Reporting life insurance transactions by S corporations.

• Author: Chandler, Peter L.

There is room for disagreement, if not confusion, over how to report transactions involving life insurance on the tax returns of S corporations. This is largely because federal tax law provides alternative computations of income and gain (and occasionally loss) on the disposition of life insurance products. The differences lie in the distinction between the basis of a life insurance contract and the "investment in the contract."

To implement the Subchapter S Revision Act of 1982, P.L. 97-354, the IRS designed Schedule M-2 of. Form 1120S, U.S. Income Tax Return for an S Corporation, and therein complicated the discussion further by inventing a concept called the other adjustments account (OAA), which has no basis or definition in the Code or regulations. Curiously, the instructions for Schedule M-2 provide for entries of specific information in the columns for the accumulated adjustments account (AAA), OAA, and previously taxed income (PTI), but they do not require that these columns reconcile to the corporation's retained earnings.

Furthermore, the instructions are silent with respect to the treatment of transactions encountered by many taxpayers, including transactions involving life insurance. Such gaps in the instructions invite preparers to create their own answers, which inevitably leads to different presentations of the same or similar events and may lead to incorrect answers to questions that really matter. This item attempts to identify the information that does matter and suggests approaches to reporting life insurance transactions in particular.

Secs. 1367 and 1368 provide the basic principles under which distributions from an S corporation are taxed to the corporation's shareholders. Sec. 1367 defines the adjustments to the basis of the equity and debt of the corporation owned by the shareholders that are unique to the passthrough of tax attributes under subchapter S. Sec. 1368 provides ordering rules for differentiating among tax-free distributions of the shareholders' basis, taxable distributions from the corporation's earnings and profits (E80), and distributions taxed as capital gains.

Sec. 1001(a) provides that the gain from the sale or other disposition of property is the excess of the amount realized over the adjusted basis of the property, as defined by Secs. 1011 through 1023. In the case of S corporations, the adjustments prescribed by Sec. 1367 supplement the general provisions under Secs. 1011 through 1023.

Sec. 72(e)...