Can S Corp Owners Deduct Life Insurance Premiums?

Life insurance is a significant consideration in business planning for S Corporations and their owners. S Corp owners frequently ask if life insurance premiums are tax-deductible. The answer depends on the policy’s purpose, its beneficiaries, and how it is structured within the S Corporation. Understanding these distinctions is important for proper tax planning and compliance.

General Rules for Business Life Insurance Deductibility

The deductibility of life insurance premiums for businesses, including S Corporations, is governed by a fundamental principle: if the business directly or indirectly benefits from the policy, the premiums are generally not deductible for tax purposes. The Internal Revenue Service views such premiums as payments for a capital asset or for the protection of the business’s own interests, rather than ordinary and necessary business expenses.

This non-deductibility applies when an S Corporation is named as the beneficiary of a life insurance policy insuring an owner, officer, or employee. For example, if an S Corp purchases a policy on the life of its founder to provide funds for a buy-sell agreement or to cover potential losses from the founder’s death, the premiums paid by the S Corp are not tax-deductible.

Even if the S Corp is not the direct beneficiary, if it indirectly benefits from the policy, the premiums remain non-deductible. This can occur in arrangements where the policy’s proceeds are used to redeem a shareholder’s stock or to provide liquidity for business continuity. S Corp owners must carefully consider the beneficiary designation and the ultimate purpose of any life insurance policy when assessing the deductibility of premiums.

Scenarios Where Premiums May Be Deductible

While the general rule often prevents the deduction of life insurance premiums, specific scenarios allow for deductibility for S Corporations or their owners. These exceptions depend on the policy’s structure and its intended purpose.

Group Term Life Insurance

Premiums paid by an S Corporation for group term life insurance coverage provided to employees, including owner-employees, can be deductible up to a certain limit. The Internal Revenue Code allows an exclusion for the cost of the first $50,000 of group term life insurance coverage provided to an employee. Premiums paid by the S Corp for this initial $50,000 of coverage are generally deductible as an ordinary and necessary business expense.

The cost of group term life insurance coverage exceeding $50,000 is treated differently. The value of the coverage above this $50,000 threshold is considered taxable income to the employee, calculated using a uniform premium table provided by the Internal Revenue Service and reported on the employee’s Form W-2. Even though the excess coverage is taxable to the employee, the premiums paid by the S Corp for this additional coverage generally remain deductible to the corporation as part of the employee’s compensation package.

Life Insurance as Compensation

Life insurance premiums paid by an S Corporation can be deductible if the policy is provided as a form of taxable compensation to an employee or owner, and the S Corporation is not a beneficiary of the policy. In this arrangement, the S Corp pays the premiums, and the employee or owner is the policy owner and beneficiary. The premiums paid by the S Corp are included in the employee’s gross income for tax purposes, similar to a salary or bonus.

When premiums are treated as compensation, the S Corporation can deduct these payments as a compensation expense, provided the total compensation paid to the employee or owner is considered reasonable for the services rendered. The reasonableness of compensation is a factor for the Internal Revenue Service, preventing excessive deductions for owner-employees.

Split-Dollar Life Insurance Arrangements

Split-dollar life insurance arrangements involve an agreement between an S Corporation and an employee or owner to share the costs, benefits, and ownership rights of a life insurance policy. The tax treatment of premiums depends on whether they are structured under the “economic benefit regime” or the “loan regime.”

Under the economic benefit regime, the employee is taxed on the value of the economic benefit received from the policy, such as the cost of the current life insurance protection. The S Corp typically cannot deduct the premium payments in this setup, as it retains an interest in the policy.

Under the loan regime, the S Corporation’s premium payments are treated as loans to the employee or owner. These loans may be interest-free or accrue interest, and they must comply with Internal Revenue Service rules regarding below-market loans. In this structure, the S Corp does not deduct the premium payments, as they are considered repayments of a loan rather than an expense.

Taxation of Life Insurance Proceeds

Understanding the income tax treatment of life insurance proceeds upon the death of the insured is important for S Corp owners. When life insurance proceeds are paid out by reason of the insured’s death, they are generally income tax-free to the beneficiary. This rule applies whether the beneficiary is an individual, a trust, or an S Corporation. The tax-free nature of death benefits is a significant advantage of life insurance as a financial planning tool.

If an S Corporation is the beneficiary of a life insurance policy, the proceeds received upon the insured’s death are income tax-free to the S Corp. These proceeds increase the S Corporation’s accumulated adjustments account (AAA) and the shareholders’ basis in their stock, but they do not flow through to the shareholders as taxable income. This means shareholders receive a corresponding increase in their stock basis, which can reduce capital gains if they later sell their shares or allow for tax-free distributions up to the new basis amount.

However, specific scenarios exist where life insurance proceeds can become taxable. One common exception is the “transfer-for-value rule.” If a life insurance policy is transferred from one owner to another for valuable consideration, a portion of the death benefits may become taxable to the recipient. The taxable amount is generally the death benefit minus the consideration paid for the transfer and any subsequent premiums paid by the new owner.

Proceeds can also become taxable if the policy is surrendered for its cash value or if withdrawals or loans from the policy exceed the policyholder’s basis in the contract. Basis refers to the total premiums paid into the policy, less any prior tax-free withdrawals. Any amount received in excess of this basis is taxed as ordinary income. If life insurance proceeds are held by the insurer and interest is paid to the beneficiary, that interest income is taxable.

While life insurance proceeds are generally income tax-free to the beneficiary, they can be included in the deceased’s taxable estate for estate tax purposes. This depends on who owned the policy at the time of death and whether the deceased retained any “incidents of ownership,” such as the right to change the beneficiary or borrow against the policy. Proper estate planning, often involving irrevocable life insurance trusts, can help exclude policy proceeds from the taxable estate.