Is Key Person Life Insurance Tax Deductible?
Navigate the tax landscape of key person life insurance. Discover its financial impact on your business, from premium considerations to tax-free benefits and essential compliance.
Navigate the tax landscape of key person life insurance. Discover its financial impact on your business, from premium considerations to tax-free benefits and essential compliance.
Key person life insurance is a financial tool businesses use to mitigate risks associated with the unexpected loss of critical personnel. This type of policy is taken out by a business on the life of an essential employee, with the business itself named as the beneficiary. Its purpose is to provide a financial cushion that allows the company to navigate the challenges arising from the death or incapacitation of an individual whose skills or relationships are central to the business’s operations. This insurance can offer the company time to find a replacement, cover lost revenue, or manage other financial disruptions during a difficult transition period.
A common question businesses have about key person life insurance centers on the tax deductibility of the premiums. Generally, premiums paid by a business for key person life insurance are not tax deductible for federal income tax purposes. This rule is outlined in Internal Revenue Code (IRC) Section 264, which specifically states that no deduction is allowed for premiums paid on any life insurance policy if the taxpayer is directly or indirectly a beneficiary under the policy. The rationale behind this non-deductibility is that the death benefit proceeds, when received by the business, are typically income tax-free.
Since the business is the beneficiary and receives the death benefit tax-free, the Internal Revenue Service (IRS) views the premium payments as a non-deductible expense. This means that premiums must be paid from the business’s after-tax income, impacting its cash flow and financial statements. For instance, these payments will reduce the company’s retained earnings or increase its liabilities, rather than directly reducing its taxable income.
There are rare and specific circumstances where life insurance premiums might be deductible, but these typically do not apply to standard key person policies. For example, if a policy is used as collateral for a loan, the interest on the loan might be deductible, but not the premiums themselves.
When a key person passes away, the death benefits received by the business as the beneficiary are generally treated as income tax-free. This exclusion from gross income is an advantage of life insurance and is provided under IRC Section 101.
Despite the general rule of income tax-free death benefits, certain exceptions and nuances can alter this tax treatment. One exception is the “transfer-for-value” rule, detailed in IRC Section 101. If a life insurance policy, or any interest in it, is transferred for valuable consideration, the death benefit may become partially or fully taxable. Under this rule, the amount excluded from gross income is limited to the actual value of the consideration paid for the policy plus any premiums and other amounts subsequently paid by the transferee.
The transfer-for-value rule can apply in business contexts, such as when a policy is sold from one entity to another, or during changes in ownership structure where a policy is transferred for something of value. However, there are “safe harbor” exceptions to the transfer-for-value rule, including transfers to:
While death benefits from key person life insurance are generally income tax-free, they can have implications for a corporation’s Alternative Minimum Tax (AMT) liability. The AMT is a separate tax system designed to ensure that certain corporations pay a minimum amount of tax, regardless of their regular tax deductions and credits. For C corporations, the calculation of AMT involves an adjustment known as “Adjusted Current Earnings” (ACE).
A portion of the tax-free life insurance death benefit, specifically the excess of the death benefit over the policy’s cash surrender value, can be included in the ACE adjustment. This inclusion can potentially increase a corporation’s AMT liability. It is important to note that this does not make the death benefit directly taxable as ordinary income; rather, it can indirectly affect the overall tax burden by increasing the amount of income subject to AMT.
The AMT considerations are primarily relevant for C corporations, as other business structures typically are not subject to corporate AMT. C corporations need to consider how these proceeds might factor into their AMT calculations, potentially leading to a higher tax payment under this separate system.
To ensure the tax-free nature of death benefits from employer-owned life insurance, including key person policies, specific reporting and notice requirements must be met. These requirements are primarily outlined in IRC Section 101 and Section 6039I, which were enacted as part of the Pension Protection Act of 2006. Failure to comply with these rules can result in the death benefit becoming taxable.
One of the most important requirements is the notice and consent provision. Before the policy is issued, the employee must be notified in writing that the employer intends to insure their life, including the maximum face amount for which they could be insured. The employee must also be informed in writing that the employer will be the beneficiary of the proceeds payable upon their death. Crucially, the employee must provide written consent to being insured and acknowledge that the employer is the beneficiary. This consent should ideally be obtained before the policy is issued.
Beyond notice and consent, the insured employee must also meet certain status requirements. To maintain the tax-free status of the death benefit, the insured must either have been an employee within 12 months before death, or at the time the contract was issued, they must have been a highly compensated employee, a highly compensated individual, or a director. Employers that own employer-owned life insurance contracts issued after August 17, 2006, are also required to file Form 8925, “Report of Employer-Owned Life Insurance Contracts,” annually with their income tax return. This form reports information such as the number of insured employees and the total amount of insurance in force. Maintaining adequate records to demonstrate compliance with these requirements is also necessary.