Hello all, I hope this summer is treating you well. 

One of the topics I routinely get questions on is the Capital Dividend Account (CDA). I thought it would be worthwhile to revisit the topic and refresh everyone’s memory. Please note, the CDA is only relevant to corporate policies and is the way tax-free dividends are distributed to the owner/shareholders of the corporation using Capital Dividends.

First, the CDA is a sub-account of retained earnings (RE). The retained earnings of a corporation represent the portion of the company that is truly owned by the owner/shareholders. Retained earnings can be distributed to the owner/shareholders using a taxable dividend. This is one of the mechanisms through which owners can participate in the company’s growth, or at least get some of the value of the corporation back out into their hands. The CDA represents the portion of any distribution, either received by another corporation, or through the sale of corporate assets, that the owner/shareholders would normally have received tax-free.

The factors that contribute to the CDA include the tax-free portion that arises on the disposition of capital property and a capital dividend received from another corporation. The factors most relevant to our day-to-day activities are the proceeds of a corporately owned life insurance policy, less the policy’s adjusted cost basis (ACB). For example, if I have a life insurance policy where the total death benefit is $1 million and the ACB of the policy is $250,000, on the death of the insured shareholder, the proceeds are received by the corporation entirely tax-free. This means that $250,000 is credited to regular RE, with the remaining $750,000 credited to the Capital Dividend Account. 

As stated above, the CDA credit from a life policy is the death benefit received, less the policy’s ACB. In the most basic of terms, the ACB of a policy is simply the premiums paid, less the net cost of pure insurance (NCPI). Typically, the ACB builds early in a policy as premiums are added, but will grind down over time if premiums cease, or at least as the NCPI increases. In any event, the ACB will reduce over time, and a large portion of policies will get to zero. 

Once there is a balance in the CDA, the board of directors of the corporation can declare a capital dividend. The capital dividend is paid out to all participating shareholders in proportion to their percentage ownership of the company.

Let us look at some examples:

First, we have a male age 62 non-smoker, buying $1 million of lifepay Whole Life, contributing $91,445 (combination of base premium and additional deposit) per year for seven years, which is the earliest offset. At the end of the seventh premium, the death benefit has now risen to $1.69 million and the policy ACB is $590K. On the death of the insured, the corporation receives the full $1.69 million tax-free. The credit to the CDA is $1.1 million ($1.69M less $590K). This means the board of directors can declare a Capital Dividend of $1.1 million which flows out through the CDA and is received tax-free by the shareholders. The remaining portion of the death benefit ($590K) can only be distributed as a taxable dividend. Assuming a 50% personal dividend tax rate, the net to the owner/shareholders would be $295K plus the $1.1 million capital dividend, for a total of $1.395 million.

If we look ahead and assume the insured does not die until age 82, the death benefit is now $1.35 million*, the ACB is $266K, so the credit to the CDA will be $1.08 million. Assuming a Capital Dividend is declared for $1.08 million, and the remaining $266K is paid out as a taxable dividend, the net to owner/shareholders has risen to $1.21 million. Finally, the ACB completely disappears by year 27 (client’s age 89). After age 89 the total death benefit will be fully paid out through the CDA.

*note, the death benefit has been reduced due to the fact premium payments ceased after year seven.

Looking at a second example, we will take the same client, but this time we will pay the base premium of $42,125 for life (no offset). Again, looking at year 7, the death benefit has risen slightly to $1.07 million. The ACB is now only $256K, and the net to the owner/shareholders is $943K.

Now at age 82, the death benefit has grown to $1.46 million, with an ACB of $497K, leaving a net to the owner/shareholders of $1.21 million. In this example, the ACB never truly gets ground down to zero due to ongoing premium payments. 

Overall, I hope you feel you have gained a better understanding of the CDA, or at the very least, have had your understanding confirmed. Stayed tuned for the next blog, where I will examine the increased importance of the CDA in a buy-sell scenario. 

Keep well.