Taxation of corporate-owned life insurance policy proceeds payable to shareholders.

• Author: Headley, Richard A.

Generally, amounts received under a life insurance contract paid by reason of the death of the insured are excluded from gross income. This general exclusion rule of Sec. 101(a)(1) certainly applies when a corporation purchases a key-man life insurance policy on one of its shareholder-officers and the proceeds are paid directly to the corporation. However, there is a question as to whether this exclusion is applicable if the beneficiaries of the corporate-owned life insurance policy are the insured's family or estate.

Case law history

The leading case in this area is Golden, 113 F2d 590 (3d Cir. 1940). In Golden, a corporation purchased 11 life insurance policies on the life of its president, under which the corporation was the sole beneficiary. All policies were subsequently transferred to a trust company that was instructed by the corporation to collect and distribute all proceeds from the policies to the corporation's stockholders in direct proportion to their stock ownership on the date of distribution. The corporation did reserve the right to receive any dividends paid on the policies, to change the beneficiaries with the permission of the trustee and the trust beneficiaries [the stockholders}, and to sell the policies. The corporation paid all premiums on the policies out of its own funds through the date of the insured's death.

When the insured died, the trust collected and distributed the policy proceeds according to the trust agreement. The IRS assessed a deficiency on the trust beneficiaries on the theory that the corporation had retained valuable incidents of ownership, and therefore the distributions were dividends. The taxpayers argued that Section 22(b)(1} of the 1939 Code (predecessor to Sec. 101} controlled, making the proceeds exempt from gross income. The court found the Service's argument more persuasive, and held that dividend distributions did occur, since sufficient earnings and profits existed at the time of the distribudons.

This dividend distribution theory was argued successfully by the IRS several times until the Ducros decision, 272 F2d 49 (6th Cir. 1959}, rev'g 30 TC 1337 (1958). In Ducros, a closely held corporation caused a life insurance policy to be purchased on the life of its president with the intention of distributing the proceeds to various shareholders by making them beneficiaries. The corporation paid all the premiums and had all the incidents of ownership, including the right to change the...