Filed Under:Life Insurance, Life Products

Paying Life Insurance Premiums with Company Cash Flow: The Tax Effect

Image:FreeDigitalPhotos.net

Image:FreeDigitalPhotos.net

Successful C Corp, S Corp, and LLC business owners often want to use the cash flow from their business to pay life insurance premiums. These premiums may be for either employer-owned polices or for personally owned policies, depending on the specific insurance protection needed.

Tracking the income tax effect of that business cash flow is an important part of understanding how “business dollars” can be used to pay annual insurance premiums. The summary that follows highlights important income tax and FICA tax considerations producers should understand when selling business or personal insurance to business owner clients.

C Corporations

For policies owned by the C Corp or QPSC: The premium is a non-deductible expense to the corporation (IRC Section 264). Since the premium is non-deductible, the annual premium amount will be part of the C Corp profit each year. This U.S. Form 1120 profit (net income) will be taxed to the C Corp as a separate tax entity at C Corp tax rates. These rates range from a low of 15% to a high of 39%, depending on the amount of taxable profit (net income).

For policies owned personally by the C Corp owner-employee, there are two options:

Option #1: If current business cash flow is used to pay premiums, the amount is deductible to the corporation as bonus compensation paid (IRC Section 162). This amount is taxable to the C Corp owner-employee personally as W-2 compensation received. Bonus comp is considered “earned income,” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching corporate level.

Option #2: The C Corp owner can make dividend withdrawals from balance sheet “Retained Earnings” to pay premiums. This withdrawal is considered to be a dividend distribution, which is not deductible to the C Corp. The dividend is taxable to the C Corp owner as dividend income. For tax years 2011 and 2012, this dividend distribution is taxed at a low “qualified dividend” rate of 15%. If the income tax sunset occurs this December 31, dividends distributed in 2013 and beyond will again be taxed as ordinary income at rates as high as 39.6%.

S Corporations

For policies owned by the S Corp: The premium is a non-deductible expense to the corporation (IRC Section 264). Since the premium is non-deductible, the annual premium amount will be part of the S Corp profit each year. This U.S. Form 1120S profit (net income) will be “passed-through” as K-1 income to the S Corp owner personally on Schedule E of the Form 1040 U.S. Income Tax return.

For policies owned personally by the S Corp owner-employee, there are three options:

Option #1: If current business cash flow is used to pay premiums, the amount is deductible to the corporation as bonus compensation paid (IRC Section 162). This amount is taxable income to the S Corp owner-employee personally as W-2 compensation received. Bonus comp is considered “earned income,” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching corporate level.

Option #2: The S Corp owner can use some end of year distributed K-1 “pass-through” profit to pay premiums. As stated just above, this K-1 profit is taxable to the S Corp owner personally. However, this S Corp profit is generally considered to be “unearned passive income” and, therefore, is not subject to the FICA taxes levied on “earned income.”

Option #3: The S Corp may have a previously taxed profit account, known as the Accumulated Adjustments Account (AAA) for tax accounting purposes. This AAA is the cumulative amount of any previously taxed S Corp K-1 profits from prior years that have been left in the S Corp. A tax-free withdrawal can be made from this previously taxed AAA to pay for personally owned insurance of the S Corp owner. The AAA will be adjusted downward by the amount of the withdrawal. There are no FICA taxes on AAA withdrawals that have been previously taxed as “unearned income.”

Limited Liability Companies

For polices owned by the LLC: The premium is a non-deductible expense to the LLC (IRC Section 264). Since the premium is non-deductible, the annual premium amount will be part of the LLC profit each year. This U.S. Form 1065 profit (net income) will be “passed-through” as K-1 income to the LLC owner personally on Schedule E of the Form 1040 U.S. Income Tax return. LLCs are treated as partnerships for income tax purposes.

For policies owned personally by the LLC owner, there are three options:

Option #1: If current business cash flow is used to pay premiums, the amount is deductible to the corporation as bonus compensation paid (IRC Section 162). This amount is taxable income to the LLC owner personally as W-2 compensation received. Bonus comp is considered “earned income,” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching employer level.

Option #2: The LLC owner can use some of the distributed K-1 “pass-through” profit to pay premiums. As stated just above, this K-1 profit is taxable to the LLC owner personally. However, this LLC profit is generally considered “unearned passive income” and, therefore, is not subject to the FICA taxes levied on “earned income.”

Option #3: The LLC may have a previously taxed profit account, known as the capital account for tax accounting purposes. This capital account is the cumulative amount of any previously taxed LLC K-1 profit from prior years that has been left in the LLC. A tax-free withdrawal can be made from this previously taxed capital account to pay for personally owned insurance of the LLC owner. The capital account will be adjusted downward by the amount of the tax-free withdrawal. There are no FICA taxes on capital account withdrawals, which have been previously taxed as “unearned income.”

As a general rule, it is important to ask business owner clients for permission to see their business tax returns so that sources of business cash flow can be identified to pay for insurance premiums. These tax returns are: (1) the Form 1120 U.S. Corporation Income Tax Return for C Corps; (2) the Form 1120S U.S. Income Tax Return for S Corps; and (3) the Form 1065 U.S. Return of Partnership Income for LLCs.

These returns can reveal potential tax accounting sources of cash flow described above to fund annual premiums for business or personal life insurance.

 

For more on life insurance and tax planning, see:

Estate Planning: Focus on the Legacy, Not the Tax Bill

The Right Buy-Sell Agreement for Your Client

As April 15 Looms, What Can You Do to Help Your Clients?

More Resources

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