Obscure tax laws and new life insurance products with special features have the potential to create some tax time bombs for the unwary business owner. We’re not talking about some small deductions disallowed on business life premiums paid. We’re talking about full-blown income taxation of the entire insurance proceeds at time of claim. And once a claim occurs, you can never go back and fix it. What’s done is done.
This is an important reason why agents in the business marketplace need to have the support of a general agent who thinks outside the box, is familiar with products from a number of companies, and considers issues that aren’t just found on the company brochures. Health insurance agents, especially with the Affordable Care Act becoming law, want to rapidly contact their group clients (business owners) about life insurance for more market penetration and new sales. It’s important that they have maximum support in these dangerous tax waters.
Let’s look at a few examples of how your clients’ plans can potentially blow up. After you read these examples, you’ll want to make sure your clients’ plans are set up properly-it’s easy. However, the consequences for mistakes are horrendous.
Bruce is age 56 and brought Sue, age 49, into his law firm as an equal partner four years ago. They have a stock redemption agreement with all the typical provisions and triggers for buyout in case of disability, at voluntary withdrawal or retirement, and upon death. They each carry $1 million of inexpensive term life insurance to fund the agreement should one die; in addition, they have disability buy-out insurance.
So far, so good-in fact, this is a situation better than most. They have funding tools in place. And, of course, everything is fine until something happens.
Example Number 1: Taxation of Proceeds
Did Bruce and Sue comply with IRC 101(j) effective August 17, 2006? If they didn’t, all of their insurance is taxable income at the time of claim.
The Pension Protection Act generally provides that death proceeds from business insurance policies issued after August 17, 2006, will be taxable income; however, when specific employee notice and consent requirements are met and certain exceptions apply, death proceeds can still be received income-tax free.
Note that they’re only safe where the insured employee receives notice of and consents to the insurance in writing prior to policy issue. In addition, your business owner clients need to include IRS form 8925 each year with their income tax returns. If you’re seeking some tax advice regarding your business, there are lots of reputable companies that can help you. When it comes to tax, it’s better to be prepared!
Example Number 2: Taxation of Proceeds
The corporation (a C corporation) pays the premiums and deducts them as a reasonable business expense. After all, it’s business insurance, right? Wrong. Premiums are not a deductible expense if a corporation is the direct or indirect beneficiary of the policies. Deducting the premiums could easily make the entire $2 million subject to income taxes. Plus this arrangement cannot be considered “group” insurance and deducted that way, either.
Example Number 3: Taxation of Proceeds
Everything’s fine until one day Sue is diagnosed with a particularly nasty form of cancer. It could be fatal, but the doctors think there is hope. Bruce calls you, and you tell him that the insurance is in place and it has a provision to allow the insurance company to release up to 100 percent of the proceeds early just in case the doctors give her less than a year to live. Bruce is relieved and thinks it’s great to have this ability to buy Sue out early enough to put a lot of money in her hands. It might even improve her chances for survival.
Not so fast! From 2003 to 2009, the IRS issued several private letter rulings (PLRs) involving critical illness and terminal illness riders on life insurance policies. Section 101(a)(1) says that life insurance received after actual death is income-tax free to the business and IRC 101(g)(1)(a) says that benefits accelerated under a terminal illness (accelerated benefit) rider are treated the same way as if death had occurred. Is Bruce safe if he gets the million bucks if Sue is found to be terminally ill? Let’s assume you didn’t mention the potential problems and just said it was a “good thing it was there.”
Of course, with the IRS code there are always exceptions. Here’s the exception in the code just hiding and waiting for you. Section 101(g)(5): “…shall not apply in case of any amount paid to any taxpayer other than the insured if that taxpayer has an insurable interest in the life of the insured, by reason of the insured being a director, officer, or employee of the taxpayer or by reason of the insured (that’s Sue) being interested in any trade or business carried on by the taxpayer.”
If Sue isn’t going to make it, Bruce had better wait a few more months until she passes away. Taking the benefits from the insurance company a few months early might leave him with a million dollar legal contract to fulfill. But the IRS will take a huge chunk out of that, leaving Bruce with a heck of a shortfall he still has to pay. Probably a $350,000 mistake. Is your E&O up to date?
Example Number 4: Taxation of the Proceeds
Same problem as number two, but this time Bruce and Sue have some excellent universal life policies funding their agreement. You said it was the best stuff around, since the top-rated company also allowed the death benefits to be accelerated for long term care problems at no additional cost. The only kicker is that the condition has to be permanent.
Now, it’s Bruce’s turn. Bruce has had mild Parkinson’s disease for years, and while it’s progressed, he has still been able to work. Now the disease has developed into a serious problem that makes continuing to work difficult for Bruce. In this case, if the insurance company releases the insurance money to the corporation to fund the buyout, will the corporation receive the money tax free?
No, again, for the same reason as in example number two. “This subsection (to the exclusion from income tax) shall not apply if paid to any taxpayer other than the insured if that taxpayer has an insurable interest in the life of the insured officer, director, or employee…”
Example Number 5: A Good Story for a Change
Let’s say that Bruce and Sue have those million dollar policies and Bruce did die. Now Sue’s alone and she considers the value of her million dollar term policy with a great price on it and 16 more years of low guaranteed premiums. She doesn’t need it corporately anymore, but she thinks it is a super deal for her personally.
Another exception to the rule: Sue can transfer ownership of the corporate policy to herself with no transfer for value problems. She can then appoint her own personal beneficiary(ies) and pay the premiums personally.
Example Number 6: Taxation of Proceeds
Let’s say that Bruce and Sue are in great health, but Bruce decides it’s finally time to retire and move to the coast. The remaining nine years left on his term policy are a great deal for him, and he knows he can transfer ownership from the corporation to himself and appoint his wife as beneficiary. But Sue says, “Not so fast, that policy has a value and the right thing to do is pay the corporation for the last annual premium that was paid just three months ago.” Bruce reluctantly agrees, writes the corporation a check for $1,800, and changes the ownership to himself.
Is everything okay now? Could be. Purchasing any corporate asset for less than fair market value will look like a disguised dividend and could create additional tax liability. A form 712 should be requested from the insurance carrier just to be sure.
Example Number 7: Capital Gains Taxes
Bruce and Sue have a corporate stock redemption agreement and have fully funded it with life insurance. They really think the value of the law firm is $2 million. They want a clean arrangement and they want their families to get the maximum dollars possible whether they die or live.
Are there ways that the insurance could have been structured differently to provide more value to each of them? Probably not with the entity buyout arrangement. Of course, another problem with a corporate buyout is that the survivor doesn’t get a stepped-up cost basis at the death of a partner. If the surviving partner sold out later on, the capital gains taxes on a million dollars won’t be a trifling amount, and who knows what the capital gains tax rates will be in the future?
Bruce and Susan might consider a cross-purchase agreement instead, with cross ownership and cross beneficiaries for the insurance. The survivor would get a stepped-up cost basis and could avoid capital gains taxes later on if he sold out.
Another potential issue with corporate stock redemptions to always consider is whether a C corporation could owe alternative minimum taxes; of course, a cross-purchase arrangement would avoid that entirely.
Unfortunately the issue with the chronic and terminal accelerated death benefits in a cross-purchase agreement would still remain.
Using Living Benefits to Enhance Financial Security
If Bruce and Sue were intrigued by the power and possibilities of accelerating their life insurance benefits for personal coverage, all the benefits could be received income tax-free if the insurance company allowed them to accelerate the benefits for long term care or for critical illnesses such as cancer, heart attack, stroke, Lou Gehrig’s disease and more.
In a C corporation, as long as the amounts spent for coverage are reasonable, they could each load up on personal insurance, have their C corporation pay for it and deduct it. They would pay income taxes each following year on the premiums only.
Since Bruce and Sue did have long term care insurance, they realized that even at their younger ages they had exposures to risks that their regular insurance didn’t completely cover. They liked the idea that, while the Affordable Care Act was going to eliminate some of their coverage, increase their premiums, their deductibles and their co-pays, their personal life insurance could provide hundreds of thousands of tax-free dollars to them (not just “reimbursement” dollars), even for things like experimental treatments or treatments overseas where their insurance provided nothing at all.
Their life insurance would give them tax-free cash in a number of ways they didn’t have to die to use:
• If they were diagnosed with a critical illness such as cancer, had a heart attack, stroke or kidney failure, or needed an organ transplant.
• If they were diagnosed with Alzheimer’s, dementia, or couldn’t perform two of the normal six activities of daily living (eating, bathing, dressing, toileting, transferring or maintaining continence).
This coverage could help close the health insurance gaps under the Affordable Care Act, and could pay out hundreds of thousands of dollars tax free, regardless of whether disability insurance paid out or not. However, if accelerated benefits were being paid out for a chronic illness where IRC 101(g)(5) wasn’t an issue, they would still be taxable if they exceeded the per diem (or per annual) payouts established by the IRS; however, they would not be taxable if less than this or for actual costs incurred by the policyholder for long term costs actually incurred.
Remember that insurance companies do not provide tax advice. The main purpose of this article is that you need to be a source of competent, ethical advice…especially at claim time. Of course, we are not attorneys nor are we providing tax advice here, just our understanding of the tax pitfalls that could easily occur if clients aren’t paying attention. Each client should seek his own counsel.
Your clients should find out exactly what they have now. We strongly suggest that you recommend a simple review of business coverage and agreements to make sure everything is in shape, so that their insurance is owned and structured to best meet their business or personal needs. A review such as this will allow you to position yourself as an expert, and may uncover potential sales, conversions for people with health changes, and the potential for lifetime settlements for business insurance no longer needed.
Be your clients’ trusted advisor and rely on your general agent for guidance. You will better serve your clients and make more money, plus you may avoid a serious E&O claim.
