Five Ways to Accidentally Create a Big Tax Bill With Your Business’s Life Insurance

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Written by G. Tate Groome, CFP®, CLU®, AEP®, Co-CEO of Colton Groome Financial

Life insurance is a great business tool when properly implemented and managed – providing a tax-free death benefit or tax-free access to cash value. Businesses deploy life insurance to address a variety of needs from business succession to retention of select key executives to protection from the untimely death of key employees.  However, failure to properly manage the policies, follow the terms of accompanying agreements (i.e. buy/sell, split dollar), and submit and retain any required tax documents can lead to unexpected tax problems and expenses.  Sometimes, the best laid plans must adjust for changes in current law lest you run afoul of new tax rules.  Below are five ways your business could fall into a life insurance tax trap. 

1. Ignore rules that changed.

A recent ruling in a U.S. Court of Appeals has flipped the script on life insurance death benefits paid to a business under a buy/sell agreement resulting in an inflation of the value of the business and consequently, inflation of the value of the deceased’s taxable estate.

2. Pay for it wrong.

Did you know that naming an employee’s or owner’s spouse or children as beneficiaries of a business owned life insurance policy can cause the entire proceeds to be taxable income to the beneficiary?  Also, paying the premium for an employee-owned policy may create tax issues.

3. Poor record keeping.

If your business fails to maintain proof of employee notice and consent for business owned life insurance issued or materially modified after August 17, 2006, the death benefit paid to the business may be taxable income. 

4. Failure to file required tax forms.

Since 2009, businesses have been required to include a special “Report of Employer-Owned Life Insurance Contracts” as part of their annual income tax return.  Failure to file could result in penalties and taxes.

5. Ignore the Agreement

If you fail to follow the terms of various agreements involving life insurance such as a buy/sell or split dollar loan agreement, it could throw the expected outcome into total disarray and generate unexpected tax bills.  There are several court cases where families lose to the IRS after years of legal battles, and the failure to follow the terms of an agreement is a common theme.

Like a car, maintenance keeps your business life insurance running smoothly.  The first step is to do a diagnostic of your business life insurance to determine if any of these issues apply to you.  A knowledgeable life insurance professional can help you do that and then engage with your advisory team to determine the necessary corrective actions.  After all, an ounce of prevention is worth a pound of cure.

Reach out to Colton Groome Financial for more information on how we can help with your business and personal life insurance.

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