cash available for business or investment purposes.
Keep in mind that you will have to pass medical and financial underwriting and only permanent life insurance plans can be used for structuring an immediate financing arrangement.
If you are interested in setting up an IFA, Dundas Life can save you money by ensuring you get the right coverage at the lowest price.