Can my S corp pay my life insurance?

Buying life insurance can be an important financial decision for small business owners. Term life or permanent life insurance policies provide protection for your loved ones if you pass away unexpectedly. But life insurance policies also have unique tax implications, especially when combined with an S corporation.

In this comprehensive guide, we’ll cover everything you need to know about whether and how an S corp can pay for life insurance, including:

• Benefits of S corp-owned life insurance
• Term life insurance rules
• Permanent/cash value life insurance rules
• Tax consequences and accounting
• Setting up life insurance policies properly
• Common mistakes to avoid

Why would an S corp buy life insurance?

There are two main reasons an S corp may want to purchase life insurance on its owners or key employees:

• Key person protection – Losing an owner or valued employee could financially damage the company. Life insurance proceeds can help the S corp survive the loss.
• Shareholder buyout – If an owner dies, life insurance can provide liquidity to buy back their shares from the estate. This allows the S corp to control who becomes a shareholder.

In both cases, the benefits of life insurance must be weighed against the costs of premiums.

How do the tax rules differ for term vs. permanent life insurance?

The tax treatment depends on whether the policy is term or permanent/cash value:

• Term life insurance:
  • Premiums are NOT deductible by the S corp
  • Death benefit payouts are tax-free
  • Premiums reduce shareholder basis and AAA but not OAA
• Permanent/cash value life insurance:
  • Premiums have an insurance element (non-deductible) and investment element (deductible)
  • Increases in cash value are NOT taxable events
  • Complex rules on distributions, basis, and accounts

The split between insurance and investment elements causes more tax complications for permanent policies.

What are the tax consequences of an S corp buying life insurance?

Here are key tax considerations when an S corp purchases life insurance:

• Premiums are usually non-deductible expenses
• Shareholder basis is reduced by premiums
• Death benefits received are tax-free
• Term policy premiums reduce AAA but not OAA
• Permanent policy premiums have split impact on accounts
• Cash value increases don’t impact basis or accounts

Complex rules determine how accounts like AAA and OAA are impacted by premiums and payouts. This affects the S corp’s ability to make tax-free distributions.

How should life insurance policies be set up and documented?

To optimize tax treatment, life insurance policies should adhere to the following:

• S corp should be policy owner & beneficiary – This avoids taxable income for shareholders
• Insure key persons – Owners, executives, revenue generators
• Document premium allocation – Permanent policies require splitting insurance/investment elements
• Track basis & accounts – Impact on basis, AAA, OAA must be recorded properly
• Structure buyouts as redemptions – If buying back shares from estate, use a sale transaction

Proper documentation is key. Consult a tax professional to ensure your situation follows all IRS rules and your accounting is accurate.

Common mistakes S corps make with life insurance

Some common mistakes to avoid with S corp-owned life insurance include:

• Forgetting to reduce shareholder basis for premiums
• Misallocating permanent policy premiums between insurance and investment
• Recording cash value growth as tax-exempt income
• Distributing cash value instead of basis and exhausting AAA
• Not filing a redemption when buying back shares from an estate

Mistakes can lead to unwanted taxable income for shareholders or loss of S corp status. Prevent issues by working with an experienced tax professional.

The bottom line

With the right circumstances, life insurance can benefit an S corp by providing liquidity and protecting against the loss of a key person. But the complex tax and accounting rules make professional guidance a must. Consult a knowledgeable tax advisor or CPA if you’re considering having your S corp purchase life insurance. With proper setup and documentation, you can optimize the benefits while avoiding costly mistakes.