Life Insurance Proceeds and the
Alternative Minimum Tax
What is the alternative minimum
tax?
The alternative minimum tax (AMT) is a
complicated tax calculation that is intended to eliminate the potential for
taxpayers to report large financial profits while reporting little taxable
income for federal income tax purposes, thus paying little or no tax. The AMT
is essentially a separate system of taxation with its own rules and tax
computation methods. It requires the taxpayer to perform a set of calculations
that may result in reclaiming some of the tax breaks otherwise available to
taxpayers. The AMT amount is compared to the tax liability computed under the
regular income tax calculation. If the AMT amount is higher than the regular
tax amount on income, the AMT becomes the tax amount due.
Who is affected by the AMT?
The AMT applies to corporations (except S
corporations) as well as noncorporate taxpayers. This discussion will focus on
the corporate taxpayer. Small corporations are not subject to the alternative
minimum tax. A corporation qualifies as a small corporation if its average
gross receipts are $7.5 million or less over the prior three-year period
(although a lower threshold may apply to a corporation's first three-year
period beginning after December 31, 1993). If the corporation hasn't been in
existence for the entire three-year period, the test will be applied on the
basis of the time during which the corporation has been in existence. When a
corporation qualifies as a small corporation for purposes of the AMT, the AMT
won't apply as long as the corporation's average annual gross receipts for the
prior three-year period don't exceed $7.5 million.
Corporate-owned life insurance
can have an effect on AMT
As part of the risk management plan for your
business, your company may have bought life insurance coverage on a key
employee, such as an officer, manager, or owner. Or, life insurance may have
been purchased to fund a buy-sell agreement. While corporate-owned life
insurance can serve a critical function at the death of a key employee, it also
can cause a C corporation to be subject to the AMT or increase a C
corporation's AMT liability. This doesn't mean the corporation will always be
subject to the AMT if it owns life insurance--the AMT treatment of corporate
owned life insurance is only one of the many factors that are part of the AMT
calculation.
Tip: When
buying corporate-owned life insurance for key person coverage or buy-sell
agreement funding, it may be wise to keep the potential AMT liability in mind.
Proceeds
payable to C corporation could trigger AMT
As a general rule, death benefits from a life
insurance policy are exempt from income tax. However, when a covered employee
dies and the proceeds are paid to the corporation, exposure to the AMT is
increased to the extent that the death benefit exceeds the corporation's basis
in the policy. The basis of the policy for AMT purposes is generally the sum of
the aggregate premiums paid plus any cash value buildup in the policy that has
been included in the corporation's adjusted current earnings (see below). See
the worksheet Calculate the Effect of the AMT on Corporate-Owned Life Insurance
for an example of the effect.
Policy cash
value buildup could trigger AMT
Generally, the internal buildup of the cash
value within a life insurance policy is not subject to income tax unless the
policyowner takes lifetime distributions from or surrenders (cancels) the
policy. However, if life insurance policies owned by a C corporation build cash
values, the increase in cash value could cause the corporation to be subject to
the AMT or increase the corporation's AMT liability. This is because the amount
that the cash value buildup exceeds the premium payments for the year must be
included in the adjusted current earnings calculation (ACE), which is part of
the overall AMT calculation.
Is there any way to avoid the AMT
triggered by the receipt of death benefits on corporate-owned life insurance?
Increase the
amounts of the insurance coverage
The corporation could buy enough additional
insurance on each shareholder to cover any AMT liability triggered by the
receipt of the death benefit. The amount of insurance needed to still have
enough money after the AMT can be calculated in advance. See the worksheet Calculate
the Target Amount of Insurance to Offset AMT for an example. An increase in
insurance will ensure that the after-tax amount of the proceeds is sufficient,
but such a strategy can be difficult if any of the shareholders are
uninsurable. This doesn't avoid the AMT, but it allows for advance planning and
coverage of the tax liability.
Caution: While
this sounds acceptable in theory, there may be an underwriting concern. The
business would likely have to provide justification (and possibly medical
evidence of insurability) for the additional insurance amount applied for.
Check with your insurance advisor.
Elect to
become an S corporation
The AMT does not apply to S corporations.
While changing the form of entity may be an option in certain circumstances, it
may not be the best choice because of all the tax and legal effects involved in
changing the corporate structure
CornerStone Financial
Whether your
nest-egg is worth millions or thousands,
You and your
family deserve it more than the government....
We are here to help you with all of your
financial and insurance needs. Our skilled professionals are licensed with
over 100 top name companies and can help you gain a better understanding of the
concepts behind insurance including investing, retirement and estate
planning. There are literally thousands of products to choose from,
but we can help pinpoint what is best for you and your situation. Please
do not hesitate to contact us if you have questions.
Contact:
Eric Tuttobene
President/CEO
CornerStone
Financial
(615) 427-8780
IMPORTANT DISCLOSURES
The
information presented here is not specific to any individual's personal
circumstances.
To the extent
that this material concerns tax matters, it is not intended or written to be
used, and cannot be used, by a taxpayer for the purpose of avoiding penalties
that may be imposed by law. Each taxpayer should seek independent advice from a
tax professional based on his or her individual circumstances.
These
materials are provided for general information and educational purposes based
upon publicly available information from sources believed to be reliable—we
cannot assure the accuracy or completeness of these materials. The information
in these materials may change at any time and without notice.
