Using Tax-Deductible Company Dollars For Personal Life Insurance

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.