Taxation and Business Uses of Insurance - Key-Employee Life Insurance

In many instances employers have employees whose skills, talents, experience, or business and personal contacts are of great value to the business. Such employee's death would cause severe financial loss for the company and would be difficult to replace. Many businesses cannot afford the financial loss incurred if a key employee were to experience an untimely death. One way to mitigate this risk is through key-employee life insurance.

Definition
A life insurance policy owned by the business or corporation on a key-employees life. The business or corporation purchases the policy and receives the proceeds of the policy in the event of the key-employee's death.

Advantages
The advantages of key-employee insurance are...
Provides the corporation or business benefits in the loss of income derived from the death of a key employee
Also, may provide peace of mind to the corporation or businesses creditor's that are fearful of the company's future in the case of a key-employee's death.
The policy can insure that the price of the company's stock will not plummet in the case of a key-employee's death thus giving shareholders peace of mind.
Can protect the financial interest of investors in the case that the key-employee is the business.
Can insure a key-employees retirement giving the cash surrender value of the policy to the employee upon the employee reaching retirement (not dying before retirement).

Tax Considerations
The following are several tax considerations that should be made when purchasing key-life insurance

  • Premiums paid by the corporation are not tax deductible.
  • Policy proceeds are received free from federal income taxes provided that the policy has not been transferred to any other party for valuable consideration. However, if the policy has been transferred to the insured, a partnership in which the insured is a part of, or a corporation in which the insured is a shareholder or officer the proceeds retain the tax free status.
  • Large "C" corporations will have to include the policy benefits for purposes of calculating the Alternative Minimum Tax.
  • Premiums paid by the corporation will not be included in the insured's taxable income provided that the insured has no current ownership in the policy.
  • Policy proceeds payable to a corporation in which the insured is a majority shareholder will not be included in the gross estate. But, if the proceeds are payable to any person/entity other than the corporation the proceeds are considered in the insured's gross estate.

Practice Question:
Jody is employed by ABC Corporation. The corporation's shareholders have become increasingly concerned with Jody's importance to the corporation. They have come to a resolution to purchase a $1,000,000 whole life policy on her life. They feel it will protect the corporation from the income loss due to her death and would like to provide her with a retirement benefit when she retires. Due to Jody's interest in the cash surrender value of the policy upon her retirement; she must include the premiums paid by the corporation in her taxable income for the year.

A. True
B. False

Answer: False
Jody holds no current ownership in the policy, therefore the premiums need not be included in her taxable income. Split-Dollar Life Insurance
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