Life Insurance and S Corporations: Unique Rules Present Opportunity and Peril

Editor: Mindy Tyson Weber, CPA, M.Tax.

Life insurance on key employees and owners can be a powerful tool. It can generate tax-exempt proceeds that companies can use to help protect themselves against the death of key personnel while providing critical liquidity to the company if it must buy back shares from a deceased owner’s estate. This can be especially important for S corporations, which often have a unique interest in controlling the makeup of their shareholders to ensure continued qualification under Subchapter S.

However, life insurance policies, regardless of the type, present special considerations for S corporations. Those considerations and some of the related issues are outlined below.

Term Life Insurance

The tax issues associated with key person term life insurance are relatively unambiguous. Sec. 264(a)(1) provides, “No deduction shall be allowed for premiums on any life insurance policy . . . if the taxpayer is directly or indirectly a beneficiary under the policy or contract.” The tax treatment of death benefits associated with such a policy is similarly straightforward. Sec. 101(a)(1) states, “Except as otherwise provided . . . gross income does not include amounts received . . . under a life insurance contract, if such amounts are paid by reason of the death of the insured.” Therefore, an S corporation that chooses to purchase term life insurance on key employees and/or owners receives no current tax deduction when it pays the premiums, but the death benefits will be tax-free when the insured dies.

S corporation issues: The more interesting issues with term insurance relate to how the above rules affect various S corporation accounts. Again, the rules are relatively clear, but because they can affect a shareholder’s ability to access cash on a tax-free basis, they are important to understand.

As discussed, premiums are not deductible. Nonetheless, S corporation shareholders must reduce stock basis for their allocable shares of that expense (Sec. 1367(a)(2)(D)). The big question, however, is whether that nondeductible expense reduces the accumulated adjustments account (AAA) or the other adjustment account (OAA). The answer is important because S corporations with prior C corporation earnings and profits (E&P) can generally make tax-free distributions only to the extent of AAA; additional amounts are taxable to the shareholders to the extent of the company’s E&P. Thus, if these nondeductible premiums reduce AAA, they reduce the pool from which the S corporation can make tax-free distributions.

The answer to this question is indirectly addressed in the Code and regulations and appears to be more definitively addressed in a revenue ruling. Sec. 1368(e)(1)(A) provides that AAA is an entity-level account that is adjusted in a manner similar to shareholders’ stock basis, except that no adjustment is made for income (and related expenses) that is exempt from tax. Regs. Sec. 1.1366-1(a)(2)(viii) defines tax-exempt income in this context as “income that is permanently excludible from gross income in all circumstances in which the applicable provision of the Internal Revenue Code applies. For example, income that is excludible from gross income under [Sec.] 101 (certain death benefits).”

Therefore, as long as these premiums are considered to be expenses related to tax-exempt income, they will not affect AAA. This is precisely what Rev. Rul. 2008-42 concludes—that premiums paid on corporate-owned life insurance do not reduce AAA, presumably based on a conclusion that those premiums are expenses related to income that would be nontaxable under Sec. 101.

The same authorities cited above dictate the impact to S corporation and shareholder accounts of the company’s receipt of death benefits. Shareholders increase stock basis by their allocable shares of the S corporation’s tax-exempt income, and the S corporation increases its OAA by a like amount. This presents an important point. S corporations with E&P make distributions first from AAA and then from E&P. Because it is only after AAA and E&P are exhausted that S corporation distributions represent a tax-free return of basis (and OAA), an S corporation that distributes insurance proceeds may have difficulty doing so on a tax-free basis unless there is sufficient AAA from other sources or no E&P.

As a practical matter, however, this rule may have little effect if the company bought the life insurance to provide liquidity to redeem a deceased shareholder’s stock. In that case, the payment to the shareholder’s estate would, if properly structured, receive sale or exchange treatment (rather than distribution treatment), in which case neither AAA nor E&P would be relevant for purposes of determining the impact of the payment on the recipient.

Cash-Value Life Insurance

The issues related to cash-value policies, although similar in many ways to those associated with term policies, are in some cases more troublesome and uncertain. As with term policies, Sec. 264(a)(1) disallows any deduction for premiums paid on a cash-value policy where the S corporation is the beneficiary of the policy. Similarly, death benefits received under a cash-value policy are not taxable.

One major difference between cash-value policies and term policies is that cash-value policies have value that the owner might choose to realize via a surrender of the policy or a sale. In contrast, term policies generally have value only if the insured dies. With a sale or surrender, the income exclusion outlined in Sec. 101(a)(1) usually does not apply. Instead, the transaction is generally taxable. In the case of a surrender, Sec. 72(e) governs. With a sale or exchange, Sec. 1001(a) applies.

The application of these rules is outlined in detail in Rev. Rul. 2009-13, which addresses a surrender (Situation 1) and a sale (Situation 2).

With respect to the surrender in Situation 1, the revenue ruling concludes that the amount received is included in gross income to the extent it exceeds the “investment in the contract.” Under Sec. 72(e)(6), the investment equals the cumulative premiums paid, less amounts received under the contract that were excludable from gross income (e.g., policy dividends).

In Situation 2, the revenue ruling provides that the sales proceeds are again taxable, but rather than being offset by the “investment in the contract,” they are offset by the contract’s “adjusted basis.” Adjusted basis is computed similarly to the investment in the contract, except that basis is reduced for the portion of the premium that was expended for the provision of insurance.

As the preceding discussion implies, an increase in a policy’s cash surrender value is not a taxable event but instead represents either an additional investment or unrealized appreciation in an asset. This is confirmed in various IRS rulings, including Letter Ruling 9443020 and Field Service Advice 1999-832, in which the IRS confirmed that a policy owner’s tax basis in a policy does not include accrued inside buildup.

S corporation issues: Although premiums paid on cash-value policies and term policies are nondeductible under the same provision (Sec. 264(a)(1)), the effects of cash-value policy premium payments on shareholder basis and OAA are far more complex than is the case with term policies. A shareholder’s stock basis is reduced for nondeductible expenses that are not chargeable to capital account. With term policies, no portion of the premium is considered chargeable to capital account. For cash-value policies, the premium payment must be allocated between the amount attributable to insurance coverage (not chargeable to capital account) and the amount attributable to the investment (chargeable to capital account). The portion not chargeable to capital account generates consequences similar to those of premiums paid on term policies—reduction in shareholder basis, reduction in OAA, and no impact to AAA (Rev. Rul. 2008-42). The portion chargeable to capital account is an investment in the asset and, as such, has no immediate effect on shareholder basis, AAA, or OAA.

The issue, of course, is determining how to allocate the premium between the insurance coverage and the investment. Unfortunately, there is no clear guidance on how to make this allocation. In some cases, the insurance carrier may be able to provide an allocation. In other cases, taxpayers may use the uniform one-year term premium (P.S. 58) table to estimate the insurance element. Absent those options, taxpayers might choose to use a simplified procedure to make the allocation (e.g., considering the premium to be an investment to the extent of the increase in the policy’s cash surrender value, with any excess treated as the insurance element). However, this may overstate the nondeductible portion of the premium. Regardless, it is important to recognize that premiums on cash-value policies contain both insurance and investment elements that have differing implications on shareholder basis, OAA, and the tax basis in the investment.

With respect to death benefits,the rules that apply to term policies also apply to cash-value policies. Amounts that represent tax-free income under Sec. 101(a)(1) increase shareholder basis and OAA, and the same distribution ordering rules for companies with E&P apply.

As mentioned previously, increases in cash surrender value are not recognition events. As such, they have no impact on either the S corporation shareholders’ stock basis or the S corporation’s AAA and OAA. Companies often record increases in cash surrender value as tax-exempt income for book purposes, but these increases do not represent tax-exempt income for tax purposes and, as such, do not create basis against which a shareholder might otherwise take distributions.

S corporations that surrender or sell cash-value policies recognize taxable income based on the difference between the amount received and either the investment in the contract (surrender) or the contract’s adjusted basis (sale). This taxable income is treated the same as any other type of taxable income. The shareholders increase stock basis for their distributive shares of the taxable income, and the S corporation increases AAA by the same amount. Therefore, it becomes important for companies to track both amounts—the investment in the contract and the adjusted basis—so the company can appropriately account for a surrender or sale.

Summary

Life insurance can be an important tool for an S corporation. In particular, it can provide the company the liquidity to redeem an owner’s shares in the event of death. However, life insurance policies are subject to unique tax rules that are not always well-understood. Those rules, when coupled with the similarly unique basis and distribution rules that apply to S corporations, present opportunities for mistakes. It is important to keep those rules in mind to help avoid unexpected results.

EditorNotes

Mindy Tyson Weber is a senior director, Washington National Tax, for RSM US LLP.

For additional information about these items, contact Ms. Weber at 404-373-9605 or mindy.weber@rsmus.com.

Unless otherwise noted, contributors are members of or associated with RSM US LLP.