Know About Taxes When Using Business Life Insurance

Q.: I own a business with two other equal owners. We believe that the business is worth more than $750,000 if we were to sell it. The business owns a total of three policies of term life insurance, $250,000 on each of us, payable to the business. Can the business deduct the premium payments as a business expense?
A.: No, not if the business is either directly or indirectly a beneficiary under the policy.

Q.: If the business designates one of us as an owner and beneficiary of the life insurance policy, can the business deduct the premium as an ordinary business expense?
A.: Yes, indirectly. The business may deduct the premium payment as compensation paid to the insured owner, and the owner must declare that as compensation on his income tax return. It will be subject to payroll taxes.

Q.: If I die and the business owns the policy and receives the life insurance proceeds, does the business have to pay income tax on the proceeds?
A.: Probably not. Generally, life insurance proceeds are received free of income tax. However, if the business is incorporated (a C-corporation for income tax purposes) and does not meet "small corporation" status, the life insurance proceeds may be subject to "alternative minimum" income tax — a tax covering certain items (including life insurance proceeds) that would otherwise escape taxation. Although we do not know whether this business is a C-corporation, we do know that it had gross receipts of $1.5 million last year. Unless the average annual gross receipts are more than $7.5 million, the corporation will be considered a "small corporation" and will be exempt from the alternative minimum tax.

Q.: If I die and the business owns the policy and receives the life insurance proceeds, does the business owe estate tax?
A.: No.

Q.: If I die and the business owns the policy and receives the life insurance proceeds, will my estate have to pay estate tax on the proceeds?
A.: Not to the state, since Ohio repealed the state estate tax for deaths on or after Jan. 1, 2013. If the total value of your estate exceeds $5.25 million, federal estate tax may be due. So long as the business owns the policy and is the designated beneficiary, the life insurance proceeds will not be included in your estate. However, your one-third share of the business will increase by $83,333 (one-third of $250,000). Values of certain assets, such as business interests, may be established through the use of arms length agreements between the owners and/or the business. These agreements are commonly called " buy-sell" agreements. Appropriate use of buy-sell agreements often saves estate taxes by fixing reasonable values.

Q.: If I own the life insurance policy which is payable to the business upon my death, will I save Ohio and federal estate taxes?
A.: Yes and no. Ohio repealed its estate tax for deaths on or after Jan. 1, 2013. For federal estate tax purposes, $250,000 will be included in your estate even though the business receives the proceeds, because you owned the policy. However, the total value of your estate must exceed $5.25 million before there is a federal estate tax concern.

Q.: What should I do in order to protect my family and minimize my income and estate taxes?
A.: First, you and your partners should agree on your mutual business and personal objectives should one of you die. Second, you should state these objectives in a written "buy-sell" agreement. Third, you and the other owners should review the costs and benefits of using life insurance to fund the buy-sell agreement. Fourth, you and the other owners should coordinate your wills and trusts, if any, accordingly.

Fortunately, Congress has increased the federal estate tax thresholds to $5.25 million per taxpayer effective Jan. 1, 2013. A small business owner has much less worry today that his family will be forced to sell the business in order to pay estate taxes.

Note: Because this area of the law is very complex, you should seek counsel from a qualified estate or business planning attorney.

– by Paul S. Klug, an attorney with the Cleveland firm, Ziegler Metzger LLP.