When filing taxes, every business looks for as many deductions as possible and key man life insurance is no exception. However, before you write off corporate owned life insurance premiums, you need to fully understand how the IRS is going to treat this issue. Additionally, your business needs to be aware of important IRS rules and requirements that became effective with the Pension Protection Act of 2006 with respect to employer owned life insurance policies.
The federal government and the IRS has for many years encouraged both individuals and businesses to purchase of life insurance to provide financial security. One of the inducements for purchasing life insurance has been that the death benefits when paid out are received by the beneficiary of the policy income tax free. Section 101(a)(1) of the Internal Revenue Code (IRC) states that gross income does not include proceeds received from a life insurance policy, if such amounts are paid as a result of the death of the insured.
Because the proceeds of life insurance policies are generally paid to the named beneficiary tax free, there is no deduction allowed for premiums paid. The IRS covers this in Section 264(a)(1) and provides that there is no deduction allowed for premiums paid on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract. Furthermore, key man insurance and other employer-owned life insurance is specifically covered under Section 1.264-1(a) and states that the premiums paid for life insurance on the life of any officer, employee, or person financially interested in a business carried on by the taxpayer are not deductible where the taxpayer is directly or indirectly a beneficiary of the policy. In short, the IRS prohibits the deducting key man insurance as an expense.
In addition, due to corporate abuses with key employee insurance, see “What is a Dead Peasant Insurance Policy”, the IRS has added additional guidelines in the Pension Protection Act of 2006 for all employer owned life insurance policies issued after August 17, 2006. The objective of the IRS code change was to prevent large corporations from purchasing life insurance policies on its non-key employees simply to receive a tax free death benefit when the employee or former employee dies. This is covered under IRC Section 101(j)(1) which states that death benefits from employer-owned life insurance contracts shall be taxable, in excess of premiums paid, unless the employer-owned life insurance contract meets one of the exceptions provided under IRC 101(j)(2). Key man life policies issued prior to August 17, 2006 are grandfather in and are not subject to these rules. For more details on the exemptions see key man insurance and taxes.
The bottom line is that since life insurance policy proceeds are generally non taxable to the beneficiary, no business should be writing off premiums for life insurance paid on key employee or key executive policies. Additionally, to avoid potential taxation of death benefits on business owned life policies issued after August 17, 2006, you need to adhere to the rules and guidelines established under the Pension Protection Act of 2006. For specific corporate owned life insurance tax questions, a consult with your CPA is strongly recommended.