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(Monday, December 28, 2009)Life insurance is often used in a small business corporation to provided funds to replace employees with critical skills (key man insurance), and to provide for the purchase of a shareholder’s shares in the case of death (sometimes called partnership insurance).
The proceeds from key man life insurance are tax free, and can be used by the company to fund the search for a replacement for the key employee, and to partially offset the financial losses that may be suffered on the loss of the key employee. The life insurance proceeds are added to the Capital Dividend Account, and a tax free capital dividend can be paid out to the shareholders if the corporation has the cash. This may allow the shareholders to take a lesser dividend than they ordinarily would, since the capital dividend is tax free to the shareholder.
Partnership or shareholder insurance is commonly used to pay the estate of a deceased partner or shareholder for the partnership interest or shareholdings on their death. That way the heirs get an immediate cash payment, rather than having to wait for some time for payment or receive a series of payments over time. If there were no insurance in place, the remaining partners or shareholders might not be able to immediately buy the partnership interest or shares of the deceased partner/shareholder.
In the absence of partnership or shareholder life insurance, a partnership or shareholder agreement normally provides that the deceased partner’s or shareholder’s interest is purchased over time, as the income of the business provides funds to the partners or shareholders for the purchase. Unless the heirs are qualified to join the partnership or corporation, the other partners or shareholders generally are not willing to continue paying out a portion of the profits of the business to the heirs indefinitely.
The simplest way for partners or shareholders life insurance to work is for the partners or shareholders to be the beneficiaries of the policy, and for them to then purchase the partnership interest or shares from the heirs. This requires that a written agreement, called a partnership or shareholder agreement be signed by all partners or shareholders, and that the purchase be a condition of the agreement.
A somewhat more sophisticated method exists for a corporation, where the corporation is named as the beneficiary of the life insurance policy, like key man insurance. The corporation then redeems the shares of the deceased shareholder using the life insurance proceeds. Normally the redemption of shares results in a taxable dividend, however, an election is available to deem the dividend to be paid out of the Capital Dividend Account and thus it is a non taxable capital dividend. Since the life insurance proceeds are added to the Capital Dividend Account, usually the entire redemption amount can be deemed to be a non taxable capital dividend.
The advantage to this procedure is that the corporation may be able to deduct the life insurance premiums as a business expense. Normally, life insurance premiums are not deductible by a corporation for income tax purposes; however, if the life insurance policy is required as a condition of a loan, the premiums are deductible. The life insurance policy does not have to be payable to the financial institution, it can be payable to the company. It is not unusual for a bank to require life insurance coverage for shareholders or key employees so that the company will have sufficient funds to pay the bank loan in the case of their death. It is often possible to get the bank to agree that the insurance is payable to the corporation, and to specify in the loan agreement that the life insurance coverage is required as a condition of the loan.
If you own a corporation, and are contemplating using key man insurance or partnership insurance, talk to your tax accountant about how you can avoid these problems and tax traps.
