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.
In the planning process, the appeal of pre-tax premiums must be balanced against the future income tax on policy cash values, the inability to roll over the policy to an IRA, the federal estate tax on death proceeds, and the potential gift tax liabilities if the policy is transferred to an insurance trust or other third party.
In July 2003, the IRS issued final regulations relating to “10 or more employer” welfare benefit plans under IRC section 419A(f)(6). Unfortunately, the regulations actually have finalized little, meaning more uncertainty and controversy.
The principal attraction of purchasing life insurance in a multiple employer plan is the income tax deduction for contributions (premiums) without recognition of personal income. The only limitation on the amount of the deduction is the “ordinary and necessary business expense” test of IRC section 162.
To receive a current deduction for contributions, a welfare benefit plan must not be a deferred compensation plan. This requirement, coupled with the definition of a prohibited “experience rating arrangement” contained in the final regulations, probably means that it wont be possible to receive policies or cash values from a multiple employer plan except for “standard” welfare benefits (death, disability, medical, severance, etc.).
If a business owners principal focus is on policy death benefits (e.g., estate liquidity), a multiple employer plan may be an attractive strategy. However, if lifetime access to the policy or its cash values is an important objective, then a multiple employer welfare benefit plan may not be appropriate, in spite of the instant gratification of a current income tax deduction.
During the past year or two, single employer welfare benefit plans have received greater attention and popularity, principally as a result of the IRS scrutiny and activity relating to multiple employer plans. Single employer plans are not subject to the final regulations governing multiple employer plans, but the deductibility of contributions is limited to the “qualified direct cost” of the benefits.
Plan administrators have developed contribution formulas resulting in a substantial deduction for policy premiums (60%, 70% or more), but the IRS always can challenge the “arithmetic” of computing the deduction. Such plans seem to provide more flexibility regarding access to policies and cash values (through termination of the plan).
But as these plans grow in number, IRS scrutiny probably will increase. And new tax regulations might make single employer plans more restrictive.
Internal Revenue Code section 79, relating to “group term life insurance,” permits the use of individual permanent policies if certain stringent requirements are met: Only C corporations can create a plan; benefits must not discriminate in favor of “key employees;” and all full-time employees must be covered under the plan if there are fewer than 10 participants.
In general, employer contributions will be income tax-deductible, but the tax regulations specify a formula for computing “permanent benefits,” and all such benefits are taxable income to the participant.
Until recently, the “permanent benefits” under many policies seemed to range from 25% to 40% of policy premiums (i.e., approximately one-third of employer premiums were taxable income to the individual). However, under the proposed regulations published by the IRS in February, it appears that approximately two-thirds or more of employer premiums under a typical universal life or whole life policy will be taxable income to the participant. And after 4 to 6 years, essentially all the employer premiums will be taxable income.
Although the potential tax benefits have been reduced, these plans still offer premiums that are partially non-taxable and present only minimal tax risk. The plans also provide income tax-free death benefits, tax-deferred growth of policy values and the potential for income tax-free access to policy cash values in the future.
In conclusion, it is possible to deliver to business owners the “holy grail” of insurance planning: premiums paid by the business that are income tax-deductible. However, focusing solely on the income tax treatment of premiums may not be in the best tax and financial interests of a business owner in the long term.
Additionally, it is almost inevitable that planning techniques with the greatest potential tax advantages will also entail the greatest tax risks and complexity.
David A. Scott, J.D., CLU, is assistant vice president, advanced sales, at Penn Mutual Life Insurance Company. You can reach him via e-mail at [email protected].
Reproduced from National Underwriter Edition, September 9, 2004. Copyright 2004 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.