Using Tax-Deductible Company Dollars For Personal Life Insurance
For many business owners, this is the holy grail of insurance planning
By David A. Scott
Over the course of their lifetimes, most successful business owners tend to become wealthy people with relatively little money. In many cases, their financial lives are characterized by a perpetual shortage of cash.
The cash shortage often becomes most severe at death. And many business owners recognize that life insurance can be the most cost-effective and tax-efficient source of cash at death to pay debts, federal and state taxes, and other estate settlement costs.
When purchasing personal life insurance, business owners invariably ask two questions: Can the business pay the policy premiums? Are the premiums tax-deductible? For many owners, the two questions are really one: Can the business pay the premiums and take a tax deduction?
Planning techniques that accomplish this dual objective are available, but they inevitably involve greater complexity and potential tax risks.
Business owners often focus solely on the income tax consequences of an insurance arrangement and, specifically, the deductibility of policy premiums. However, this approach can be both shortsighted and disadvantageous.
A broader, more long-term perspective on taxes should be maintained. For example, insurance planning techniques resulting in premiums that are currently non-taxable will frequently create future income tax liabilities based on policy cash values.
With current income tax rates at their lowest levels in nearly 50 years, does it make good “tax sense” to take an income tax deduction based on policy premiums at todays lower rates, thereby creating a future income tax liability based on policy cash values at tax rates that almost certainly will be higher?
Also to consider is the impact of potential federal and state transfer taxes (estate, gift, generation-skipping, etc.). Does it make good “tax sense” to save 35% income tax on policy premiums if policy death benefits or cash values will be subject to 45% transfer taxes in the future?
With this tax perspective in mind, lets review some planning techniques whereby a business owner can pay for personal life insurance using the business checkbook and receive a current income tax deduction.
Many advisors gained their first exposure to an “advanced” insurance planning strategy for business owners through the exotically titled “Section 162 Executive Bonus Plan.” For business owners, having the business pay policy premiums and receive an income tax deduction is irresistible.
However, their euphoria quickly abates when they realize that bonus premiums are taxable income to them, although this disadvantage can be neutralized with a “double bonus” arrangement (i.e., additional compensation equal to the policy premiums plus the income tax payable on the premiums).
Because current individual and corporate income tax rates are almost identical, many business owners may view a bonus arrangement as taxation “smoke and mirrors.” Nevertheless, a bonus plan is simple.
A “double bonus” plan results in no change in after-tax income for the owner. That lets the advisor focus on other tax advantages of the arrangement:
Purchasing personal life insurance under a qualified retirement plan is a popular planning strategy, principally because of the business income tax deduction for policy premiums without an offsetting recognition of personal income. The “incidental insurance rule” limits the amount of insurance that can be purchased under pension plans. But there is no limitation respecting life insurance premiums that are paid with “aged money” (accumulated more than two years) in a profit-sharing plan.