There are several reasons a business may want to transfer ownership of a corporate-owned life insurance policy to an individual. Perhaps a business owner is selling their company and would like to keep the policy for their individual planning. Maybe it is an employee who is retiring and needs the additional coverage for their spouse.

Regardless of the reason for wanting to transfer policy ownership from a business to an individual – there are several tax issues to consider.

How a policy transfer from a business entity to an individual is handled from a tax perspective is mostly a function of:

  1. The type of business entity owning the policy,
  2. Whether or not the transference of the policy is going to be treated as a distribution or compensation, and
  3. Who is the policy being transferred to – a shareholder-employee or a non-owner employee insured.

One of the first steps to understanding the economics of transferring a life insurance policy from a business entity to an individual is to determine the fair market value of the policy.

Determining the Fair Market Value of a Life Insurance Policy

There are many different rules that apply to life insurance policy valuations for income tax purposes. In many cases hiring a qualified valuation firm familiar with life insurance valuations can help provide an accurate determination of the fair market value when transferring a life insurance policy.

S Corporation

Shareholder-Employee

There are two ways to transfer a life insurance policy from an S corporation to a shareholder-employee:

  1. Employee Compensation, or
  2. Shareholder Distribution

Employee Compensation

When a policy is transferred as employee compensation the S corporation should be able to deduct the fair market value of the policy. Any policy gains will be taxable to the S Corporation. The shareholder-employee would then recognize the fair market value as taxable income by including it in their gross income as wages. The fair market value of the policy would then be the shareholder-employees cost basis in the policy.

Shareholder Distribution

Life insurance policy transfers treated as a shareholder distribution are non-taxable to the shareholder-employee assuming the shareholder-employee has a stock basis greater than the fair market value of the policy.

Distributions from an S corporation must be allocated on a pro-rata basis to all shareholders. Any gain in the policy will trigger taxable income to the S corporation. The gain will increase shareholder’s basis in the S corporation stock. The fair market value of the policy is generally a return of the shareholder’s basis, reducing the shareholder’s capital account, then adding capital gain to the shareholder’s basis.

Employee Insured

Like a shareholder-employee, when a policy is transferred from an employee insured the S corporation should be able to deduct the fair market value of the policy. Policy gains will be taxable to the S corporation. The employee insured will then recognize the fair market value of the policy in their gross income. The fair market value of the policy at the time of transfer would be the employees cost basis of the policy.

When a corporate-owned life insurance policy has a gain, the S corporation will recognize the gain as taxable income. In situations where the cost basis of the policy is greater than the policy’s fair market value, the S corporation will recognize a non-deductible loss when the policy is transferred.

C Corporations

Shareholder-Employee

Shareholder-employees of a C Corporation can transfer a life insurance policy by:

  1. Employee Compensation, or
  2. Shareholder Dividend

Employee Compensation

When a life insurance policy is transferred from a C corporation to a shareholder-employee as employee compensation the corporation should be able to deduct the fair market value of the policy as compensation. Any policy gain will trigger taxable income to the C corporation. The shareholder-employee will recognize the fair market value of the policy as income. The fair market value of the policy at the time of transfer will be the shareholder-employees basis in the policy.

Shareholder Dividend

A shareholder-employee receiving the policy in the form of a shareholder dividend will recognize the fair market value of the policy as dividend income. The shareholder-employee will likely benefit from the lower tax rates available for qualified dividends. The fair market value will be the shareholder-employees cost basis at the time of policy transfer.

However, the C corporation is unable to recognize a deduction for the fair market value of the policy since corporations are unable to recognize a deduction for dividend distributions.

Employee Insured

Like shareholder-employee transferring a policy as employee compensation, an employee insured would recognize the fair market value of the policy at the time of transfer as taxable income. The C corporation will be able to deduct the fair market value of the policy. Any policy gain will be taxable to the C corporation.

Assuming the fair market value of the policy is less than the cost basis of the policy the corporation will recognize a non-deductible loss. The cost basis to the employee insured will be the fair market value of the policy at the time of transfer.

Partnerships

Transferring a life insurance policy to a partner should not create a taxable gain to the partnership. Distributions from a partnership to a partner do not trigger a gain or loss. Since there is no gain or loss recognized by the partner there is no taxation on the distribution to the partner.

In addition, the partner receiving the policy has the benefit of carrying over the policy basis that was held by the partnership prior to distribution assuming the partner’s basis in their partnership interest is greater than the policy’s basis. When the policy distribution occurs from the partnership their partnership interest basis is reduced by an equal amount.

In situations where a life insurance policy is distributed from a partnership to an employee, the partners will recognize taxable income on the gain. The gain will be allocated to each partner based on their interest in the partnership. The partners should also be able to deduct the fair market value of the insurance policy based on their interest in the partnership. The employee will then recognize taxable income based on the fair market value of the policy.

Tracking Basis

Once a policy has been transferred from the business entity to the individual (regardless of whether they are a shareholder, partner, or employee) it is important to track the policy basis at the time the policy ownership is transferred from the business entity.

The reason tracking policy basis is so important is because most insurance carriers only track the cumulative premiums paid into the policy to determine a policy’s basis. In a scenario where the individual owner decides to surrender the policy in the future the insurance company will issue a 1099-R.

The 1099-R will likely be equal to the cumulative premiums paid into the policy. The net result is the owner of the policy may receive a 1099-R showing a higher gain than what the policy owner recognized. This can result in the policy owner having to defend their cost basis to the Internal Revenue Service to determine the taxable amount.

Conclusion

Prior to transferring a life insurance policy owned by a business to an individual it is important to know the rules. By working with your team of advisors it will ensure the transfer of ownership is accounted for properly.

Notes

  1. When a policy gain is triggered as taxable income on an ownership change, it usually generates ordinary income rather than capital gain.
  2. Transferring a life insurance policy with policy loans exceeding basis can trigger transfer-for-value rules and generate taxable income to the transferor.
  3. The general summary does not constitute legal or tax advice. Policy owners should consult with their own legal and tax advisors before transferring ownership of any policy.

About Jason Mericle

Jason Mericle is the Founder of Mericle & Company. Mericle & Company is dedicated to helping families and business owners solve their life insurance planning needs.

The services offered range from basic term life insurance planning and policy reviews to sophisticated advanced income tax and estate tax planning solutions.

He compliments his extensive knowledge of life insurance products with an in-depth understanding of the different tax and legal structures for which they are used.

About Jason Mericle

Jason Mericle is the Founder of Mericle & Company. Mericle & Company is dedicated to helping families and business owners solve their life insurance planning needs.

The services offered range from basic term life insurance planning and policy reviews to sophisticated advanced income tax and estate tax planning solutions.

He compliments his extensive knowledge of life insurance products with an in-depth understanding of the different tax and legal structures for which they are used.

[DOWNLOAD]

2018 Whole Life Dividend Rate Summary

Discover how the top rated U.S. insurance companies dividends have performed over the past decade.

We have received your request for the 2018 Whole Life Insurance Dividend Rate Summary. Please check your email to access the information.

[DOWNLOAD]

The Life Insurance with

Long-Term Care Guide

Consider securing your family's financial future and yours with a combination of life insurance and comprehensive long-term care rider.

We have received your request for the Life Insurance with Long-Term Care Rider Guide. Please check your email to access the information.

Curious About How Much Life Insurance Coverage You Should Have?

Download the life insurance calculator worksheet to find out...

We have received your request for the Life Insurance Needs Analysis Worksheet. Please check your email to access the information.

[DOWNLOAD]

Restricted Property Trust

Case Study

Learn more about how a Restricted Property Trust can benefit you and your business...

We have received your request for the Restricted Property Trust Case Study. Please check your email to access the information.

[DOWNLOAD]

The Insider's Guide To

Estate Planning

Learn more about the different techniques used for estate planning...

We have received your request for the Insider's Guide to Estate Planning. Please check your email to access the information.

Share This