Are life insurance premiums tax deductible for a business?
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UPDATED: Jan 9, 2017
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- Section 162 Executive Bonus is a plan allows the business to bonus an employee the amount of the life insurance premium to fund the cost of the policy
- Life insurance is designed to pay an amount of cash or income to a beneficiary if the insured dies prematurely
- If an owner of a business feels he or she should be able to deduct life insurance premiums, they should seek the advice of a CPA, a CFP or a CLU
The question frequently arises as to whether or not life insurance premiums are tax deductible if they are paid for by a business. This is a legitimate request from a business owner who is used to deducting expenses that occur during the usual course of operations.
Companies purchase various types of life insurance from time to time, including key man life insurance, deferred compensation plans, which can be funded by life insurance, and life insurance as a benefit to employees.
This question needs to be answered as making the wrong decision could result in improper tax deductions with the occurrence of unnecessary penalties and interest from the IRS.
The current treatment of life insurance premiums is that they are not tax deductible given the fact that the death benefit is paid tax-free to the named beneficiary and any inside buildup of cash value does not incur any income tax liability.
Since the purpose of the life insurance is for the protection of a breadwinner or a key person, in the case of business, for example, there is no deductible provision for premiums. (I.R.C. § 264(a)(1)
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Life Insurance Plans That Allow Deductible Premiums
Even though from a general standpoint, premiums for life insurance are not deductible from a business perspective, there are two instances where it is allowed, and there will be no adverse IRS repercussions if they are set up correctly and maintained in a similar fashion.
–Section 162 Executive Bonus
This plan allows the business to bonus an employee the amount of the life insurance premium to fund the cost of the policy. The employer then bonuses the amount of the taxes that will be due because of the bonus.
While this does not cover the entire cost, it is in many cases less costly than paying the premium outright. This is also called the “Double Bonus” method funding a company sponsored benefit.
This is a non-qualified benefit and will only result in a reduced tax to the employee, and a deduction to the employer for the bonus amounts.
–Life Insurance That an Employee Purchases Through a Qualified Plan
If an employee of a business purchases life insurance that is offered through a qualified plan, he can take a tax deduction. Since the life insurance is being held by the 401(k) or pension plan, the contributions to the life insurance benefit will be tax deductible.
The participant should understand that there is an economic benefit that will be taxed and that economic benefit will be taxed to the employee.
The tax is calculated using special government tables, usually called PS-58 tables.
The downside to this plan is that if the employee dies before retirement, the amount of the proceeds going to the beneficiary that is more than the policy cash value will be received tax-free by the beneficiary.
However, the amount that represents the cash value that is more than the basis of the policy will be taxable as ordinary income.
–The Tax Benefits of Life Insurance
It should be noted that there are several very positive attributes about life insurance which makes it that much more attractive. The death benefit of a life insurance is, for the most part, received income tax-free to the beneficiary of the policy.
In a permanent life insurance policy such as whole live, variable life, universal life, or indexed universal life, the cash buildup withing the policy is not taxed during the build-up period, and neither is any earnings.
If the policy is surrendered for the cash value, any excess money over and above the cumulative cost of the policy is taxed as ordinary income.
Dividends are not taxed if a life insurance policy is participating, as the dividends are considered to be a refund to the policy of an overcharge of the mortality costs of the policy. If there is interest earned on the dividends, then that interest is taxable.
The way around that is to take the dividends in another form such as paid-up additional insurance, premium reduction, or cash.
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The Purpose of Life Insurance
Life insurance is designed to pay an amount of cash or income to a beneficiary if the insured dies prematurely. Life insurance comes in two forms, term and permanent.
Term coverage lasts for only a certain amount of years, such as 10, 15, or twenty years and then it expires. This is the least expensive form of life insurance due to its temporary nature.
The second kind of life insurance is permanent live insurance. It is called whole life, universal life, and indexed universal life insurance.
Permanent life insurance has an extra reserve that is used to keep the premium of the coverage level over the years of the life of the policy. This reserve offsets the increasing mortality risk as the insured gets older in age.
When the taxation of life insurance is discussed, the point is usually made that it far better to not have the life insurance proceeds not be subject to income tax and to have the life insurance premiums not be tax deductible.
The logical thought process has always been that it would be much worse to have the premiums tax-deductible, and then have the life insurance proceeds be taxed.
If an insured person had a $100,000 death benefit, then the beneficiary would have to pay $25,000 in taxes at an insured’s death, if the couple were in a 25% tax bracket. That philosophy would negate the significant advantage of life insurance as being protection for dependents.
A good explanation comes from Black’s Law Journal which explains, “According to the IRS, private taxpayers, and business owners are not permitted to claim their life insurance premiums as a tax deduction.
This is because life insurance benefits aren’t subject to regular taxation.
Since the vast majority of life insurance beneficiaries aren’t required to pay taxes on the benefits that they receive, it would be redundant for the IRS to provide policyholders with a tax break.” Go to Black’s Law Journal
Be Careful and Get Good Advice
If an owner of a business feels he or she should be able to deduct life insurance premiums, they should seek the advice of a CPA, a CFP or a CLU.
There is no point in heading off into uncharted waters here, as it can be much more costly if the IRS rules against the decision. That could cost more in back taxes and penalties than any savings acquired from the deductions.
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