In business succession planning, especially when funding corporate buy-outs, one of the primary considerations should be the tax advantages of permanent life insurance.
The primary reason businesses purchase life insurance is to protect the company from unnecessary risks. However, permanent life insurance has other valuable business uses as well including providing valuable executive benefits, funding corporate buyouts or to supplement retirement income for business owners.
Here’s a quick guide to what we’ll be discussing below:
- Tax Deferred Accumulation of Cash Values
- Tax-Free Income Using Withdrawals and Loans
- Income Tax-Free Proceeds to Policy Beneficiaries at Death
These advantages include:
- tax deferred cash values
- tax-free income via withdrawals
- loans and income tax-free death benefits
One of the chief tax advantages of permanent life insurance is the tax deferred growth of cash values.
With business life insurance, policy cash values can be listed as assets on the company balance sheet and can be accessed for use by the company at any time. The tax deferral of cash growth makes life insurance an ideal vehicle for funding executive compensation plans, creating supplemental retirement income for business owners, or to fund a corporate stock redemption plan.
Tax deferred growth is also available with other financial and investment products such as annuities and qualified retirement accounts. However, life insurance is the only cash accumulation product which offers the combination of tax deferred growth of cash values and the ability to structure cash distributions which may be received tax free.
Another tax advantage found in whole life or universal life insurance policies is the cash value may be accessed by the company tax free. If structured properly, policy withdrawals and loans can be used to essentially eliminate taxes on cash received from a life insurance policy.
Withdrawal of cash value from a life insurance policy is generally not taxable as long as the amount withdrawn does not exceed the policy premiums which have been paid, commonly referred to as the “basis”. Once the policy’s basis has been withdrawn, future withdrawals are subject to income taxation.
To avoid taxation on policy distributions in excess the policy’s basis, loans can be used to access additional cash values tax free. You also need to be careful any deductions you attempt to take, as it can impact the taxation of the policy benefits.
As long as the insurance policy meets certain IRS guidelines, policy loans are not taxable. There is no income tax on the amount borrowed, but loan interest will be charged by the insurance company on any outstanding loan balance. Policy loans do not have to be repaid.
However, if an outstanding loan is not repaid before the insured’s death, the policy loan balance including any unpaid interest will be deducted from the policy’s death benefit.
Even though policy loans are not taxed, there are certain conditions when taxes on loans may apply. When a policy is surrendered, any amount of cash values actually received in excess of the policy’s basis will be subject to income taxation. Existing policy loans are then considered cash distributions and included in the calculation of the policy basis.
When a policy lapses, any outstanding loans are treated as cash value distributions and subject to taxation on any amount in excess of the policy basis.
Under IRC section 101 (a)(l), business-owned life insurance policy death benefits payable to the company may be received income tax free as long a certain conditions are met.
These conditions, for both the state and federal level, may include, but not be limited to:
- the covered employee or executive providing written consent to be insured;
- signing an acknowledgement and them falling within a certain employee classification or group.
Tax Advantages of Permanent Life Insurance- A Flexible Tool For Businesses
This combination of attributes is not found in any other cash accumulation product. The special tax advantages of permanent life insurance make it a an extremely attractive solution for cash growth, supplement retirement income or retaining key employees with executive bonus plans.
(1) All of the above tax information is for information purposes only and is provided to explain the basic tax treatment of life insurance based on the Internal Revenue Code. Any individual or entity considering any life insurance policy should consult with their own CPA or tax/legal advisor that understands their particular tax circumstances and the rules governing their state. In no way is this information intended to be tax or legal advice.