Understanding the Capital Dividend Account
What is a Capital Dividend Account? The Capital Dividend Account, or CDA, is a notational account that small business can use to pay out tax free income to its shareholders. Small business must be a Canadian controlled private corporation (CCPC), in order to use this notational account. The Capital Dividend Account makes note of certain income (tax free) paid to the CCPC and then allows that income to paid out to the shareholders tax free. Some examples of the type of income allowed are:
- Life Insurance Death Benefits
- The non taxable portion of a capital gain
Adjusted Cost Base (ACB).
Briefly, the Adjusted Cost Base on a life insurance policy is the sum of the premiums minus the net cost of pure insurance. When life insurance death benefits are paid to the Corporation and therefore create a credit in the CDA that credit is the face value of the life insurance policy minus the ACB.
Life insurance and the use of the CDA.
Two examples of how life insurance and CDA can work hand in hand are in a Buy/Sell agreement and a Key Person Coverage scenario.
Two partners (let’s call them Hank and Dan) are equal owners in Company A. They each own 50% which is valued at $500,000 each. Their written agreement states that at the death of one partner the Corporation will buy the shares back for $500,000. (Ignoring growth in price of shares for ease of example) Company A owns $500,000 of Term life insurance on each partner. Hank passes away suddenly. The life insurance proceeds are paid to Company A who then in turn pays it out through the CDA to buy back Hank’s shares for the agreed price of $500,000. The CDA now has a credit of $500,000 that can be paid to Dan tax free sometime in the future.
The reason I used Term insurance and not a Permanent insurance plan was to keep the ACB simple. Term can have next to nothing in terms of ACB or in fact no ACB at all. Permanent insurance can have dividends that buy more insurance or policy loan interest which affect the ACB.
Related article: What is the best type of life insurance?
The CDA can also be used when insuring a key person of a company. A key person is someone who has a very large hand in the success of a company. Without that person, the company would not be as profitable or successful. The life insurance on the key person, owned by the company, can be used to hire and train someone to take over the role of the deceased key person. Again, when the death benefit is paid to the corporation the CDA credit is created which can be used now or in the future.
Written and funded agreements
Many agreements are written by shareholders taking into account what happens when someone dies or disabled but never do they get around to properly funding that agreement. Make sure that if your corporation has a written agreement that it is funded by life insurance and disability insurance.