Guidelines for Transferring Business Owned Life Insurance

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.

From a tax perspective, transferring a policy from a business entity to an individual is a function of the following:

  1. The type of business entity owning the policy,
  2. Whether or not the transference of the policy is going to be a distribution or compensation, and
  3. Who is receiving the policy – 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 an employee receives a policy 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 then recognizes the fair market value as taxable income by including it in their gross income as wages. The fair market value of a policy is 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 the 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 the ownership of a policy is 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 is 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 changing the ownership of the policy.

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 transfers 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 as a shareholder dividend recognizes 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 is 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 is 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 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 from 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 goes down by an equal amount.

In situations where a distribution of a life insurance policy occurs from a partnership to an employee, the partners will recognize taxable income on the gain. Each partner will recognize the gain 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. If 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 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

It is important to know the rules prior to transferring a business-owned life insurance policy to an individual. By working with your team of advisors will ensure the transfer of ownership and accounting of the transfer is correct.

Notes

  1. When a policy gain exists 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.

DISCLOSURE

TAX ADVICE

Any tax advice contained in this communication is not intended or written to be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed herein.

These materials are not intended to be opinions or advice on legal, tax, accounting, or investment matters. It is important to consult private counsel prior to application of this general information to specific situations.

These materials are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable. We cannot assure the accuracy or completeness of these materials. The information in these materials may change at any time and without notice.

Jason Mericle

Jason Mericle

Founder

Jason Mericle created Mericle & Company to provide families, business owners, and high net worth families access to unbiased life insurance information.

With more than two decades of experience, he has been involved with helping clients with everything from the placement of term life insurance to highly sophisticated and complex income and estate planning strategies utilizing life insurance.

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