Key Employee Life Insurance Proceeds: Taxable Or Not?

Life insurance is a crucial financial safety net for individuals and businesses alike. While the former is more commonly known, corporate-owned life insurance policies are an important consideration for companies, especially smaller businesses, that want to protect themselves from the financial fallout of losing a critical employee. Also known as key person or key employee insurance, these policies are taken out by companies to cover founders, owners, or executives, with the company as the beneficiary. But are the proceeds from such policies taxable?

Are life insurance proceeds taxable for key employees?

Life insurance is a way to provide financial security to beneficiaries after the policyholder's death. Generally, life insurance proceeds are not taxable and can be received by the beneficiary tax-free. However, there are certain scenarios where the proceeds may be taxable, and specific requirements must be met to avoid taxation.

In the case of key employees, life insurance policies are owned and paid for by the employer, and the company is the beneficiary. Key employees can include founders, owners, executives, or anyone essential to a company's operations. The proceeds from key employee life insurance are intended to help the company recover from the loss of a critical employee by providing a financial buffer to recoup lost business, invest in hiring and training a replacement, or fund other necessary expenses.

The premiums for key employee life insurance are generally not tax-deductible. However, the death benefit proceeds are typically provided to the company tax-free. There are some exceptions to this rule. For example, death benefit proceeds from employer-owned life insurance contracts are taxable if they exceed the premiums paid, unless certain exceptions are met.

To avoid taxation on key employee life insurance proceeds, companies must adhere to specific IRS rules and guidelines, such as obtaining the employee's written consent and meeting the requirements under the Pension Protection Act of 2006 and the COLI Best Practices Act. Additionally, proper record-keeping and reporting are essential to ensure compliance with IRS requirements.

It is important to note that the tax treatment of life insurance proceeds may vary depending on the specific circumstances and the location of the policyholder. Consulting with a tax advisor or professional is recommended to understand the specific tax implications of key employee life insurance proceeds.

What are the tax implications for the insured employee?

If you are the insured employee, there are generally no tax implications for you. The premiums for key man insurance are not tax-deductible, but they are also not considered part of your taxable income. This is because the company is both the owner and the beneficiary of the policy. However, if you have ownership in the policy or are a beneficiary, then the premiums may be considered part of your taxable income.

If the company transfers ownership of the policy to you, you may have to pay taxes, as the transfer may be considered compensation. It is important to note that if you are the beneficiary of the policy and receive the proceeds in installments, you may have to report this as interest received.

Additionally, if you are the beneficiary of a policy that was transferred to someone else for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration paid, additional premiums paid, and certain other amounts. There may be exceptions to this rule, and you can refer to Topic 403 for more information about interest and Publication 525 for more information about taxable and non-taxable income.

It is always recommended to consult with a tax professional or advisor to ensure full compliance with all tax requirements and regulations.

Can key man insurance premiums be deducted?

When filing taxes, businesses typically look for as many deductions as possible. However, key man insurance premiums are not tax-deductible. The IRS prohibits the deduction of key man insurance as an expense.

The IRS covers this in Section 264(a)(1) and provides that there is no deduction allowed for premiums paid on any life insurance policy if the taxpayer is directly or indirectly a beneficiary under the policy. Key man insurance is specifically covered under Section 1.264-1(a) and states that premiums paid for life insurance on any officer, employee, or person financially interested in a business are not deductible if the taxpayer is directly or indirectly a beneficiary of the policy.

In addition, the Pension Protection Act of 2006 added further guidelines for all employer-owned life insurance policies issued after August 17, 2006. This change was made to prevent large corporations from purchasing life insurance policies on non-key employees to receive a tax-free death benefit when the employee dies.

Key man insurance premiums are not tax-deductible because the proceeds of life insurance policies are generally paid to the named beneficiary tax-free. However, there are exceptions to this. A trusted tax advisor would be able to guide a company through the regulations and documentation needed.

A company's tax forms would have to include how many employees have key person insurance, if there was consent given by each employee, and the amount of coverage in place. Tax law has restrictions on employer-owned policies to protect employees – life insurance death benefit proceeds that exceed the cost basis will be subject to income taxation if specific requirements aren't met.

What are the tax forms for key man insurance?

Key man insurance, also known as key person or key employee insurance, is a type of life insurance policy purchased by a company to cover a founder, owner, executive, or anyone else essential to a business's operations. The company is both the owner and beneficiary of the policy and must obtain the written consent of the employee before purchasing it. While the premiums for key man insurance are not tax-deductible, the proceeds of the policy are usually provided to the company tax-free. However, there are some exceptions and important considerations to ensure compliance with IRS requirements.

The specific tax forms and requirements related to key man insurance include:

• Form 8925 "Report of Employer-Owned Life Insurance Contracts": This is an annual reporting requirement imposed by the IRS under IRC Sec. 6039I. It includes information such as the total number of employees, the number of employees insured under COLI arrangements, the total insurance amount, the employer's details, and a statement of valid consent for each insured employee.
• Notice and Consent Requirements: Prior to issuing a key man insurance policy, employers must provide written notification to the employee, disclosing the intention to insure their life and the maximum face amount of the policy. The employee must then provide written consent to be insured and acknowledge that the employer may retain the policy even after the employee leaves the company. Additionally, the employee must be informed in writing that the employer is the beneficiary of the death benefit proceeds. These requirements are crucial to avoid taxable status on the death benefit.
• Exceptions to Taxing Death Proceeds: To avoid taxation on death proceeds payable to the employer, one of the following exceptions must be met:

• The insured was an employee at any time during the 12 months before their death.
• The insured was a director or "highly compensated employee" when the contract was issued.

Payment to Designated Beneficiaries: Any amount received by the employer as a result of the insured's death must be paid to specific beneficiaries to avoid taxation. These beneficiaries include:

• A family member of the insured.
• A designated beneficiary of the insured other than the employer.
• A trust established for the benefit of a family member, designated beneficiary, or the insured's estate.
• A family member, designated beneficiary, trust, or estate in exchange for any interest they hold in the corporation/employer (buy-sell agreement).

• Compliance with the Pension Protection Act of 2006: This act includes the COLI Best Practices Act, which has significant implications for key man insurance taxation. It states that death benefits from employer-owned life insurance policies issued after August 17, 2006, are taxable if they exceed the employer's premiums, unless certain exceptions are met.
• Alternative Minimum Tax (AMT) for C Corporations: Death benefits received by C corporations from key man insurance policies are included in the calculation of the AMT due, which may result in additional tax liabilities.
• Tax Treatment for Employees: If the company is the sole owner and beneficiary of the key person policy, there are generally no tax implications for the insured employee. However, if ownership of the policy is transferred to the employee, they may be subject to taxes as the transfer may be considered compensation.

In summary, while the proceeds from key man insurance policies are typically tax-free for the company, proper attention to the IRS requirements, exceptions, and reporting is crucial to avoid unnecessary taxation. Consulting with a tax professional or CPA is highly recommended to ensure full compliance with the applicable tax laws and regulations.

How does tax treatment vary for employees of C corporations?

C corporations, or C corps, are a legal structure for a corporation in which the owners, or shareholders, are taxed separately from the entity. C corps are subject to corporate income taxation, creating a double taxation situation. Profits are taxed twice: first when the company files its income taxes, and again when those profits are distributed as dividends. Shareholders in a C corporation cannot deduct business losses on their tax returns.

C corps can pay corporate taxes on earnings before distributing profits to shareholders as dividends. Individual shareholders then pay personal income taxes on the dividends they receive. C corps are required to hold at least one meeting each year for shareholders and directors, during which minutes must be maintained to display transparency in business operations. The business must also keep voting records of the company's directors and a list of the owners' names and ownership percentages.

C corps have the advantage of legally separating owners' or shareholders' assets and income from that of the corporation. This limits the personal liability of directors, shareholders, and other company officers, as the legal obligations of the business cannot become a personal debt obligation of any individual associated with the company. The C corporation continues to exist as owners change and members of management are replaced.

C corps can have many owners and shareholders and can raise capital by issuing and selling shares of stock. However, they are subject to greater regulation than other business structures, which can incur higher legal fees.

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