The two things you can count on, death and taxes, right? Well, done correctly at least the two don’t need to be mixed. The Gold Nugget in life insurance death benefits has always been the fact that the proceeds are not income taxable. If you take out $500,000 worth of life insurance and die, your beneficiaries get $500,000.
There is a logical IRS (oxymoron) explanation for this gift. Like a Roth IRA, life insurance is purchased with after tax dollars so the income (death benefit) is not taxable. Then there is just the fair and practical reason. If a person wanted their family to receive $500,000 and it was income taxable, in today’s tax climate there would be almost no way to determine how much insurance to buy to net $500,000. A lump sum is bound to whack your tax bracket to the moon. Even if you set down with your accountant and life insurance agent today and came up with a plan, what are the chances that it would be valid 5 years from now? The only conceivable way to make sure your family netted the half million would be to over insure yourself to the point where that goal was bombproof.
But this post is about business life insurance. The same scenario would be a train wreck in a business buy/sell life insurance policy or a key man business life insurance policy. If the proceeds were taxed there would be no conceivable way to make a coherent plan for business succession. Having said that, businesses and business people have a habit of wanting to pay for everything through the business and deduct the expense. I know in my own business that deducting the air I breathe is the goal. But that is where the golden nugget can turn to fool’s gold when you run head long into the logical IRS (oxymoron) rule about paying for something with before tax or after tax dollars. Just like the Roth IRA, as long as life insurance, even though it is business life insurance, is paid for with after tax dollars, all is well with the world and $500,000 is really $500,000 free and clear.
If you get greedy and decide to deduct the premium the dynamics change. It can be tempting with business insurance, especially when you get into large policies that are costing the company tens or even hundreds of thousands a year, to write it off as an expense. Step back from that temptation!! As soon as you deduct the expense you just paid for life insurance with pre tax dollars and the death benefit becomes taxable. You can’t have your tax break and eat it to. If it was a buy/sell agreement and the funds were supposed to go to buying out your partner’s family, you’re going to come up short and probably only solve half of the challenge.
Having warned you about how it really works, I am now going to interject my own opinion. This country needs business succession and business continuity to remain healthy and allowing a tax credit to offset the premium on business life insurance , leaving the death benefit non taxable, would be a great idea. Just so I don’t get rocks thrown at me, personally owned business insurance such as a buy/sell policy can be deducted through a Section 162 bonus plan.
Bottom line. My opinion doesn’t count with the government so for now, stick to the rules. If you have any questions about taxation of life insurance proceeds and how to avoid it, or have been given bad advice and need to fix it, call or email me directly. My name is Ed Hinerman. Let’s talk.