Key person insurance plays a vital role in protecting businesses from the financial impact of losing key individuals within the organization. It provides a safety net by compensating the company for the loss incurred due to the death or disability of a key employee. While key person insurance is a valuable risk management tool, business owners must understand the taxation aspects associated with these policies.
Tax Treatment of Premiums
Generally, the premiums paid for key person insurance policies are not tax-deductible as a business expense. The Internal Revenue Service (IRS) considers key person insurance premiums as a capital expense rather than an ordinary and necessary business expense. As a result, the premiums are typically not deductible from the company's taxable income.
Tax Treatment of Proceeds
When a key person insurance policy pays out due to the death or disability of the insured employee, the tax treatment of the proceeds depends on various factors. Generally, the insurance proceeds the business receives are not considered taxable income. Therefore, the payout is not subject to income tax.
However, there are situations where tax implications may arise. For instance, if the business has previously deducted the premiums paid as a business expense, any insurance proceeds exceeding the total premiums paid would be subject to income tax. Additionally, if the business has transferred ownership of the policy to the key employee, the proceeds may be taxable to the employee.
Tax Treatment of Cash Value
Some key person insurance policies, such as whole life or universal life insurance, accumulate cash value over time. The growth of this cash value is tax-deferred, meaning that the business does not have to pay taxes on the growth of the policy's cash value until it is withdrawn.
However, suppose the company surrenders the policy and receives the cash value. In that case, any amount received above the total premiums paid is subject to income taxes. It is important to note that withdrawing cash value from the policy can have tax implications, and consulting with a tax professional is recommended.
Tax Treatment of Premium Financing
Premium financing is a strategy where a third party provides a loan to the business to cover the premiums of a key person insurance policy. The company repays the loan with interest over time. From a tax perspective, the interest paid on the premium financing loan may be tax-deductible as a business expense, subject to certain limitations and restrictions.
Conclusion
Key person insurance is essential for businesses to mitigate the financial risks of losing key individuals. While the premiums paid for key person insurance are generally not tax-deductible, the death benefit received by the company upon the insured individual's death is typically tax-free. Businesses need to be aware of the potential tax implications of key person insurance, especially regarding cash value growth, policy transfers, and premium financing. Consulting with a qualified tax professional can help ensure compliance with tax regulations and maximize key person insurance benefits while minimizing tax burdens.
Contact us at email@ennislp.com or 301-859-0860 if we can be of service in reviewing your key person insurance program.