Life Insurance Proceeds: S-Corp Tax Implications

Life insurance policies can be a powerful tool for S-corporations, providing tax-exempt proceeds that can protect the company from the death of key personnel and offer critical liquidity. However, the interplay of life insurance proceeds and taxation in an S-corporation context is complex. While life insurance proceeds received by beneficiaries due to the death of the insured are generally not taxable, the tax treatment becomes more intricate when an S-corporation is involved. The rules governing how these proceeds impact the corporation and its shareholders' accounts, including the accumulated adjustments account (AAA) and other adjustment account (OAA), are crucial to understand as they can affect shareholders' access to tax-free cash distributions. Furthermore, the Supreme Court has ruled that life insurance proceeds received by a company upon a shareholder's death must be included as corporate assets for federal estate tax purposes, impacting succession planning for closely held corporations.

Life insurance proceeds are generally non-taxable

For corporations, the rules and considerations regarding life insurance proceeds and taxation can be more complex, especially for S corporations. In general, life insurance proceeds received by a corporation upon the death of a shareholder are not taxable to the corporation. However, these proceeds are considered an asset of the corporation and can increase its fair market value. This was affirmed by the US Supreme Court in the case of Connelly v. United States, where the Court ruled that life insurance proceeds received by a company upon the death of a shareholder must be included as an asset when determining the value of its shares for estate tax purposes.

The tax implications of life insurance proceeds for S corporations depend on various factors, including the type of insurance, the distribution of proceeds, and the corporation's accumulated adjustments account (AAA) and earnings and profits (E&P). S corporations with prior E&P can generally make tax-free distributions only up to the extent of AAA; additional amounts may be taxable to shareholders depending on the company's E&P. Additionally, premiums paid on cash-value and term policies are generally non-deductible for S corporations.

It is important to note that life insurance can be a valuable tool for corporations, especially in the event of the death of key personnel or shareholders. Life insurance policies can provide critical liquidity to a company, enabling it to buy back shares from a deceased owner's estate and maintain control over the makeup of its shareholders. Proper planning and consideration of the unique tax implications for S corporations are essential when utilizing life insurance as a tool for succession planning and ensuring the continuity of the business.

Interest on life insurance proceeds is taxable

Life insurance proceeds are generally not taxable to the beneficiary. However, interest on life insurance proceeds is taxable. This means that when a beneficiary receives life insurance proceeds after a period of interest accumulation, rather than immediately upon the policyholder's death, the beneficiary must pay taxes on the interest. For example, if the death benefit is $500,000 but it earns 10% interest for one year before being paid out, the beneficiary will owe taxes on the $50,000 growth.

The IRS states that if the life insurance policy was transferred to you for cash or other valuable consideration, the exclusion for the proceeds is limited to the sum of the consideration you paid, additional premiums you paid, and certain other amounts. There are some exceptions to this rule. Generally, you report the taxable amount based on the type of income document you receive, such as a Form 1099-INT or Form 1099-R. If the amounts are taxable, you can submit a Form W-4S, Request for Federal Income Tax Withholding From Sick Pay, to the insurance company or make estimated tax payments by filing Form 1040-ES, Estimated Tax for Individuals.

If the policy is a modified endowment contract (MEC), taxes are different. For tax purposes, withdrawals are on a last-in, first-out (LIFO) basis. This means that all withdrawals are treated as taxable income until they cumulatively equal all interest earnings in the contract.

It is important to note that life insurance premiums are typically not tax-deductible for personal policies. However, there are a few exceptions. If you gift a life insurance policy to a charity and continue to pay the premiums, those payments are generally considered charitable donations and may be tax-deductible.

Life insurance proceeds are a corporate asset

Life insurance is a valuable tool for S-corporations, as it can provide tax-exempt proceeds that help protect the company in the event of the death of key personnel. However, the tax implications of life insurance policies can be complex and present unique considerations for S-corporations.

In the United States, the Supreme Court has affirmed that life insurance proceeds received by a company upon the death of a shareholder are considered a corporate asset for federal estate tax purposes. This means that the insurance payout increases the company's value and must be included when determining the value of its shares for estate tax purposes. The ruling specifically addressed a case where the corporation used the life insurance proceeds to redeem the deceased shareholder's shares, and the court determined that this redemption did not constitute a "liability" that offset the value of the life insurance proceeds.

The implications of this ruling extend to S-corporations, which often have specific interests in controlling shareholder makeup to maintain their qualification under Subchapter S. When an S-corporation distributes insurance proceeds, it may face challenges in doing so on a tax-free basis unless there is sufficient accumulated adjustments account (AAA) from other sources or no earnings and profits (E&P). This is because S-corporations with prior E&P can generally make tax-free distributions only up to the extent of AAA, and additional amounts may be taxable to shareholders based on the company's E&P.

While the life insurance proceeds themselves are typically not taxable to the corporation, any interest received on the proceeds is taxable and should be reported accordingly. Additionally, it is important to ensure that the corporate-owned insurance policy names the company as the beneficiary, policy owner, and the shareholder as the covered person.

In summary, life insurance proceeds received by an S-corporation upon the death of a shareholder are generally considered a corporate asset and can impact the company's value for estate tax purposes. However, the tax implications can vary depending on the specific circumstances and the structure of the corporation.

Life insurance premiums are non-deductible

It is important to note that S corporations with prior C corporation earnings and profits (E&P) can generally make tax-free distributions only up to the amount of their Accumulated Adjustments Account (AAA). Any additional amounts are taxable to the shareholders to the extent of the company's E&P. As a result, 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.

In the context of life insurance, the IRS has ruled that an increase in a policy's cash surrender value is not a taxable event. Instead, it represents either an additional investment or unrealized appreciation in an asset. This means that a policy owner's tax basis in a policy does not include accrued inside buildup.

While life insurance premiums are generally non-deductible, there are some exceptions. For example, in the case of health and accident insurance, a 2-percent shareholder-employee of an S corporation may be eligible for an above-the-line deduction for amounts paid during the year for medical care premiums if certain conditions are met. Additionally, if the S corporation obtains and pays for health insurance in its name, covers the shareholder, and reports the premiums as wages, the shareholder may be allowed an above-the-line deduction.

In summary, while life insurance premiums are typically non-deductible for S corporations, there are specific situations where the tax treatment may vary, such as when the corporation distributes insurance proceeds or when there are health and accident insurance policies in place for shareholder-employees.

Life insurance proceeds can be used to buy out shareholders

Life insurance is frequently used by private companies to fund buy-sell transactions that are triggered by a shareholders' agreement upon death. In many cases, the surviving shareholders may not be interested in having the deceased shareholder's family involved in the business. Similarly, the family may not be interested in staying involved in the business and may prefer to receive estate proceeds. Life insurance proceeds can be used to buy out the shares owned by the deceased shareholder's estate or beneficiaries. Using corporate-owned life insurance to fund the buyout helps ensure the business can continue operating while providing cash to the deceased's beneficiaries.

There are a number of ways to structure this. For example, the proceeds can be used to redeem shares or can be paid as a capital dividend to fund a personal purchase of shares from the deceased's estate. The latter option allows the corporation to pay the premiums for the policy and collect the proceeds upon the death of the covered person. While the premiums are typically not deductible, they can be financed by corporate dollars, which is more financially prudent than using after-tax personal dollars. Once the insurance proceeds are received, they are not taxable to the corporation and an equivalent amount (net of any adjusted cost basis) is added to the company's capital dividend account. This can then be paid out tax-free to shareholders as a capital dividend.

It is important to ensure that any corporate-owned insurance policy names the company as the beneficiary and policy owner and names the shareholder as the covered person. This was demonstrated in the 2024 US Supreme Court case Connelly v. United States, which ruled that life insurance proceeds received by a company on the death of a shareholder must be included as a corporate asset when determining the value of its shares for estate tax purposes. The case involved two brothers who were the sole shareholders of a building supply business. Their agreement provided that upon the death of one brother, the surviving brother had the option to purchase the deceased brother's shares from the deceased brother's estate. The company was the beneficiary of the life insurance policy, so the proceeds were used to fund a buyout of the deceased shareholder's shares. The court determined that the company's obligation to redeem the shares was not a liability that could be offset against the value of the shares. Therefore, the fair market value of the life insurance proceeds must be included when calculating federal estate tax.

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