273 / What are the tax consequences when an S corporation pays a premium on a life insurance policy insuring a shareholder or employee?

An S corporation generally does not pay taxes; instead, items of income, deduction, loss, and credit are passed through to shareholders who report their pro rata shares on their individual returns. Payment of premiums by an S corporation should be characterized as a nondeductible expense, as deductible compensation, or as a nondeductible distribution of profits under the same general rules applicable to regular (C) corporations ( Q 264 to Q 271).The resulting tax treatment of the shareholders would differ in some instances.

Where the payment is a nondeductible expense, as it would be if a corporation was both owner and beneficiary of a key person policy, each shareholder reduces his or her basis in his or her shares by his or her proportionate part of the nondeductible expense.¹

If particular premium payments are considered compensation as in the example where an employee owns a policy or has a beneficial interest in it ( Q 269 to Q 271), the amount of compensation would be deductible in determining the corporation’s income or loss that is reported pro rata by each shareholder. The amount of compensation then would be included in income by the insured employee.²

If a premium payment is considered a distribution with respect to stock to an individual shareholder ( Q 269, Q 271), the tax treatment would depend on whether or not a corporation has accumulated earnings and profits. If a corporation has no accumulated earnings and profits, the payment is treated first as a return of investment and then as capital gain. If a corporation has accumulated earnings and profits, part of the distribution might be treated as a dividend.³ An
S corporation may have accumulated earnings and profits from years when it was a C corporation or as the result of a corporate acquisition.

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Planning Point: An S corporation cannot have more than one class of stock. In order to avoid an inadvertent termination of the S election, care must be taken to avoid treating shareholders differently. In Private Letter Ruling 9735006, the Treasury ruled that a split dollar agreement between a single shareholder and the S corporation did not create a second class of stock because the split dollar arrangement required reimbursement for premiums paid. Arrangements not involving reimbursement, however, could be problematic. Before an S corporation pays insurance premiums, a qualified tax advisor should be consulted.

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In a revenue ruling issued in 2008, the IRS outlined the effects of premiums paid by an
S corporation on an employer-owned life insurance (“EOLI”) contract and the benefits received by reason of death of the insured on its accumulated adjustments account (“AAA”) under IRC Section 1368. The IRS ruled that premiums paid by an S corporation on an EOLI contract, of which the S corporation is directly or indirectly a beneficiary, do not reduce the S corporation’s AAA, and benefits received by reason of the death of the insured from an EOLI contract that meets an exception under IRC Section 101(j)(2) do not increase the S corporation’s AAA.⁴