Reporting Life Insurance Transactions by S Corporations
There is room for disagreement, if not confusion, over how to report transactions involving life insurance on the tax returns of S corporations. This is largely because federal tax law provides alternative computations of income and gain (and occasionally loss) on the disposition of life insurance products. The differences lie in the distinction between the basis of a life insurance contract and the “investment in the contract.”
To implement the Subchapter S Revision Act of 1982, P.L. 97-354, the IRS designed Schedule M-2 of Form 1120S, U.S. Income Tax Return for an S Corporation, and therein complicated the discussion further by inventing a concept called the other adjustments account (OAA), which has no basis or definition in the Code or regulations. Curiously, the instructions for Schedule M-2 provide for entries of specific information in the columns for the accumulated adjustments account (AAA), OAA, and previously taxed income (PTI), but they do not require that these columns reconcile to the corporation’s retained earnings.
Furthermore, the instructions are silent with respect to the treatment of transactions encountered by many taxpayers, including transactions involving life insurance. Such gaps in the instructions invite preparers to create their own answers, which inevitably leads to different presentations of the same or similar events and may lead to incorrect answers to questions that really matter. This item attempts to identify the information that does matter and suggests approaches to reporting life insurance transactions in particular.
Secs. 1367 and 1368 provide the basic principles under which distributions from an S corporation are taxed to the corporation’s shareholders. Sec. 1367 defines the adjustments to the basis of the equity and debt of the corporation owned by the shareholders that are unique to the passthrough of tax attributes under subchapter S. Sec. 1368 provides ordering rules for differentiating among tax-free distributions of the shareholders’ basis, taxable distributions from the corporation’s earnings and profits (E&P), and distributions taxed as capital gains.
Sec. 1001(a) provides that the gain from the sale or other disposition of property is the excess of the amount realized over the adjusted basis of the property, as defined by Secs. 1011 through 1023. In the case of S corporations, the adjustments prescribed by Sec. 1367 supplement the general provisions under Secs. 1011 through 1023.
Sec. 72(e) contains rules for calculating income and gain from disposition of certain insurance products. These rules depart from the general rule of Sec. 1001. They apply to amounts received under an annuity, endowment, or life insurance contract that is not received as an annuity. While a complete analysis of Sec. 72(e) is beyond the scope of this item, attention should be paid to a concept called “investment in the contract,” which is described in Sec. 72(e)(6):
For purposes of this subsection, the investment in the contract as of any date is—
(A) the aggregate amount of premiums or other consideration paid for the contract before such date, minus
(B) the aggregate amount received under the contract before such date, to the extent that such amount was excludable from gross income under this subtitle or prior income tax laws.
The investment in the contract is similar to the basis of a life insurance product, but it is different, and that difference is at the heart of the confusion over life insurance transactions.
Rev. Rul. 2009-13 illustrates how the tax treatment of dispositions of life insurance products differs with the type of insurance (term vs. cash value, or “whole life”) and the manner of disposition. It provides that upon the surrender of a life insurance policy, income is recognized to the extent that the amount received exceeds the investment in the contract. In contrast, the amount of income recognized on the sale of a life insurance contract is the excess of the amount realized over the basis of the contract. In other words, the tax consequences of the surrender of a policy are governed exclusively by Sec. 72, and the tax consequences of a sale are governed exclusively by Sec. 1001.
The difference between the basis of, and investment in, the contract has been the subject of discussion and litigation for years (see Century Wood Preserving Co., 69 F.2d 967 (3d Cir. 1934); and Keystone Consolidated Publishing Co., 26 B.T.A. 1210 (1932)). The investment in the contract includes every dollar of premium paid over the history of the contract (net of any nontaxable distributions), whereas the basis is reduced by the portion of the premiums paid that represent the “cost” of the life insurance protection provided under the contract. Therefore, for purposes of tracking the basis of a life insurance contract, the premiums must be allocated between the additional investment in the contract and a (nondeductible) insurance expense. (For a discussion of methods of allocating premiums, see Talbot, “Effects of Key-Man Insurance on Stock Basis Can Be Puzzling,” 3 J. S Corp. Tax. (Fall 1991).)
To appreciate the issues involved in preparing Schedule M-2, one must understand the statutory framework of Secs. 1367 and 1368. The 1982 Subchapter S Revision Act created the concept of the AAA as a “layer” of accumulated earnings that can be distributed to shareholders without being taxed as a dividend. Therefore, if an S corporation has E&P from years before its S election, it is important that the corporation calculates its AAA correctly. If the corporation has maintained its S election since inception, there will be no E&P, no potential dividend treatment, and no current need to keep track of AAA. Wise practitioners, however, will maintain the AAA balance correctly on Schedule M-2, as it is always possible that the corporation will combine with another corporation that was once a C corporation.
The definition of AAA in Sec. 1368(e) provides obliquely that AAA is a corporate-level account that “is adjusted . . . in a manner similar to the adjustments under section 1367 (except that no adjustment shall be made for income (and related expenses) which is exempt from tax . . .).” Sec. 1367 is more helpful, as it lists the specific items that increase and decrease the shareholders’ basis in their stock and debt. As it relates to life insurance, Sec. 1367(a)(2)(D) provides that the shareholders’ basis is reduced by “any expense of the corporation not deductible in computing its taxable income and not properly chargeable to capital account.”
This suggests that the shareholders’ basis is reduced by the expense portion of the premium and is not affected by the investment portion. It follows, then, that the negative entry to Schedule M-2 should be only the “cost of insurance” component of the total life insurance premium. Many practitioners simply eliminate the life insurance expense recorded on the company’s books via Schedule M-1 or M-3 and enter the same amount as a nondeductible reduction of AAA or OAA on Schedule M-2. Without further investigation into the components of the book entry, this will likely lead to an incorrect calculation of the shareholders’ basis and the corporation’s AAA.
Having identified the portion of the premium that is recognized as a nondeductible expense, one must still ask whether the expense is charged to AAA or to OAA. Applying the parenthetical language of Sec. 1368(e)(1)(A) quoted above (“no adjustment shall be made for income (and related expenses) which is exempt from tax . . .”) would lead to the conclusion that no part of the insurance premium would reduce AAA, if it is correct to characterize the premium as related to the proceeds from disposition of the policy that might (or might not) be tax-exempt to the corporation. The problem is that the corporation may not know how it will dispose of the policy. There seem to be three possibilities: surrender to the insurance company, sell to a third party, or hold until the death of the insured. In the first instance, reducing AAA by the expense portion creates a mismatch: AAA is reduced, but the investment in the contract is not. Therefore, the gain on the disposition is too small to restore the prior reductions to AAA.
Example 1: An S corporation acquires a life insurance policy with cash value on a key person and pays premiums of $10,000 per year for five years. Each annual premium includes $1,500 of cost of insurance and $8,500 of investment. At the end of the fifth year, the basis of the policy is $42,500, and the investment in the contract is $50,000. At that five-year anniversary, the corporation surrenders the policy and receives $55,000 from the insurance company.
If the nondeductible insurance cost has been charged against AAA, the aggregate reduction in AAA will have been $7,500. The surrender of the policy results in income of $5,000, restoring only $5,000 of AAA. The acquisition and surrender of the policy therefore results in a net reduction of AAA of $2,500.
In this instance, it may actually make more sense to charge the annual insurance cost to OAA. In that case, AAA would increase by the $5,000 gain realized on the surrender, which should be the correct result. Note that the aggregate decrease of $7,500 in OAA is benign, since OAA has no significance to any other calculation. The effect of the mismatch is also felt in the shareholders’ basis. Whether charged to AAA or OAA, the nondeductible cost of insurance reduces the shareholders’ basis under Sec. 1367. The basis also is increased only by the gain recognized upon surrender. So regardless of how the expense is reported, these insurance transactions result in a net decrease in basis.
There are fewer anomalies in the two other dispositions of the policy (sale of the policy or death of the insured). In the case of a sale, because the gain is measured by the basis of the policy, AAA would be restored by the same amount commensurate with the reductions for the nondeductible expense.
Example 2: The facts are the same as in Example 1, except that the corporation sells the policy at the fifth anniversary for $55,000. The gain recognized upon the sale is $12,500. If the cost of insurance had been charged against AAA as the premiums were paid, the net effect of the insurance transactions would be an increase in AAA of $5,000, which is arguably the real economic gain.
In this case, it would make no sense to have charged the insurance cost to OAA; doing so would result in a net increase in AAA of $12,500, which would be an illogical windfall. Since Congress has established that nontaxable death benefits do not increase AAA, the parenthetical exclusion of insurance costs as “related expenses” in Sec. 1368(e)(1)(A) makes sense only if it is known or assumed that the corporation will hold the policy until the death of the insured.
In practice, uncertainty surrounding the accounting for the cost of insurance could make it impossible to correctly characterize distributions from S corporations with E&P. Perhaps more important, a failure to recognize the correct amount of nondeductible insurance costs will result in cumulative miscalculations of the shareholders’ basis. In any case, barring further instructions or interpretations from the IRS, it is appropriate to make an assumption concerning the most likely disposition of the policy and prepare the corporation’s returns consistently with that assumption. Meanwhile, “off-the-return” schedules should keep track of the basis of the policy, the investment in the policy, and the shareholders’ basis in their stock and debt.
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