Closely-held C-corporations often face a conundrum: how can the business owner access corporate cash without triggering double taxation—first at the corporate level and again as a dividend when distributed? A tax-efficient solution lies in the strategic use of key man life insurance. When implemented correctly, this approach enables the business owner to maximize value in a manner that is not taxed as a dividend distribution.
Here’s how a key man life insurance policy strategy works.
In this strategy, the C-corporation purchases a permanent life insurance policy on the business owner, naming itself both the owner and the beneficiary. The corporation overfunds premiums to the maximum extent permitted by Internal Revenue Service (IRS) rules, and cash value accumulates tax-deferred inside the policy under IRC §7702.
Indexed Universal Life (IUL) insurance is used in this strategy for its flexibility to time expenses and growth. In this case, expenses are accelerated as much as allowed in the first five years. Growth follows the five-year S&P index, so no return is credited to the policy until the end of year five. By structuring this way, it creates a unique opportunity in year five, where the value is temporarily depressed.
At this time, the business owner or an Irrevocable Life Insurance Trust (ILIT) where the owner is a grantor may purchase the policy from the corporation for its fair market value (FMV), which is typically measured using the PERC method (premiums paid, earnings, and reasonable charges) or the interpolated terminal reserve (IRT) value as recognized under Treas. Reg. §25.2512-6(a).
There are four high-impact tax advantages to purchasing key man life insurance.
1. IRS treatment of policy purchases avoids dividend taxation.
So long as the owner purchases the policy for its FMV, the IRS does not treat the transaction as a dividend; this avoids the double taxation that would result if the policy were simply distributed or surrendered with proceeds paid to the owner.
2. Premiums are taxed at a rate lower than the owner’s marginal tax bracket.
While the life insurance premiums paid by a C-corporation for the key man policy are not deductible under IRC §264(a)(1), the corporation-owned life insurance policy is paid with after-tax dollars that are taxed at 21% rather than the business owner’s marginal tax bracket; this delivers a powerful way to reposition after-tax corporate dollars into a policy that the owner may eventually purchase and personally benefit from.
3. Policies provide tax-free income in retirement.
After the buyout, the policy becomes a personal asset of the owner or an ILIT. As the cash value accumulates in the policy, it can be accessed via tax-free loans or withdrawals. In retirement, the policy can function as a tax-free, supplemental income stream. Ultimately, the death benefit will pass income tax-free to the owner’s heirs under IRC §101(a).
4. Proceeds pass to beneficiaries without exposure to income or estate tax.
If an ILIT is used for the buyout, future growth is not subject to income or estate tax. The ILIT holds the policy outside the owner’s taxable estate, and the death benefit proceeds are eventually paid to the ILIT, where no estate tax is paid, and the beneficiaries can access funds.
Avoid policy undervaluation that attracts IRS scrutiny.
Valuing the policy correctly is critical. The IRS has challenged undervalued policy transfers in the past, particularly where the policy was transferred at book value or without consideration of accumulated earnings.
ITR is most typically used to value a life insurance policy for transfer tax purposes and is provided by the issuing life insurance carrier via Form 712, Life Insurance Statement. Use of the ITR value, as described in Rev. Rul. 59-60 and Treas. Reg. §25.2512-6 provides a defensible FMV benchmark.
Planning should address the following rules and considerations.
- The transaction must be documented carefully, including a Form 712 and payment of FMV by the owner.
- No corporate deduction is allowed for premium payments, but the cash grows tax-deferred inside the policy.
- The corporation should ensure the purchase is not a constructive dividend, which could trigger IRC §301(c) treatment if not properly executed.
- This strategy can pair well with succession planning, allowing the owner to extract value without triggering capital gains or dividend taxes.
When implemented correctly, a key man life insurance strategy offers tax advantages that preserve and grow wealth for you and your estate.
The key man life insurance strategy is a creative, IRS-compliant method for extracting cash from a closely-held C-corporation without incurring dividend treatment, provided the owner purchases the policy at its FMV. With proper structuring, documentation, and valuation, this approach can provide significant long-term tax advantages and estate planning benefits.
