Premiums paid by the corporation are not tax deductible. Premiums paid by the corporation will not be taxable to the insured employee as long as that person is given no current rights in either the policy or its values. If the proceeds are payable to the employee’s estate or personal beneficiary, the result changes. In that case, premiums will likely be taxable to the employee where the policy is owned by the corporation and the premiums will be taxable to the employee where the policy is owned by the employee.
Tax Treatment of Proceeds
Generally, policy proceeds are free of federal income taxes. For life insurance contracts entered into after August 17, 2006, certain requirements must be met for the death proceeds of an employer-owned life insurance contract to be received income-tax free. One set of requirements is that before an employer-owned life insurance contract is issued the employer must meet certain notice and consent requirements. The insured employee must be notified in writing, at the time the contract is issued, that the employer intends to insure the employee’s life, and the maximum face amount the employee’s life could be insured for. The notice must also state that the policy owner will be the beneficiary of the death proceeds of the policy. The insured must also give written consent to be the insured under the contract and consent to coverage continuing after the insured terminates employment.
If the insured key employee holds no equity interest in the business, at his or her death, there should be no estate tax inclusion due to the payment of the key employee life insurance proceeds. The death proceeds of a corporate-owned life insurance policy on the life of a sole or controlling (one who owns more than 50 percent of the voting stock) shareholder will not be included separately as life insurance in the insured’s gross estate to the extent that the proceeds are paid to – or for the benefit of – the corporation.
Instead, the life insurance paid to the corporation (or to its creditors) is considered together with all other nonoperating assets in the valuation process. That cash which includes what was policy proceeds is therefore part of the weighing that occurs in the determination of corporate net worth, prospective earning power, and dividend earning capacity.
To the extent the proceeds of a corporate owned life insurance policy on the life of a controlling shareholder are payable to a party other than the corporation or its creditors, those proceeds will be includable separately from the valuation of the business – as life insurance – in the insured shareholder’s estate.
When a corporation owns a policy on the life of a noncontrolling (50 percent or less) shareholder, the proceeds when paid to the corporation at the insured’s death impact the value of the business. The life insurance paid to the corporation or its creditors is added together with all other nonoperating assets in the valuation process. That cash is therefore part of the weighing that occurs in the determination of corporate net worth, prospective earning power, and dividend earning capacity.
Proceeds payable to or for the benefit of a partnership that owns a policy on the life of a partner are not included separately as life insurance in the gross estate of the key partner. The partnership rather than its partners is considered owner of the policy and its incidents of ownership. Of course, the proceeds increase the value of the insured partner’s proportionate interest in the partnership for estate tax purposes.
If proceeds of a partnership owned policy are payable to someone other than the partnership (or its creditors), they will be included separately as life insurance proceeds in the gross estate of an insured partner since the insured is deemed to hold incidents of ownership actually possessed by the partnership. The proceeds will be fully includable in the insured partner’s estate (even if the insured is a minority partner). Contrast this with the requirement of control (more than 50 percent of the voting power) required in the case of corporate-owned life insurance.
Effect on Earnings
A corporation’s Earnings and Profits (E&P) will be increased to the extent that the death proceeds exceed: (a) total premiums in the case of term insurance; or (b) corporate owned cash values in the case of permanent coverage. This is important because the amount and character of income distributed from a corporation to its shareholders is determined in large part by reference to the firm’s E&P.
Also, C corporations are subject to the accumulated earnings tax – a 15 percent surtax on unreasonable accumulations of earnings and profits. The accumulated earnings tax may be imposed on a corporation that has E&P in excess of the reasonable needs of the business. A corporation is allowed to accumulate up to a safe harbor amount of $250,000 ($150,000 for certain personal service corporations).
During the lifetime of the insured, the internal build-up of cash values should not trigger an accumulated earnings tax problem. Many courts have agreed that an accumulation of earnings is appropriate to pay for insurance (or to self insure) as a means of protecting the business against such contingencies as unsettled business conditions and the loss of a key employee. Generally, therefore, the cash values inside of permanent coverage should not create a problem under the accumulated earnings tax.
A corporation typically acquires a key person life insurance policy to assure adequate working capital after a key employee’s death. To the extent key employee death proceeds are used up in ordinary business operations, they should not cause an accumulated earnings tax problem.
Interest Paid on Loans Secured by a Policy
Generally, interest paid on loans secured by a key employee life insurance policy is not deductible unless one or more of the following exceptions are met:
Four out of seven exception – At least four of the first seven annual premiums are paid without recourse to policy loans.
$100 a year exception – If the interest does not exceed $100 for any taxable year, the interest deduction will not be disallowed even if there is a systematic plan of borrowing.
Unforeseen event exception – If the debt was incurred because of an unforeseen substantial loss of income or substantial increase in obligations, the deduction will not be disallowed even though the policy loan was used to pay premiums.
Trade or business exception – If the debt is incurred in connection with the client’s trade or business, the interest deduction will not be summarily disallowed. Generally, amounts to finance key employee coverage will not be considered to fall within this exception and in any event interest deductions for company-owned life insurance are severely restricted.
Generally, with respect to contracts issued after June 8, 1997, no interest deduction is allowed for any interest paid or accrued with respect to a policy loan on a contract owned by a business. Almost all exceptions making an interest deduction possible on newly issued policies have been eliminated and the IRS is currently attacking interest deductions on many older contracts on the grounds that in reality the taxpayer did not meet at least one of the four tests above.
Obviously, corporations in a relatively low tax bracket will have little interest in systematic borrowing in any event.
Selling the Policy to the Insured
When an employee retires, quits, or is fired, a business owning insurance on his or her life may choose to sell it to the employee. If a key employee policy is sold to the insured at retirement or other termination of employment, even though it is a transfer and is for valuable consideration, since it is to the insured, it falls within an exception to the transfer for value rule. The value of the policy for sale or transfer purposes is its fair market value, which is generally the greater of its interpolated terminal reserve (ITR) or PERC (premiums plus earnings less reasonable charges) value. Planners should beware of transfers of key employee coverage by the business to others and check to be sure such assignments fall within one or more of the exceptions to the transfer for value rule.
Consideration should be given to the income tax implications when a business transfers a key employee policy to the insured who is an employee or owner. If the business transfers the policy to a nonowner employee, the employee will realize taxable income equal to the difference between the Fair Market Value (FMV) of the policy and the amount paid by the employee. If a C corporation transfers a key employee policy to an owner, the IRS could classify the difference between the FMV and the amount paid by the owner as a dividend rather than as compensation. If an S corporation transfers a key employee policy to an owner, the difference between FMV and the amount paid by the owner will reduce the owner’s basis in the corporation (but not below zero) and the excess above basis will be subject to capital gains taxation. If a partnership or Limited Liability Company (LLC) taxed as a partnership transfers a key employee policy to an owner, the difference between FMV and the amount paid by the owner will reduce the owner’s (outside) basis in the business (but not below zero) and the excess above outside basis will reduce the basis of the policy being transferred.
If the nonowner employee pays nothing for the policy, the entire fair market value is taxable to the employee as ordinary income. Also, if the amount paid by the nonowner employee exceeds the business’ net premium cost or the FMV of the policy distributed to the nonowner employee exceeds the business’ net premium cost, the business will realize taxable income equal to that excess. However, the business may receive an offsetting deduction to the extent that the FMV of the policy transferred to the nonowner employee exceeds the amount paid by the employee.
The tax consequences to the business of transferring a policy to an owner depends upon the business entity type. If the business is a C corporation or S corporation and the amount paid by the owner exceeds the corporation’s net premium cost, or the FMV of the policy distributed to the owner exceeds the corporation’s net premium cost, the corporation will realize taxable income equal to that excess. If the business is a partnership or LLC (taxed as a partnership) and the amount paid by the owner exceeds the corporation’s net premium cost, or the FMV of the policy distributed to the owner exceeds the corporation’s net premium cost, there will be no income tax consequences to the business, as transfers of property by a partnership or LLC to an owner are disregarded for income tax purposes.
Selling a Policy to the Corporation
A key employee sometimes sells a policy on his life to the corporation that will use it as key employee coverage. This transaction not only has the practical disadvantage of reducing personal coverage that may be needed but also has a number of serious adverse tax implications:
If the insured is neither an officer nor shareholder of the company, the transfer for value rule is triggered.
Taxable gain (ordinary income) will be realized by the seller to the extent that the amount paid by the corporation exceeds his net premium cost.
If the insured sells the policy to the corporation for less than his net premium cost, he will not be able to claim a deductible loss.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM