308 / Will the accumulated earnings tax be imposed where corporate earnings are used to purchase business life insurance?

Editor’s Note: The 2017 tax reform legislation limited the members of a controlled group of corporations (the members of which are determined as of December 31 of the relevant year) to a single $250,000 ($150,000 if any member of the group is a service organization in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting) amount in order to compute the accumulated earnings credit.¹ This amount must be divided equally among the members of the controlled group, unless future regulations provide that unequal allocations are permissible.²

The accumulated earnings tax is imposed when a corporation, to prevent profits from being taxed to shareholders, retains earnings not needed in the business.³ The Jobs and Growth Tax Relief Reconciliation Act of 2003 reduced the accumulated earnings tax rate to 15 percent ( Q 798). For tax years beginning after 2012, the American Taxpayer Relief Act of 2012 increased the accumulated earnings tax rate to 20 percent.

In computing the amount of income subject to the tax, a credit is allowed for accumulations to meet reasonable current and anticipated business needs. Consequently, the tax should not be imposed on income retained for the purchase of life insurance if the insurance serves a valid business need and generally is related to that need.⁴

The purchase of life insurance to compensate a corporation for loss of a key person’s service through early death is a reasonable business need and earnings used for that purpose therefore are not subject to the penalty tax.⁵ Emeloid Co., although not an accumulated earnings tax case, is excellent authority for the proposition that key person life insurance is a reasonable business need.

In Novelart Mfg. Co. v. Commissioner,⁶ premiums for key person life insurance were included in the taxable base on which the accumulated earnings tax is imposed. The taxpayer failed to argue that because key person life insurance is a reasonable business need, the premiums should be included in the calculation of the accumulated earnings credit. Instead, the taxpayer argued only that the amounts paid out for life insurance premiums no longer were available for distribution and should not be included in the measure of the tax because the tax is imposed on what is accumulated rather than on what is distributed. The argument was dismissed as inconsistent with the IRC rules for calculating the tax.

It also has been held that the cash surrender value of key person life insurance is not considered a liquid asset, along with cash and marketable securities, in determining whether further accumulations to finance plans for business expansion are necessary.⁷

An accumulation of earnings to meet a corporation’s obligations incurred under a deferred compensation agreement should be considered a reasonable business need.⁸

Under certain circumstances, including to promote corporate harmony or management efficiency or to enable a corporation to continue its accustomed practices or policies, an accumulation of earnings to fund a stock redemption may constitute an accumulation for a reasonable need of the business.⁹ Several cases do not deal with the accumulated earnings tax but contain persuasive statements concerning the business need for life insurance to fund close corporation stock redemptions.¹⁰

Several cases, not involving life insurance, have held that an accumulation of income for the purpose of affecting an IRC Section 303 redemption ( Q 303) serves the purpose of an individual stockholder rather than a corporation. The effect of these cases is limited by IRC Section 537, which provides that the phrase “reasonable needs of the business” includes a business’s IRC Section 303 redemption needs. The IRC language is not clear on the extent to which accumulations in years prior to a stockholder’s death are to have protection from the tax. The IRC limits the amount of tax-sheltered accumulation in the year of a stockholder’s death or in a subsequent year. Regulations provide that the reasonableness of accumulations in years prior to a year in which a shareholder dies is to be determined solely on the facts and circumstances existing at the times the accumulations occur.¹¹

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Planning Point: To avoid the accumulated earnings tax, a corporation should document the reason for retained earnings or the reason for the purchase of corporate owned life insurance. Contemporaneous documentation of the business need will go a long way toward avoiding this tax.

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In the case of a professional corporation ( Q 798), a stock redemption following a shareholder’s death usually is not made under IRC Section 303 but is a complete redemption of all shareholder stock under IRC Section 302 ( Q 300). The requirement of many state laws that a corporation must purchase stock of a deceased or disqualified professional would appear to establish a valid business purpose for accumulations to fund such redemptions. Consequently, an accumulation under these circumstances, particularly if funded by life insurance, should be immune from imposition of the accumulated earnings tax.¹²