8776 / Are death proceeds of business life insurance exempt from income tax? Could receipt of tax-exempt income from insurance proceeds reduce an otherwise tax-deductible capital loss?

See Q 8777 for rules pertaining to employer-owned life insurance contracts issued after August 17, 2006.

A portion of the death proceeds may be taxable if the proceeds are paid out under a life income or other installment option. In this case, the amount payable at death may be prorated and recovered from the payments in equal tax-free amounts over the payment period, but the interest earned on the proceeds over the distribution period is taxable.

Proceeds received by a partnership or by an S corporation retain their tax-exempt character when passed on to individual partners or shareholders. Proceeds received tax-free by a regular
(C) corporation are, when paid out, usually taxable to the recipients as compensation or dividends.

Despite the general rule, there are some circumstances where death proceeds paid out in a lump sum are not wholly tax-exempt. For example, the IRC expressly provides that proceeds are taxable, under some circumstances, where a policy has previously been sold or otherwise transferred for a valuable consideration (see Q 8778 to Q 8781).

Under Section 101(a), in the case of proceeds payable under qualified pension or profit sharing plans, only the amount in excess of the cash surrender value is tax-exempt. The same rule applies to proceeds received under a tax sheltered annuity and proceeds received under individual retirement endowment contracts.

In some cases, the exemption may not be available because proceeds are not considered to be received as life insurance proceeds. These include proceeds that are taxable as dividends or compensation, proceeds that are taxable because of lack of insurable interest, proceeds taxable as a return of embezzled funds, and proceeds of creditor insurance.

Where liquidation of a business after a partner’s death resulted in a loss, but life insurance on that partner had been purchased by the other partner for the purpose of protecting his capital investment in the business, the court ruled that because the loss was compensated for by insurance, it was not deductible. IRC Section 165(a) provides that “[t]here shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise” (emphasis added).²