Life Insurance for Business Owners-What Is and What Is Not Deductible
These days, there are so many companies incorrectly deducting the costs of “key-man” and other life insurance premiums for owners and many business owners do not consider this erroneous accounting issue to be a big concern.
But to echo my mother, “Before you jump off the bridge with the others, please consider the consequences.”
It’s no wonder that there is a considerable misunderstanding as to what is and is not a tax-deductible insurance premium expense.
I’m sure you know that the IRS allows you to deduct most of the insurance expenses for your business as long as they’re ordinary and necessary. These deductible costs typically include the costs for insurance on:
business vehicles
liability or malpractice
bad debts
casualty and theft
health and accidents
business buildings and equipment
and more
But when it comes to life insurance for owners, that line between what is and what is not deductible sometimes need clarification.
Business owners use life insurance products to secure loans for the business, fund succession plans, protect against the risk of a key owner or employee’s death, as part of a retirement plan and for many other good reasons.
But many of the owners I have discussed this issue with have never been informed about the significant tax implications of deducting, or not deducting, the cost of life insurance premiums for policies owned by or that benefit the owners and the business.
And the issue for an S-Corporation is especially complex.
Here’s an example.
One of my new clients operates a small business (an S-Corp.) that is 50% owned by the 80-year-old mother and 25% by each of two sons—Bill who is 60 and Jake who is 50.
Bill and Jake together personally own a life insurance policy on their mom. The cost of the premiums for that policy is $15,000 per year.
Jake has a policy on Bill that costs $6,000 per year.
And Bill personally owns a policy on Jake that costs $4,000 per year.
NOTE: If this is starting to sound like a really hard story problem from school, it gets even worse!
In this case, the company has been paying the premiums on all these policies, and that by itself is not a problem.
The accounting issue is this:
When the company makes the payments for the premiums, whose distribution is it?
Answer: The distribution is to the shareholders of the S-Corporation who own the policy.
And since, in this case, the amounts of the premium payments are different and the percent of the company owned by each shareholder is not equal, there must be an “equalization” of these distributions to make the total of distributions to the shareholders proportionately equal in order to safeguard the S-Corp. status of the business.
Making matters more difficult is the fact that this client, like many others, posted the owner life insurance and key-man premium expenses to the same life insurance account that is used to post the deductible expense of the life insurance the company provides for its employees.
The result of this is that the person preparing the taxes cannot really tell what is and is not deductible without digging deeper into what was posted to the account.
The water is getting murky, isn’t it?
I suggest clients have a separate account for owner life insurance premiums. When it comes to an IRS audit, if you cannot prove it was properly accounted for it was not.
The IRS looks at it this way: If there is no paper trail, it did not happen.
And if it did not happen correctly, the consequences may be an increased tax liability for benefits paid under the policy, repayment of taxes not properly paid and penalties as well as a possible loss of the favorable S-Corp. status of the business.
So please ask questions and understand the possible consequences. The general rules for legally accounting for the expense of life insurance premiums are:
Not deductible:
You may not deduct the cost of premiums for life insurance where you, the business owner, are directly or indirectly the beneficiary.
This includes policies you take out on yourself to secure a loan for your business. It also includes the cost of premiums for loss-of-earnings insurance, which is also called business interruption insurance.
You may not deduct the cost of life insurance premiums paid on behalf of an employee or any person who has a financial interest in the business if the business is the beneficiary of the policy.
Deductible:
The cost of life insurance premiums is deductible if the insurance is provided as a benefit for employees and if the business is not the beneficiary of the policy.
The cost of the premiums paid by an employer for insurance on the life of an officer or employee is deductible ONLY if it can be shown that:
(1)Premium payments are in the nature of additional compensation,
(2)Total compensation, including premiums, is not unreasonable, and
(3)The employer is not directly or indirectly a beneficiary under the policy.
Premiums on group term life insurance covering the lives of employees are deductible by the employer if the employer is not a direct or indirect beneficiary. The payment of such premiums generally represent income to the employee to the extent that the coverage provided exceeds $50,000
Note: If you deduct the premiums, the proceeds of a claim on the policy are taxable only to the amount of the premiums paid. If you take no tax deduction for the premium expense, then proceeds of the claim are not taxable.
Bottom line
This issue all boils down to: Who owns the policy? And who is the beneficiary?
Like most IRS rules, it makes sense when you look at the reasoning behind the regulations. So please take a precautionary step this tax season to be confident that you are complicit with these regulations.
Ask questions. Get good answers. And leave a paper trail!