Tax Aspects for Employer

Premiums

Section 264 of the Internal Revenue Code states that there is no deduction for premiums paid by a taxpayer on any insurance policy, or endowment or annuity contract (other than annuity contracts used to fund specified retirement vehicles or held by persons who are not natural persons) when the taxpayer is directly or indirectly a beneficiary under the policy. When a business is the beneficiary under a key employee policy (which is most often the case), the premiums are not tax-deductible.

Policy Loans

Interest paid or accrued by a business after October 13, 1995, on loans against policies that cover employees of a business, or persons financially interested in the business, is nondeductible. A limited exception is available for key-person policies.

For this purpose, key persons are defined as officers and 20%-or-greater owners. However, the number of key persons covered by this exemption cannot exceed the greater of—

five persons, or
the lesser of 5% of total officers and employees, or 20 individuals.

For such key persons the deduction for policy loan interest is allowed but only to the extent that—

the total policy indebtedness for any key person does not exceed $50,000, and
interest paid or accrued for a month does not exceed the Moody's Corporate Bond Yield—Monthly Average Corporates rate for that month.

Inside Buildup

The increase in cash value of a life insurance contract is generally exempt from the federal income tax, even for corporations (not so in the case of annuity contracts!). However, the corporate alternative minimum tax may reach the increase in cash value of the policy for a particular tax year. This increase is added to "adjusted current earnings" for the year, and is one of the many factors which determine whether the corporation will be subject to the alternative minimum tax.

Death Proceeds

While premiums are not tax-deductible, death proceeds from the policy are generally exempt from the federal income tax under IRC Section 101(a). If these proceeds are received in installments rather than as a lump sum, the part of each installment that represents interest is, however, taxable as income.

It should also be noted that proceeds received by a corporation may be subject to the corporate alternative minimum tax if the corporation is subject to this tax. There are many other factors which affect whether a C corporation will ultimately be subject to the alternative minimum tax.

If the proceeds are income tax-free, this can have a dramatic effect on a business.

Distributions of Proceeds by the Company

Although the proceeds of a key employee insurance policy are usually exempt from the federal income tax (but perhaps not the corporate alternative minimum tax), they lose their exempt character if distributed to some third party. The tax consequences may vary depending on what kind of distribution is made and to whom. For example, if the proceeds are later distributed by a corporation as dividends to its shareholders, the dividends will usually be taxable as ordinary income to the shareholders.

Policy Surrender

There may be a good reason to surrender a policy while the key employee is still alive; for example, perhaps the employee is no longer "key" because he or she left the company. In such a case, the business will have a taxable gain to the extent the surrender proceeds exceed the net premium paid. (Net premium equals gross premium minus dividends, withdrawals, and, in the case of modified endowment contracts, loans.) Nonetheless, if the net premium paid exceeds the surrender proceeds, the loss is not tax-deductible by the business.

Tax Effect on the Employee

In a properly structured key employee insurance arrangement, all incidents of ownership are in the business. This means that premiums paid for the policy are not taxable as income to the employee.

Further, the proceeds paid at the employee's death are not included in the employee's estate for estate tax purposes. Keep in mind, however, that if the employee has any incidents of ownership—such as the right to change the beneficiary or obtain a policy loan—the proceeds become a part of his or her gross estate.

If the deceased employee was also an owner of the business, the proceeds paid to the company may increase the value of the deceased owner's business interest. This value, of course, is included in the insured's estate. On the other hand, even after the proceeds become a business asset, the loss of the key employee's services may cause the total value of the business to be less than it was before the key employee's death.

This service is designed to provide accurate and authoritative information in regard to the subject matter covered. It is provided with the understanding that neither the publisher nor any of its licensees or their distributees intend to, or are engaged in, rendering legal, accounting, or tax advice. If legal or tax advice or other expert assistance is required, the services of a competent professional should be sought.

While the publisher has been diligent in attempting to provide accurate information, the accuracy of the information cannot be guaranteed. Laws and regulations change frequently, and are subject to differing legal interpretations. Accordingly, neither the publisher nor any of its licensees or their distributees shall be liable for any loss or damage caused, or alleged to have been caused, by the use of or reliance upon this service.

U.S. Treasury Circular 230 may require The Pentera Group, Inc. to advise you that "any tax information provided in this document is not intended or written to be used, and cannot be used, by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer. The tax information was written to support the promotion or marketing of the transaction(s) or matter(s) addressed and you should seek advice based on your particular circumstances from an independent tax advisor."