Company-Provided Life Insurance Taxation.

This summary highlights important income tax considerations for company-provided life insurance.

Premiums Paid for by C Corporations

For policies owned by the C Corporations  or Qualified Personal Service Companies: The premium is non-deductible expense to the corporation (IRC Section 264). Since the premium is non-deductible, the annual premium amount will be part of the C Corp profit each year. This U.S. Form 1120 profit (net income) will be taxed to the C Corp as a separate tax entity at C Corp tax rates. These rates range from a low of 15% to a high of 39%, depending on the amount of taxable profit (net income).

For policies owned personally by the C Corp owner-employee, there are two options:

Option #1: If current business cash flow is used to pay premiums, the amount is deductible to the corporation as compensation paid (IRC Section 162). This amount is taxable to the C Corp owner-employee personally as W-2 compensation received. Bonus comp is considered “earned income,” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching corporate level.

Option #2: The C Corp owner can make dividend withdrawals from balance sheet “Retained Earnings” to pay premiums. This withdrawal is a dividend distribution, which is not deductible to the C Corp. The dividend is taxable to the C Corp owner as dividend income. For tax years 2011 and 2012, this dividend distribution is taxed at a low “qualified dividend” rate of 15%. If the income tax sunset occurs this December 31, dividends distributed in 2013 and beyond will again be taxed as ordinary income at rates as high as 39.6%.

Premiums Paid for by S Corporations

Premiums paid for by an S Corp: The premium is a non-deductible expense to the corporation (IRC Section 264). Since the premium is non-deductible, the annual premium amount will be part of the S Corp profit each year. This U.S. Form 1120S profit (net income) will be “passed-through” as K-1 income to the S Corp owner personally and must be reported on the individual's Schedule E of the Form 1040 U.S. Income Tax return.

For policies owned personally by the S Corp owner-employee, there are three options:

Option #1: If current business cash flow is used to pay premiums, the amount is deductible to the corporation as compensation paid (IRC Section 162). This amount is taxable income to the S Corp owner-employee personally as W-2 compensation received. Bonus comp is considered “earned income,” and therefore, all the usual social security taxes must be withheld at both the personal level and the matching corporate level.

Option #2: The S Corp owner can use some end of year distributed K-1 “pass-through” profit to pay premiums. As stated just above, this K-1 profit is taxable to the S Corp owner personally. However, this S Corp profit is generally considered to be “unearned passive income” and, therefore, is not subject to the FICA taxes levied on “earned income.”

Option #3: The S Corp may have a previously taxed profit account, known as the Accumulated Adjustments Account (AAA) for tax accounting purposes. This AAA is the cumulative amount of any previously taxed S Corp K-1 profits from prior years that have been left in the S Corp. A tax-free withdrawal can be made from this previously taxed AAA to pay for personally owned insurance of the S Corp owner. The AAA will be adjusted downward by the amount of the withdrawal. There are no FICA taxes on AAA withdrawals that have been previously taxed as “unearned income.”

Premiums Paid for by Limited Liability Companies

For polices owned by the LLC: The premium is a non-deductible expense to the LLC (IRC Section 264). Since the premium is non-deductible, the annual premium amount will be part of the LLC profit each year. This U.S. Form 1065 profit (net income) will be “passed-through” as K-1 income to the LLC owner personally on Schedule E of the Form 1040 U.S. Income Tax return. LLCs are treated as partnerships for income tax purposes.

For policies owned personally by the LLC owner, there are three options:

Option #1: If current business cash flow is used to pay premiums, the amount is deductible to the corporation as compensation paid (IRC Section 162). This amount is taxable income to the LLC owner personally as W-2 compensation received. Bonus comp is considered “earned income,” and therefore, all the usual FICA taxes (OASDI and HI) must be withheld at both the personal level and the matching employer level.

Option #2: The LLC owner can use some of the distributed K-1 “pass-through” profits to pay the premiums. As stated above, this pass thru type profit is taxable to the LLC owner personally. However, this LLC profit is generally considered “unearned passive income” and, therefore, is not subject to the social security taxes.

Option #3: The LLC may have a previously taxed profit account, known as the capital account for tax accounting purposes. This capital account is typically the cumulative amount of any accumulated  profit (plus contributed capital) from prior years that has been left in the LLC.  A tax-free withdrawal can be made from this capital account to pay for personally owned insurance of the LLC owner. The capital account will be adjusted downward by the amount of the tax-free withdrawal.