KTT Global Advisors – CFO & Finance for Growing Tech Startups

Tax Question: Can I Deduct the Premiums on the Life Insurance Policy I Just Took Out on My Cheatin’ Husband?

Attention-grabbing headline.  Following content not the exact situation I hinted at.So the question is in which situation a company can pay life insurance premiums on behalf of an owner and deduct those premiums for tax purposes. In this case, the owner of a single member LLC has two policies:

  • $7,500 annual premium whole life policy

  • $15,000 annual premium term life policy

The owner’s wife is 100% beneficiary of both policies.For starters, regardless of the type of company, generally the premiums are not deductible if the company or company owner is a direct or indirect (such as through a family member) beneficiary of the policy.  As a result, in the event the policy is paid out, the beneficiary (the company) generally does not pay tax on the proceeds (IRC Sec 101).

So, does that mean that if the company is NOT the beneficiary of the policy, that the premiums are deductible?  Well that depends on the definition of “company”.

In this case we have a single-member LLC that intends to be taxed as a sole proprietorship.  From a tax perspective, the company is a “disregarded entity”, meaning that the IRS could care less if the LLC actually exists – the owner will file through Schedule C same way as if he was not running the business through a legal entity.  So it’s as if the owner were simply buying the insurance for himself independent of the the business. Since life insurance is not a deductible expense to individual filers, the owner would not be able to deduct the premiums on his Schedule C.

What about other scenarios?  A single-member LLC can choose to be taxed as an S Corporation by filing Form 2553, Election by a Small Business Corporation.  In this case, provided that the owner pays himself “reasonable compensation” as an employee of corporation, remaining profits of the business can be passed through to him as a dividend, not subject to self-employment tax.  In addition, the premiums on the life insurance policies can be a deductible expense to the company (provided they adhere to the beneficiary restrictions mentioned above) – but they are taxable benefit to the employee.Let’s use a simple example to illustrate the difference between the two scenarios:

  • $10 in revenue for the year

  • $2 in annual insurance premiums (taxable benefit to owner if paid as employee)

  • $5 “reasonable compensation” to owner

  • No other expenses assumed (for simplicity)

  • 30% fed, state, local income tax rate

  • 10% payroll tax rate (SS, medicare; includes employer and employee portions). Note the actual rate is 15.3% plus the .9% adder if you make a lot of money

For the LLC as disregarded entity you would have $10 net income passing through to the owner.  This would be taxed to the owner at 30% + 10% = 40%. Ignoring the deductible portion of the self-employment tax: $10 * (1 – 40%) = $6 – $2 insurance premiums = $4 net to owner.

For the LLC taxed as an S-corp you would have $10 in revenue less $2 in insurance premiums and $5 in “reasonable compensation” to the owner/employee.  The company would cover half the payroll tax as a deductible corporate expense and then pay the owner the salary less withholding (30% + 5%). Any reminder would be distributed to the owner as a dividend.  So……$10 – $5 – $2 – $0.25 (employer portion of payroll tax) = $2.75 dividend at 30% tax = $1.92.  PLUS net salary = $5 – $0.25 – (income tax withholding on $5 + $2 = $2.1) = $2.65. Total $4.57.

This results in a slight benefit in making the S election.  However the deadline for the filing of Form 2553 that would make the S corp alternative available for the 2017 tax year is March 15. So the filing must be completed, along with the 1120S and K-1s, by this date.

Lastly, what if the LLC made the conversion to a corporation?  Well, in this event the corporation would have two tax options: taxed as an S corp (see above) or a traditional C corp.  The C corp taxation example would be similar to the S corp example with the exception there would be no pass-through of profits to the owner, unless the corporation were to elect to make a distribution.  Thin the latter case the profit would face “double taxation”; once at the corporate rate (21% starting in 2018) and again at the owner/employee’s individual rate. If the corporation did not distribute the profits then the corporate rate would not apply and the taxes to the individual would be deferred to the time a dividend is issued or some liquidity event happens.

So what is the best option to the taxpayer for 2017? For 2017 there is still time to make the S election (by Mar 15), which has some tax benefits, but there is an increase in overhead as the owner would need to be treated as an employee and issued a W-2 at the end of the year.  And if investigated the IRS might still decide that the company should be taxed as a disregarded entity if they determine that the sole purpose of the S election was tax avoidance.Since most of the tax benefits can be realized by having the LLC make an S election, becoming a corporation is probably overkill.

DISCLAIMER:This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax advice. You should consult your own tax advisor with regard to your particular tax position.

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