Revenue Ruling 83-49: Impact on Partnership Basis
Understand the tax consequences for surviving partners when a business-owned life insurance policy is paid out as part of a succession plan.
When a business partnership faces the death of a partner, the financial transition involves specific tax rules. Partnerships often use life insurance policies for business succession planning, ensuring funds are available to manage the change. The receipt of these insurance proceeds triggers tax considerations that directly affect the surviving partners.
The Foundation of Partnership Basis
A partner’s basis in a partnership is the measure of their investment for tax purposes. This figure, often called “outside basis,” is initially established by the amount of cash contributed or the tax basis of any property transferred to the partnership.
The basis adjusts to reflect the partnership’s financial activities. When the partnership earns income, each partner’s basis increases by their respective share of those profits. Conversely, when the partnership incurs a loss, each partner’s basis decreases. Additional capital contributions from a partner will increase their basis, while distributions of cash or property from the partnership to a partner will reduce it.
How Insurance Proceeds Affect Partner Basis
When a partnership receives proceeds from a “key person” life insurance policy following a partner’s death, those funds are generally considered tax-exempt income under Section 101 of the Internal Revenue Code. This means the partnership itself does not pay income tax on the money received from the insurer.
Even though the insurance proceeds are not taxable income, they still increase the individual outside basis of each partner. This is an application of Section 705 of the Internal Revenue Code, which requires that a partner’s basis be increased by their share of the partnership’s tax-exempt income.
To illustrate, consider a partnership with two equal partners, each having an outside basis of $50,000. Upon one partner’s death, the partnership receives a $100,000 tax-exempt death benefit. The surviving partner’s basis is increased by their 50% share of these proceeds, which is $50,000, making their new outside basis $100,000.
Partnership Reporting Requirements
The partnership must document the receipt of life insurance proceeds on its annual tax return, Form 1065, U.S. Return of Partnership Income. Although the income is tax-exempt, it is disclosed on Schedule M-1, Reconciliation of Income (Loss) per Books With Income (Loss) per Return. This schedule reconciles the partnership’s book income with its taxable income.
The tax-exempt income is then allocated to the partners. The total amount is reported on Schedule K of Form 1065, and the partnership provides each surviving partner with a Schedule K-1. This individual form shows the partner’s specific share of the tax-exempt life insurance income, which is the information a partner uses to adjust their outside basis.