Key Man Life Insurance: Are Proceeds Taxable?

Key man life insurance is a type of insurance that businesses purchase to insure the lives of their key employees. The death benefit from this insurance helps companies reduce the risk of business disruption by providing financial security in the event of the death of a critical employee. While the premiums paid for key man life insurance are generally not tax-deductible, the proceeds from the policy are typically provided to the company free of income tax. However, there may be certain situations, such as specific corporate structures or policies issued after a certain date, where the proceeds could be subject to taxation. Therefore, it is essential for businesses to understand the applicable tax laws and consult with tax professionals to ensure compliance and make informed decisions regarding their key man life insurance policies.

Key man life insurance premiums are not tax-deductible

Key man life insurance is a type of insurance purchased by a business to insure the life of one of its employees. It is intended to help the company recover from the death of an employee who contributes significantly to the business, and whose death would reduce productivity or the company's value.

While the proceeds of the policy are usually provided to the company tax-free, the premiums paid for key man life insurance are not tax-deductible. This is because the business is usually both the owner and beneficiary of the policy, and the premiums paid by the business are generally not considered taxable income for the employee.

The Internal Revenue Code (IRC) states that no deduction is allowed for premiums paid on a life insurance policy covering the life of an officer, employee, or any person financially interested in the business where the business is directly or indirectly a beneficiary of the policy. This is outlined in IRC Section 1.264-1(a) and Section 264(a)(1).

The federal government and the IRS have long encouraged both individuals and businesses to purchase life insurance to provide financial security. One of the incentives for purchasing life insurance is that the death benefits are typically received by the beneficiary of the policy tax-free. However, because the proceeds of life insurance policies are generally paid to the named beneficiary tax-free, there is no deduction allowed for premiums paid.

It's important to note that there may be tax implications for the insured employee if the business is the sole owner and beneficiary of the policy. In this case, the premiums may be considered taxable income for the employee unless they have ownership in the policy or are a beneficiary.

Proceeds are usually provided to the company tax-free

When a key employee passes away, the company usually receives the proceeds from their life insurance policy tax-free. This is because, in general, life insurance proceeds paid due to the death of the insured are exempt from income tax.

However, this is not always the case. For example, in the US, the Internal Revenue Code (IRC) states that death proceeds from employer-owned life insurance contracts issued after 17 August 2006 will be taxed as ordinary income if the amount paid exceeds the premiums paid by the employer. This was implemented to prevent corporate abuse, where companies were purchasing life insurance policies on non-key employees to receive a tax-free death benefit.

There are exceptions to this rule, however, and death benefits can be exempt from income tax if certain notice and consent requirements are met before the policy is issued. For example, death benefits will not be taxable if the insured qualifies as a director or a highly compensated employee (defined as an employee with a 5% ownership stake in the business or who received compensation over a certain amount in the preceding year).

It is important to note that the tax treatment of key man life insurance can be complex and vary based on the specific circumstances and location. Therefore, it is always recommended to consult with a tax professional or financial advisor to ensure compliance with all requirements and to fully understand the tax implications.

The death benefit may be taxable income for C corporations

While the proceeds of a key man life insurance policy are usually provided to the company free of income tax, there is an exception for C corporations. If a C corporation receives the death benefit, this will be included in the calculation of the alternative minimum tax (AMT) due.

In 2006, the Pension Protection Act was passed to prevent corporate abuses with key employee insurance. The Act added additional guidelines for all employer-owned life insurance policies issued after 17 August 2006. This change in the IRS code was designed to prevent large corporations from purchasing life insurance policies on non-key employees and receiving a tax-free death benefit when the employee or former employee died.

The new legislation was a reaction to Congress' concern about the practice of certain large corporations purchasing life insurance on rank-and-file employees, naming themselves as beneficiaries. The legislation, however, ended up affecting many more situations than the large corporation scenario.

The impact of this law is that the gross proceeds from life insurance policies issued after 17 August 2006 (adjusted for premiums paid) are subject to income tax. There are, however, extensive exceptions that allow the company to claim a full exemption of the death benefit from gross income. To use these exceptions, certain notices and consents must be issued and obtained before the policy is issued.

The notice and consent requirements are met if, before the issuance of the contract, the employee:

• Is notified in writing of the intent to insure their life and the maximum face amount of the policy for which they can be insured
• Provides written consent to being insured under the contract and that such coverage may continue after they leave the company
• Is informed in writing that the company will be a beneficiary of any proceeds payable upon their death

In addition, the company is required to report to the IRS annually on IRS Form 8925:

• The number of employees at the end of the year
• The number of employees insured under an employer-owned life insurance contract at the end of the year
• The total amount of insurance in force at the end of the year under such contracts
• The company name, address, and taxpayer identification number, and the type of business it is engaged in
• A statement that the company has a valid consent from each insured employee

The death benefit is taxable if the policy was issued after August 17, 2006

The death benefit from a key man life insurance policy is usually provided to the company free of income tax. However, there are certain situations where the death benefit may be taxable. One such situation is when the policy was issued after August 17, 2006.

The taxability of the death benefit in this case arises from changes to the tax code made by the Pension Protection Act of 2006. This legislation added a new section, Sec. 101(j)(1), which limits the amount of tax-free treatment on proceeds from employer-owned life insurance (EOLI) contracts. Under this new section, only the total amount of premiums paid and other amounts paid by the policyholders are considered tax-free, and any remaining proceeds are taxable.

The definition of an EOLI contract is outlined in Sec. 101(j)(3)(A) as a contract that is owned by a person or business entity engaged in a trade or business, where the policy covers the life of an insured employee. It's important to note that this definition includes split-dollar arrangements, which involve multiple policy owners.

To avoid the tax implications of this new section, employers must meet certain notice and consent requirements before the policy is issued. Specifically, the employee must be notified in writing about the intent to insure their life, provide written consent to being insured, and be informed that the employer will be the beneficiary of any proceeds upon the employee's death. These requirements ensure that the employee is aware of the insurance coverage and that they consent to it.

By meeting these notice and consent requirements, employers can ensure that the death benefit from a key man life insurance policy issued after August 17, 2006, remains tax-free. However, failure to comply with these requirements will result in the proceeds being taxable. Therefore, it is crucial for employers to carefully follow the necessary steps to avoid unexpected tax liabilities.

The death benefit is taxable if the insured is also an owner of the business

A key man life insurance policy is purchased by a business to insure the life of one of its employees. It is intended to help the company recover from the death of an employee who contributes significantly to the business. A key man policy can be an employee benefit, if the company agrees to transfer the life insurance policy to the insured employee when the employee meets the criteria set by the company.

A key employee can be either an owner or an employee. What distinguishes someone as a "key person" is that their loss would severely impact a business until a replacement could be found and trained.

In general, life insurance proceeds paid due to the death of the insured are exempt from income tax under IRC § 101(a). However, there are situations where the death proceeds from a key person policy might be subject to income tax. One such situation is when the insured is also an owner of the business. This can occur since the gross estate of a business owner includes the value of their interest in the business. Life insurance proceeds paid at the business owner's death and received by the business are taken into account when valuing their business interest.

It is important to note that the proceeds do not necessarily increase the value of the business on a dollar-for-dollar basis since the business has also lost the value of its key employee. In this case, the death benefit is included in the calculation of the alternative minimum tax (AMT) due. Therefore, it is vital for any business with a life policy paid by the business, or other S-corporation, to discuss the tax policy and estate planning particulars with an accountant or tax professional.

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