Individuals often have life insurance policies provided by their employer, whose ownership is transferable to the employee in the case which the employee is retiring, or for other qualifying reasons. Whatever the reason may be, it is important for these individuals to be aware of the fact that this could have tax implications. Since many employees opt for this option, here is an article by AG Tax outlining the tax treatment of a business-owned insurance policy transferred to the insured employee as bonus instead of cash, on retirement or other reasons. There is also a possibility that the policy is transferred to someone other than the insured, in such cases it is important to consider if it will be a “transfer for value” under Section 101(a)(2) of the Internal Revenue Code, but this we will discuss in a future article.
In case of a business-owned life insurance policy, the tax treatment depends on various factors such as the type of entity, i.e. whether it is a S-Corp or C-Corp, Partnership or other , and also upon whether it is given as a distribution, bonus or in lieu of compensation.
Policy Transfer as Compensation
If the policy is transferred as compensation then the receiver has to include its fair market value as income on their annual income tax return. If the insured person paid any amount, the amount paid will be reduce the total value reported as income.
Policy Transfer to Shareholder
In the case of a transfer to shareholder, it may either be treated as compensation or as a dividend.
If it qualifies as compensation then the treatment would be as mentioned above, but if the insurance transfer is considered as dividend, the insured shareholder receiving the policy must report the income as dividend income on their tax return, which would be subject to dividend tax rates.
Transfer in the case of a C-Corp or S-Corp
If a C-Corp or an S-Corp transfers a corporate-owned life insurance policy, the corporation will recognize taxable income to the extent of the policy’s gain as per IRC §311(b) and if the policy’s fair market value is below the policy’s basis, the corporation will realize a non-deductible loss upon the transfer as per IRC §311(a).
If the transfer is to a non-shareholder employee, it is treated as compensation and the employee will have to include the policy’s fair market value in his or her gross income. The corporation would deduct the fair market value of the policy as compensation, if deemed reasonable.
If a life insurance policy is distributed to a shareholder-employee, then the transfer may either be treated as compensation to an employee or as a distribution to a shareholder, depending on the circumstances. As with a transfer to a non-shareholder employee, treating the transfer of the policy as compensation should allow the corporation to deduct the policy’s fair market value as compensation and the shareholder would include the policy’s fair market value in his or her gross income as wages.
If the transfer is treated as a distribution, then the shareholder would receive a non-taxable distribution as long as the shareholder’s basis in his or her corporation stock exceeds the value of the distribution (i.e., the policy’s fair market value). No tax deduction is allowed in the case of a distribution.
However, if an S corporation was previously a C corporation and if the S corporation has accumulated earnings and profits from C corporation years, the distribution may be treated as a dividend.
Transfer in the case of Partnerships & LLCs
When a life insurance policy is transferred from a partnership to an employee, the partners recognize taxable income to the extent of the policy’s gain. The gain is allocated to each partner based on their respective partnership allocations. The partners should also be able to deduct the policy’s fair market value as compensation paid to an employee and the deduction would be allocated to each partner based on their respective partnership allocations. The employee recognizes taxable income equal to the policy’s fair market value and would have a basis in the policy equal to that amount. (The amount, if any, that the insured pays for the policy in the transfer will reduce the amount included in the insured’s gross income).
If a policy is transferred to a partner, there should not be any taxable gain to the partnership because a distribution to a partner does not trigger gain or loss to the partnership. Similarly, there is no immediate taxation of the distribution to the partner because generally no gain or loss is recognized by the partner on a distribution.
The partner who receives the policy would obtain a carry over basis in the policy equal to the partnership’s basis in the policy immediately before the distribution.
Tax situations can be complicated, and being uninformed can cost you severely in the form of penalties and interest. Therefore, it is always recommended that in case of any monetary transactions or asset transfer to consult a tax practitioner for proper guidance and treatment of the transfer in a tax compliant and yet tax beneficial way.
AG TAX LLP Can Help
If you have any queries regarding the above, or any other tax-related queries, and/or need assistance with tax planning/filing please contact AG Tax. Our tax professionals are highly-experienced with U.S. and Canadian tax laws and can provide you the right guidance to handle your tax situation.
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