Has your S-Corporation been paying your shareholder life insurance policy premium? Not so fast. According to the court in Machacek, Jr. v. Commissioner, life insurance premium payments made on behalf of the shareholder by an S-Corporation (S-Corp) have been determined to be property distributions. To explain a bit further, life insurance premiums paid by the S-Corp for a shareholder should be shown as a property distribution to the shareholder as long as the shareholder has the power to designate a beneficiary and that beneficiary is someone other than the corporation (Machacek, Jr. v. Comm., (CA6 10/12/2018) 122 AFTR 2d 2018-6269). This applies so long as the insurance is provided for under a split-dollar life insurance arrangement, i.e. an arrangement entered into between the corporation and shareholder, but not your typical non-highly compensated discriminatory group-term life insurance policy that does not provide permanent benefits to employees. Thus, where in the past you may have been taking it as an expense, adding it to reasonable compensation, or a schedule M adjustment, it no longer is an expense, reasonable compensation, or a schedule M adjustment, but rather a property distribution.
By reclassing this payment from an expense to a property distribution, the shareholders will no longer be able to deduct the premium. This decrease in deductible expense would cause the shareholders to effectively recognize the payment as income on their tax returns. Of course, life insurance premiums paid on behalf of a shareholder should not be taken as a tax deduction, but rather, perhaps prior to Machacek, a non-deductible expense item on the Schedule M.
However, this new requirement denies the S-Corp from taking the premium as a non-deductible schedule M item. Causing the premium to be taken as a property distribution is not as good as making the payment a non-deductible expense item shown on the schedule M. This is due to the fact that the shareholders must now report any increase in value of the policy caused by the payment to be included in the shareholders’ taxable income (generally, whole life). When an S-Corp distributes appreciated property to its shareholder(s), the gain must be recognized on the shareholders’ Form K-1. As an example, S-Corp has three shareholders A, B, and C. Shareholder A’s annual life insurance premium of $4,000 is paid by the S-Corp. A’s life insurance value increased by $1,500 due to this payment. Under this scenario, A, B, and C would show a gain of $500 ($1,500 divided by 3) each on their Form K-1s.
Also, S-Corps must keep distributions pro-rata. Distributions have to be paid out in a manner that reflects ownership. As an example, shareholder A owns 2 shares, shareholder B owns 3, and shareholder C owns 4 shares. Under this scenario, if shareholder C receives $4 as a distribution, shareholder B must also receive $3, and shareholder A must also receive $2. Therefore, if shareholder C has their annual life insurance premium of $4,000 paid by the S-Corp, shareholders A and B must also now receive as a distribution payment of $2,000 and $3,000 respectively. So, because shareholder C had their premium paid by the S-Corp, the S-Corp now has to make total distributions to its shareholders in the amount of $9,000.
As this case involved a married couple as the only shareholders, the court likely did not understand the rippling ramifications of its determination. So whereas a sole shareholder S-Corp may work somewhat ok (however, some gains may be taxed), a multi-shareholder S-Corp may not. A multi-shareholder S-Corp may not work since S-Corporations have to keep their distribution payments on a pro-rata ownership basis.
A suggestion may be that if a shareholder has a loan, that any premium payment goes against that shareholder’s loan first, and then as a distribution, to avoid gouging the Corporation’s cash position. That, or as an easy solution that the IRS likely won’t challenge is that the shareholder runs it through their wages, which in dicta, does not appear to be to the liking of the court either.â?¯Another not quite so simple solution may be to have an operations LLC owned by an S-Corp as the mega majority owner with the individuals being minority owners. In this case, the LLC would pay out guaranteed distributions to each minority member to cover the premiums. Another potential solution may be to have an operating LLC that pays consulting fees to multiple S-Corp’s where each S-Corp pays the premium. However, ultimately, we can all thank the Machaceks for causing life Insurance premium payments, if paid by the S-Corp on behalf of the shareholder, to now be classified as property distributions on the S-Corp return.
By: Anton Rees,
CPA, ABV, JD, LLM
Tax Manager
Cowart Reese Sargent CPA’s, P.C.
anton.rees@crscpa.com
Any tax advice in this communication is not intended or written by the author to be used, and cannot be used, by any person or entity for the purpose of (i) avoiding penalties that may be imposed on any taxpayer or (ii) promoting, marketing or recommending to another party any matters addressed herein.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax advisor.