How Business Life Insurance Works: Owner, Insured, Beneficiary and Who Pays

Ownership, Premiums and Beneficiary: How the Combination Drives the Tax Result

The federal tax analysis asks two separate questions: whether the premiums can be deducted, and whether the death benefit is excluded from income.

Premiums. Section 264(a)(1) provides that "No deduction shall be allowed for— (1) Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract." The regulation applies this rule to policies covering "any officer or employee of the taxpayer, or any person (including the taxpayer) who is financially interested in any trade or business carried on by the taxpayer." It applies "even though they would otherwise be deductible as trade or business expenses" (26 C.F.R. § 1.264-1(a)).

The regulation also explains when a taxpayer counts as a beneficiary. A taxpayer that buys a policy "for the purpose of protecting himself from loss in the event of the death of the insured" is a beneficiary. A deduction is not disallowed "merely because the taxpayer may derive a benefit from the increased efficiency of the officer or employee insured" (26 C.F.R. § 1.264-1(b)). The statute's text draws no distinction between term and permanent policies, or between types of business entity.

Death benefit. Section 101(a)(1) excludes death proceeds from gross income, subject to listed exceptions. The regulation confirms that the exclusion applies "whether the beneficiary is an individual or a corporation," with stated exceptions (26 C.F.R. § 1.264-1(b)). Two limits on the exclusion matter most in business planning.

- Transfer for value. When a contract or an interest in it is transferred "for a valuable consideration," the exclusion "shall not exceed an amount equal to the sum of the actual value of such consideration and the premiums and other amounts subsequently paid by the transferee" (26 U.S.C. § 101(a)(2)). That limit does not apply in two cases: - where the transferee's basis is determined by reference to the transferor's basis; or - where the transfer is "to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer" (26 U.S.C. § 101(a)(2)(A)-(B)).

A separate rule covers a "reportable policy sale" (26 U.S.C. § 101(a)(3)).

- Employer-owned contracts. For an employer-owned life insurance contract, the exclusion "shall not exceed an amount equal to the sum of the premiums and other amounts paid by the policyholder for the contract" (26 U.S.C. § 101(j)(1)). The cap lifts only when two conditions are both met: 1. A section 101(j)(2) exception applies. These are based on the insured's status (an employee within the 12-month period before death, or a director, highly compensated employee or highly compensated individual when the contract is issued) or on amounts paid to a member of the insured's family, a designated beneficiary, a trust for their benefit or the insured's estate, or used to buy an equity interest in the policyholder from one of them. 2. The notice-and-consent requirements of section 101(j)(4) were met "before the issuance of the contract."

Notice and consent alone do not lift the cap, and an exception alone does not either. The notice and consent must be in writing. Notice 2009-48 (A-7) states that "actual knowledge alone" cannot substitute, even for a wholly owned corporation and its employee-owner.

A deductible structure is a different arrangement. In an executive bonus arrangement, the employer pays a bonus that is treated as compensation, subject to reasonableness and taxable to the employee, and the employee owns the policy. "Executive bonus plan" is industry shorthand for that arrangement, not a qualified retirement plan and not a term the Code defines. Business Life Insurance covers that structure on its own page. Both the premium analysis and the death-benefit analysis for any arrangement need individual review by the insurers involved and a qualified tax professional, as the section 264(a)(1) premium rule shows in the key person setting.

Key Factors That Affect How the Arrangement Is Structured

The structure of an arrangement turns on a short list of facts:

• Entity form. Whether the business is a C corporation, S corporation, partnership, LLC or sole proprietorship affects ownership options and how the rules apply. Notice 2009-48 (A-3) states that ownership by a partnership or sole proprietorship does not prevent a contract from being employer-owned. It also states that a sole proprietor's policy on his or her own life is not an employer-owned contract.
• The insured's role. It matters whether the insured is a key employee, owner, partner, shareholder or executive. Under section 101(j)(5)(A), "employee" includes an officer, director and highly compensated employee.
• Purpose. The purpose of the coverage, whether indemnifying the business for a key person's loss, funding a buy-sell, securing a loan or providing an executive benefit, shapes the beneficiary designation.
• Who owns the contract. Employer ownership brings in section 101(j). Notice 2009-48 (A-1) states that a contract owned by an owner of the entity, for example to finance buying another owner's interest, is not an employer-owned contract.
• Planned transfers. Any expected change in ownership of the policy can bring in section 101(a)(2).
• Amount. The coverage amount is a business-planning question. The business life insurance needs calculator gives an educational illustration only, not a coverage recommendation.

Contract terms, charges and procedures vary by insurer and are confirmed with the insurers involved.

Potential Advantages of Using Life Insurance in a Business Plan

Several features of the contract and the statute explain why life insurance is used as a funding source. None of them promises a result for any business.

• Federal income tax treatment of proceeds. Section 101(a)(1) generally excludes death proceeds from the beneficiary's gross income, subject to the transfer-for-value and employer-owned limits. Whether a given payment qualifies depends on the facts of the arrangement.
• Cash from the contract. The death benefit is paid under the contract to the named beneficiary, so the business does not have to sell assets to raise it. Claim timing varies by insurer.
• Matching the obligation. The face amount can be chosen with a specific obligation in mind, such as a buy-sell price, a loan balance or an estimated key person loss.
• Flexible destination. Depending on the design, proceeds can be directed to the business, to co-owners or to a trust.
• Cash value. A permanent contract may build cash value as a feature of the contract, subject to its terms.

Important Considerations and Costs

Each arrangement also brings real costs and continuing obligations.

• Non-deductible premiums. When the business is the beneficiary, section 264(a)(1) disallows the premium deduction, so the premiums are paid with after-tax dollars.
• Notice and consent. Employer-owned contracts call for written notice and consent before issuance (26 U.S.C. § 101(j)(4)). The employee must be told in writing of the intent to insure and the maximum face amount, must consent in writing, including to coverage continuing after employment ends, and must be told in writing that the policyholder will be a beneficiary. Notice 2009-48 (A-13) describes a limited approach to inadvertent failures and states that a missing consent "cannot be corrected after the insured employee has died."
• Transfers. A transfer for value can limit the exclusion to the consideration plus later premiums (26 U.S.C. § 101(a)(2)).
• Accessing cash value. How cash value is treated for tax purposes depends on how and when it is accessed and on how the contract is structured.
• State rules. Replacement, suitability, disclosure and free-look rules vary by state, and the federal rules on this page do not address them.
• Cost of coverage. Premiums depend on the insured's age and health and on the type of contract, and are quoted by the insurers involved.
• Coordination with agreements. A buy-sell agreement and its policies have to match. A coverage amount or beneficiary designation that does not match the agreement can defeat its purpose.

When to Review a Business Life Insurance Arrangement

Business events, rather than the calendar alone, usually prompt a review. Common triggers include:

• An owner, partner, shareholder or member joins or leaves the business.
• Business value changes enough to affect a buy-sell price or a key person estimate.
• The insured's role changes through promotion, departure or retirement.
• Loan obligations or lender conditions change.
• Federal law affecting sections 101 or 264 or the employer-owned contract rules changes.
• The entity changes form, for example from a partnership to a corporation. Such a change can affect which transfer exceptions in section 101(a)(2)(B) are available.

Reviews of this kind typically involve the insurers, tax counsel and legal counsel familiar with the business's agreements.

Hypothetical Example: Three Roles in a Buy-Sell Arrangement

This example is hypothetical. It uses round figures and is not a coverage recommendation or a tax result for any reader.

Assumptions:

• A closely held C corporation has two equal owners, A and B, who each own 50 percent.
• The business is valued at $2,000,000 for illustration only.
• Both owners are employees and officers.
• The written notice-and-consent requirements of section 101(j)(4) were met before each policy was issued.

Step 1. Set the funding need. $2,000,000 × 50% = $1,000,000 per owner.

Step 2. Assign the roles. The corporation owns a $1,000,000 policy on A's life and a separate $1,000,000 policy on B's life. It pays both premiums and is the beneficiary of both. This is an entity-purchase, or redemption, structure.

Step 3. Premiums. Because the corporation is the beneficiary, section 264(a)(1) allows no deduction for the premiums. That is the after-tax cost the arrangement carries.

Step 4. Death benefit. A dies, and the corporation receives $1,000,000. Section 101(a)(1) may exclude that amount from the corporation's gross income. Because the contract is employer-owned, the exclusion goes beyond premiums paid only if a section 101(j)(2) exception applies, such as A having been an employee within the 12 months before death, and notice and consent were met before issuance.

Step 5. Redemption. The corporation uses the $1,000,000 to buy A's 50 percent interest from A's estate.

Estate-tax valuation is a separate question. In Connelly v. United States, the Supreme Court held that a corporation's "contractual obligation to redeem Michael's shares did not diminish the value of those shares." The Court noted that in that case the corporation "would receive the proceeds and thereby increase the value" of the shares. A cross-purchase structure, in which the owners insure each other, works differently and is covered under cross-purchase buy-sell agreements.