291 / When are death proceeds of life insurance taxable as dividends or compensation?
Proceeds that have been received tax-free by a C corporation lose their tax-exempt character as life insurance proceeds on distribution to employees or shareholders. Consequently, where a corporation is both owner and beneficiary of a policy, the proceeds generally will be tax-free to the corporation (but see Q 8776). If the corporation distributes the proceeds to its shareholders, however, the shareholders will be treated as having received a taxable dividend.1
If an insured is an employee and proceeds are received by a corporation and then paid to the employee’s widow or other personal beneficiary under the terms of an employment contract, they may be treated as taxable compensation for the employee’s past services.2
On the other hand, if a corporation has no ownership rights in a policy and is not the beneficiary, proceeds should be received tax–free by the beneficiary as life insurance proceeds ( Q 63, Q 65).3 Where a corporation paid the premiums on a policy that was held by a trustee for the benefit of certain shareholders and the corporation had no ownership rights in the policy, the court held the proceeds received by the shareholders were tax-exempt life insurance proceeds.4 The IRS has indicated, however, that the premiums when paid by a corporation may, in some circumstances, be taxed to shareholders as dividends ( Q 269).5