Life insurance and S corporations: unique rules present opportunity and peril.

• Author: Decker, Ed

Life insurance on key employees and owners can be a powerful tool. It can generate tax-exempt proceeds that companies can use to help protect themselves against the death of key personnel while providing critical liquidity to the company if it must buy back shares from a deceased owner's estate. This can be especially important for S corporations, which often have a unique interest in controlling the makeup of their shareholders to ensure continued qualification under Subchapter S.

However, life insurance policies, regardless of the type, present special considerations for S corporations. Those considerations and some of the related issues are outlined below.

Term Life Insurance

The tax issues associated with key person term life insurance are relatively unambiguous. Sec. 264(a)(1) provides, "No deduction shall be allowed for premiums on any life insurance policy ... if the taxpayer is directly or indirectly a beneficiary under the policy or contract." The tax treatment of death benefits associated with such a policy is similarly straightforward. Sec. 101(a)(1) states, "Except as otherwise provided ... gross income does not include amounts received ... under a life insurance contract, if such amounts are paid by reason of the death of the insured."Therefore, an S corporation that chooses to purchase term life insurance on key employees and/or owners receives no current tax deduction when it pays the premiums, but the death benefits will be tax-free when the insured dies.

S corporation issues: The more interesting issues with term insurance relate to how the above rules affect various S corporation accounts. Again, the rules are relatively clear, but because they can affect a shareholder's ability to access cash on a tax-free basis, they are important to understand.

As discussed, premiums are not deductible. Nonetheless, S corporation shareholders must reduce stock basis for their allocable shares of that expense (Sec. 1367(a)(2)(D)). The big question, however, is whether that nondeductible expense reduces the accumulated adjustments account (AAA) or the other adjustment account (OAA).The answer is important because S corporations with prior C corporation earnings and profits (E&P) can generally make tax-free distributions only to the extent of AAA; additional amounts are taxable to the shareholders to the extent of the company's E&P. Thus, if these nondeductible premiums reduce AAA, they reduce the pool from which the S corporation can make...