C-corp, life insurance proceeds

[Harvey Lucas]

My long time client is sole shareholder in a C-corp.

He was diagnosed terminal cancer with less than 3 months to live.

The corp has been paying life insurance premiums.

He has always referred to the policy as a "keyman policy".

He is the primary employee, usually draws 50k per year in w2 wage.
His wife is also an employee, usually draws 25k per year in W2 wage.

With the W2 deductions he usually has little to no corp income tax.

The death benefit on the life insurance policy is $250,000..the beneficiary is the corporation.

My understanding is that when my client dies, the $250,000 will be tax free income to the corporation (altho it has to be included in ACE to compute possible AMT).

They live in a community property state.

The wife will inherit and become the 100% owner of the corp.

Calender year 2005 is done and filed.
As of 12-31-05 retained earnings is zero, and E&P is also zero.
Stock and stock basis is $1000.
There are no loans to/from the corp.

Because of his illiness there will be little to no activity in the corp for 2006.
For ease of discussion, lets say there will be no income or expense in 2006 other than the receipt by the corp of the life insurance proceeds of $250,000.

What are her options with respect to taking this 250k out of the corp to produce the least amount of Income Tax.

She will be in no hurry for the $ as she will have other assetts to live on.

HarveyLucas

[veritas]

Why was this corporation not an S-Corporation?

[Harvey Lucas]

Clients choice.

Yes personally I prefer S-corp, however client prefered C-corp for a variety of reasons.

[OldJack]

The normal purpose of the C-corporation owning a life insurance policy on a shareholder's life is for the corporation to be able to make the premium payments (not taxable to the shareholder) and then fund the purchase of stock from the widow at death. As you know the premiums so paid were not deductible and simply add to the cost basis of the policy asset compared to proceeds that are received tax-free.

A separate tax issue is what if the corporation incorrectly deducted the premiums as insurance expense. Would that require a portion of the proceeds to be taxable now? I don't think so, but might require amended C-corp tax returns for open years.

From the widow's tax point of view s/he gets an large increase in the value of the stock (stepped-up basis) and the ability to sell shares of stock that would be reported on the 1040 Sch-D (little or no gain). S/he also has the option to continue the financially sound business and take salaries and other employee benefits. Its a win-win for all unless there is an estate tax problem.

[Harvey Lucas]

Stepped up Basis

Thanks for your thoughts Jack.

I am still struggling with this.

Using the stepped up Basis approach...let's say client pass's 9-1-06....the wife inherits 100% of corp stock and since they live in community property state, she gets a stepp up in basis based on the total value of the corp as of the date of death.

Estate Tax is not a problem because of unlimited marital rules.

Can we say that the corp is worth the $250,000 that it is to receive from the insurance?

If so, her basis in the corp is now $250,000?

The corp receives the $250,000 insurance proceeds which is tax free.

The corp then buys all of the widows stock for $250,000 and depletes all of it's assetts doing so.

The widow reports the sale of the stock on 2006 1040....basis $250,000...sales price $250,000..gain is zero. Right?

Now it seems we have a corp with no owner?...Or, I guess the corp buys back only 99% of its shares from the widow....she holds 1% which is still 100% of the issued and outstanding shares??

Am I on the right track here....somehow it does not smell right?

HarveyLucas

[OldJack]

Bingo! you got a winner. That was the way someone planned it that knew what they were doing. Cheers.

[Harvey Lucas]

Thanks Jack, but now a twist!

I wanted to make sure that I had the facts right regarding the insurance particulars, so I called the client.

Good thing I did.

Client had always indicated in corp check register that it was a "keyman" insurance policy....As such, I had always treated the premium payments as nondeductible by the corp...and as not includeable in clients w2 income...client always did his own 941/w2 filings.

Now I have just found out that it is not a "keyman" policy at all!...i.e., the client called it a keyman policy, but in fact it is simply a life insurance policy owned by the client, his wife is the designated benificiary, but the corp pays the premiums...

As such, it is my understanding that the entire annual premium cost (4800/year) needs to be added to my clients w2 income as additional compensation? True?

Also, I should go back and amend prior years w2 filings and 1120 filings to reflect the same? True?

Also, since it is my client who owns the policy, and his wife is the benificiary, the 250K death proceeds will go direct to the wife and will not affect the corporation in any way? True?

Moral of the story....believe none of what you hear and only 1/2 of what you see?
I am sure that there are some other good morals to this story as well?

HarveyLucas

[OldJack]

You need to review pub 15b to see if the premiums could possibly be considered as a group life insurance benefit with only a portion taxable. Off hand I would expect not. So you are faced with W2 benefit or maybe C-corp taxable dividend on a 1099-DIV. If the corporation does not need the deduction I would consider calling it a taxable dividend and only amend the 1040 for open years.

[OldJack]

Also Harvey, this is one of those cases where you have to consider who am I working for and what is my responsibility.

1) What is in the clients best interest as s/he is the one that I work for and does s/he want me to prepare amended tax returns?

2) Do I have the responsibility to act as an IRS agent and audit prior years tax returns?

3) Even though I prepared and signed the prior years 1120 tax return, they were signed to the best of my knowledge at that time. Do I have a responsibility to amend them without the specific request of the client?

4) Is the tax effect of amending those prior year returns material enough that they must be amended?

5) Is my responsibility to make the client aware of the prior year errors all that is required?

Sometimes Harvey, it is best to just let a dead dog lie.

[Harvey Lucas]

Thank you Jack

Thank you for your thoughts Jack, I really appreciate your feedback.

HarveyLucas