Small businesses power the United States economy. They drive innovation, create jobs, and sustain local economies. With so much at stake, small business owners are keenly aware that they need to protect their operations to ensure long-term success. Business owners who purchase property, casualty, and liability insurance, though, often still overlook critical risks, including the sudden loss of a key employee.
As an advanced sales producer, your role is twofold:
1. Reveal the urgency. For many small businesses, key person insurance is essential, as the loss of a key person can disrupt operations and diminish revenue.
2. Explain the details. This discussion should include valuation methods, the type of policy, notice and consent rules for employer-owned life insurance (EOLI), and tax implications.
The following questions and answers delve into some of the main tax implications.
Is the cost of the life insurance tax deductible to the business?
Because the business is the owner and beneficiary of the policy and stands to gain from the policy proceeds, premiums paid for key person coverage are not tax deductible.
Are the life insurance proceeds tax free?
The proceeds may be income tax free only if the business complies with the notice and consent requirements of IRC § 101(j) before the insurer issues the policy. (One exception is for accelerated death benefits for a terminal or chronic illness, which are taxable to the business when triggered.) Failure to comply with notice and consent requirements can result in the death benefit (less premiums) being partially or fully taxable, which would significantly diminish its intended purpose.
What is the tax impact on the insured key employee?
The business is the policy owner, premium payer, and beneficiary. As the insured, the key employee is not subject to any tax impact—unless the insured key employee is also an owner of the business.
What is the tax impact if the insured key employee is also an owner?
Business-owned life insurance proceeds can create significant implications for the business and the business owner’s estate when the insured key employee is also an owner. If the insured owner passes away, the insurance proceeds paid to the company will increase the company’s value. This can indirectly increase the value of the deceased owner’s shares, potentially increasing the deceased owner’s taxable estate. Unless the owner puts proper planning in place, this could lead to higher estate taxes for high-net-worth clients.
Concerning the remaining owners, an increased company value for a pass-through entity could lead to disputes if the ownership structure or buy-sell agreement is not clearly defined regarding the treatment of the proceeds. For example, the remaining owners may see an increase in their ownership percentage, which could impact their individual tax liabilities. Before purchasing key employee insurance on an owner, all owners should understand how the death benefit might impact the tax basis of ownership shares.
Help business owners analyze the risk of unexpected tax liability and review and potentially revise their insurance planning strategies to mitigate the risk for the company, the deceased owner’s estate, and the surviving owners. Simply transferring ownership of the life insurance policies from the business to the owners won’t solve this problem because it could trigger transfer-for-value rules, resulting in taxable proceeds. Business owners should also consult with their tax professional and attorney as they dig into this issue.
If a covered key employee leaves, should the business surrender the policy?
Maybe—but the business owners should first explore all options. Key person coverage protects the business against the employee’s death or disability, but not against voluntary separation or retirement. In this scenario, if the business decides to surrender a cash value life insurance policy, the cash value is taxable as ordinary income to the extent that it exceeds the owner’s basis in the insurance contract. It’s possible that a policy sale or transfer may be more tax-efficient than surrendering the policy.
How much of this information do I need to discuss with clients in advance?
Being upfront about possible tax implications ahead of the insurance purchase is critical to giving business owners a deeper understanding of the coverage and potential scenarios that can occur down the road. It also helps strengthen trust and foster a long-term relationship.
