[IMGCAP(1)][IMGCAP(2)]Companies often own life insurance policies on the lives of key employees and the owners.
A business may transfer ownership of a policy to the insured at some point for various reasons, such as the insured retiring and wanting to use the policy for personal planning purposes, the insured business owner selling his or her business interest and wanting to personally own his or her life insurance policy, or the business paying a bonus to a key employee using the company owned life insurance policy as the bonus instead of using cash.
The tax treatment to the business and the insured on a transfer of the policy depends on several factors, including the type of business entity and whether the transfer of the policy is treated either as compensation or as a distribution. Also note that if the transfer of the policy is not to the insured, it is important to consider if it will be a “transfer for value” under Section 101(a)(2) of the Internal Revenue Code. This article will discuss transfers to the insured, which is an exception to the “transfer for value” rule.
IRC § 311(b) provides that a corporation that changes ownership of a corporate owned life insurance policy to the individual insured (i.e., distributes the policy) recognizes taxable income equal to the policy’s gain. Unfortunately, while a gain must be recognized, IRC § 311(a) does not allow a corporation to deduct a loss upon the distribution if the policy’s fair market value is below the policy’s basis. If a transfer is treated as compensation, the corporation should be able to deduct the policy’s fair market value as wages, as long as it, along with all compensation paid to the employee, is deemed reasonable.
If a transfer of a policy to the insured is treated as compensation, then the insured would include the fair market value of the policy in his or her gross income. The insured’s basis in the policy after the transfer would be the policy’s fair market value. (The amount, if any, that the insured pays for the policy in the transfer will reduce the amount included in the insured’s gross income. In Revenue Procedure 2005-25 the IRS provided guidance with regard to the term “fair market value” when a policy is transferred in an employment situation.)
If the life insurance policy is transferred to a shareholder, then the transfer may either be treated as compensation to a shareholder-employee or as a dividend to a shareholder, depending on the circumstances. If treated as compensation, the same rules apply to a shareholder-employee as the rules stated above for employees. On the other hand, a transfer treated as a dividend means the corporation cannot deduct the policy’s fair market value because dividends are not deductible.
The shareholder must include the policy’s fair market value as dividend income in his or her gross income to the extent of the corporation’s earnings and profits. The dividend should be eligible for the more favorable qualified dividend tax rates. The shareholder’s basis in the policy after the transfer would be equal to the policy’s fair market value. We will talk more about the importance of tracking policy basis shortly.
Similar to a C corporation, if an S corporation transfers a corporate-owned life insurance policy, the corporation will recognize taxable income to the extent of the policy’s gain and if the policy’s fair market value is below the policy’s basis, the corporation will realize a non-deductible loss upon the transfer.
If the transfer is to a non-shareholder employee, it is treated as compensation and the employee will have to include the policy’s fair market value in his or her gross income. (The amount, if any, that the insured pays for the policy in the transfer will reduce the amount included in the insured’s gross income.) The employee’s basis in the policy after the transfer would equal the policy’s fair market value. The corporation should be able to deduct the fair market value of the policy as compensation, as long as it, along with all other compensation paid to the employee, is deemed reasonable.
If a life insurance policy is distributed to a shareholder-employee, then the transfer may either be treated as compensation to an employee or as a distribution to a shareholder, depending on the circumstances. As with a transfer to a non-shareholder employee, treating the transfer of the policy as compensation should allow the corporation to deduct the policy’s fair market value as compensation and the shareholder would include the policy’s fair market value in his or her gross income as wages.
If the transfer is treated as a distribution, then the shareholder would receive a non-taxable distribution as long as the shareholder’s basis in his or her S corporation stock exceeds the value of the distribution (i.e., the policy’s fair market value). Note that if the S corporation was previously a C corporation and if the S corporation has accumulated earnings and profits from C corporation years, the distribution may be treated as a dividend.
From a tax perspective, there are a few things that occur when a policy with gain is transferred to an S corporation shareholder:
• The corporation recognizes taxable income equal to the policy’s gain;
• The gain is allocated to all shareholders on a pro-rata basis;
• The gain allocated to each shareholder increases the basis in their S corporation stock;
• The shareholder who receives the policy as a distribution reduces his or her basis in the S corporation stock equal to the policy’s fair market value; and
• If the fair market value of the policy exceeds the shareholder’s stock basis, the excess over the stock basis is treated as a capital gain.
Note that when there is more than one S corporation shareholder, distributions must be pro-rata; otherwise there is the risk of creating a second class of stock and inadvertently terminating the S election. Therefore, it is important to consider what distributions should be made to other shareholders. For example, suppose an S corporation has three shareholders: at 60 percent, 30 percent and 10 percent. If the controlling 60 percent shareholder decides to distribute a corporate owned life insurance policy to himself that has a $100,000 fair market value, then the 30 percent shareholder should receive a $50,000 distribution in cash or property, and the 10 percent shareholder should receive a $16,667 distribution in cash or property so that the distributions are pro-rata.
Partnerships (Including Limited Liability Companies Taxed as Partnerships)
When a life insurance policy is transferred from a partnership to an employee, the partners recognize taxable income to the extent of the policy’s gain. The gain is allocated to each partner based on their respective partnership allocations. The partners should also be able to deduct the policy’s fair market value as compensation paid to an employee and the deduction would be allocated to each partner based on their respective partnership allocations. The employee recognizes taxable income equal to the policy’s fair market value and would have a basis in the policy equal to that amount. (The amount, if any, that the insured pays for the policy in the transfer will reduce the amount included in the insured’s gross income.)
If a policy is transferred to a partner, there should not be any taxable gain to the partnership because a distribution to a partner does not trigger gain or loss to the partnership. Similarly, there is no immediate taxation of the distribution to the partner because generally no gain or loss is recognized by the partner on a distribution.
The partner who receives the policy would obtain a carryover basis in the policy equal to the partnership’s basis in the policy immediately before the distribution. So, if a partnership has a $100,000 basis in a policy that is distributed to a partner, the partner’s basis in the policy after the distribution is $100,000, assuming the partner’s basis in his or her partnership interest exceeds the policy’s basis. Upon the distribution of the policy, the partner’s basis in his or her partnership interest is reduced by the policy’s basis.
Tracking Basis After the Distribution
An important consideration regarding any transfer of a policy from a business to an insured is keeping good records of the policyholder’s basis in the policy after the transfer. The policy’s cost basis according to most insurance companies’ records will probably only reflect the cumulative premiums paid.
If the insured later surrenders the policy, he or she will need good records because the insurance company may issue a 1099-R based on the policy’s basis equaling the cumulative premiums paid, which may result in a 1099-R being issued that reports a higher gain than what the policyholder actually recognized. This is especially true when policies are distributed from corporations.
Also, the insurance company could issue a 1099-R showing a gross distribution but the taxable amount as not determined, which may also require the policyholder to prove to the Internal Revenue Service what his or her basis in the policy is for determining the taxable amount, if any.
Policy Fair Market Value
A business needs to know a policy’s fair market value to determine the taxation of distributing a policy out of the business. The IRS provided safe harbor formulas for determining a policy’s fair market value in Revenue Procedure 2005-25, which provided that “the fair market value of an insurance contract . . . may be measured as the greater of: A) the sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, and B) the product of the PERC amount . . . and the applicable Average Surrender Factor.” However, other factors may impact the valuation of a life insurance policy and the overriding theme when valuing a life insurance policy, or any property, is that “the fair market value is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.”
While life insurance can be an income tax-free asset when structured appropriately, the income tax laws may result in the transfer of life insurance policies that are income taxable to both the transferor and the transferee. This may be particularly important when life insurance policies are owned by businesses and may be distributed out of the business at some point. Another important aspect of transferring a life insurance policy is determining the policy’s fair market value. Tax advisors should review the guidance in Revenue Procedure 2005-25 when determining a life insurance policy’s fair market value.
Michael Geeraerts, JD, CPA, CGMA, CLU is a Business Resource Center consultant for advanced markets at The Guardian Life Insurance Company of America. Michael works with financial advisors and provides them with business, estate, and tax planning strategies for their clients. Prior to joining Guardian, Michael was a manager at PricewaterhouseCoopers LLP where he audited large mutual funds and hedge funds. Michael also performed tax consulting for large companies while at KPMG LLP. Bryan Davis, CFP, CLU, ChFC is a senior Business Resource Center consultant for advanced markets at The Guardian Life Insurance Company of America. An 18-year industry veteran, Bryan has worked extensively with high net worth clients and their advisors on business planning, insurance planning and analytics, and personal financial planning. Bryan previously was an agency manager for TPA firms, as well as a case strategist for SEI Investment’s Wealth Network, which served high net worth clients.
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