Life Insurance Paid by a Partnership for Its Partners

Partnerships often use their funds to pay for life insurance on partners for business succession planning, such as funding buy-sell agreements, or to provide partner benefits. The financial and tax consequences of this strategy depend entirely on how the policy is owned and who is named as the beneficiary. The specific arrangement dictates everything from tax deductions for premium payments to the taxability of the death benefit itself.

Policy Ownership and Beneficiary Structures

One common arrangement involves the partnership itself being both the owner and the beneficiary of the life insurance policy. This structure is used to fund an “entity-purchase” buy-sell agreement. Upon a partner’s death, the partnership receives the life insurance proceeds and uses the funds to purchase the deceased partner’s ownership interest from their estate. This structure is also used for “key person” insurance, intended to compensate the business for the financial loss from a partner’s death.

An alternative structure is for the partnership to pay the premiums on a policy where the partner’s family or estate is the designated beneficiary. This is often treated as a fringe benefit for the partners. In this case, the partnership’s role is limited to paying the premiums, and it has no claim on the death benefit. The proceeds are paid directly to the beneficiaries designated by the insured partner, bypassing the partnership entirely.

Tax Treatment of Premium Payments

When the partnership is named as the direct or indirect beneficiary of a life insurance policy, the premium payments are not tax-deductible. This is governed by Internal Revenue Code Section 264, which disallows deductions for premiums on any life insurance policy where the taxpayer is a beneficiary. Since the death benefit proceeds will be received by the partnership tax-free, the premiums are considered a capital expenditure.

When the partner’s family or estate is the beneficiary and the partnership has no rights to the policy’s proceeds, the premium payments are considered a form of compensation. The partnership can treat the premium payment as a “guaranteed payment” for services rendered. Guaranteed payments are deductible by the partnership and are reported as taxable ordinary income to the receiving partner.

Another way to handle premiums when the partner’s family is the beneficiary is to treat the payment as a cash distribution. A distribution is not deductible by the partnership. For the partner, a distribution is tax-free, provided it does not exceed their basis in the partnership. This approach avoids immediate income tax for the partner but provides no tax deduction for the partnership, making it a less common choice.

Tax Treatment of Death Benefit Proceeds

The tax treatment of the death benefit proceeds from a life insurance policy is a primary consideration. Generally, the proceeds are received free of federal income tax under Internal Revenue Code Section 101, but who receives the funds can have secondary tax effects for the surviving partners.

When the partnership is the beneficiary, the tax-exempt income increases the outside basis of the surviving partners’ interests in the partnership. This basis increase allows the surviving partners to purchase the deceased partner’s interest from their estate without generating a large capital gain. The tax-exempt proceeds provide the cash for the buyout, and the basis adjustment facilitates the transaction.

If the proceeds are paid directly to the partner’s designated heirs or estate, the funds are also received income tax-free by the beneficiaries. In this scenario, the partnership is not involved in the receipt of the funds, so there is no impact on the surviving partners’ basis.

A tax trap to be aware of is the “transfer-for-value” rule, which can cause otherwise tax-free death benefits to become taxable. If a life insurance policy is transferred for valuable consideration, the death benefit loses its tax-free status. The taxable amount is the death benefit less the amount paid for the transfer and any subsequent premiums paid. However, there are important exceptions, including transfers to the insured, to a partner of the insured, or to a partnership in which the insured is a partner, which often protect business succession arrangements.

Partnership Accounting and Reporting Requirements

The accounting and reporting for partnership-paid life insurance require careful attention to ensure compliance and accurate financial statements. The bookkeeping entries and tax reporting must reflect the specific structure of the insurance arrangement and its corresponding tax treatment.

For bookkeeping purposes, if premiums are non-deductible because the partnership is the beneficiary, they are still recorded as an expense on the partnership’s books. For tax purposes, this book expense is added back to income on the partnership’s tax return (Form 1065), typically on Schedule M-1 or M-3. This ensures the partnership does not receive a tax deduction.

If the policy is a form of permanent life insurance that builds cash surrender value (CSV), this value is an asset on the partnership’s balance sheet. The increase in the policy’s CSV each year is recorded in an asset account. The portion of the premium payment that does not contribute to the increase in CSV is treated as an expense for book purposes.

Finally, the financial effects of the life insurance arrangements must be reported to the partners on their individual Schedule K-1s. Non-deductible premium payments are reported as a separately stated item, often in Box 18 with Code C, because they decrease a partner’s basis in the partnership. Similarly, when the partnership receives tax-exempt death benefit proceeds, this income is also passed through to the partners on their K-1s, typically in Box 18 with Code B, increasing their basis.