Dividends or Compensation

March 13, 2024

291 / When are death proceeds of life insurance taxable as dividends or compensation?

<div class="Section1"> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="8776">8776</a>). If the corporation distributes the proceeds to its shareholders, however, the shareholders will be treated as having received a taxable dividend.<a href="#_ftn1" name="_ftnref1">1</a> 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.<a href="#_ftn2" name="_ftnref2">2</a> 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 <a href="javascript:void(0)" class="accordion-cross-reference" id="63">63</a>, Q <a href="javascript:void(0)" class="accordion-cross-reference" id="65">65</a>).<a href="#_ftn3" name="_ftnref3">3</a> 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.<a href="#_ftn4" name="_ftnref4">4</a> The IRS has indicated, however, that the premiums when paid by a corporation may, in some circumstances, be taxed to shareholders as dividends ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="269">269</a>).<a href="#_ftn5" name="_ftnref5">5</a> Where a corporation owns a policy and is not the beneficiary, it appears that the proceeds are taxable as dividends and possibly as compensation. Where the proceeds of a policy were payable to a trustee for the benefit of shareholders but the corporation had substantial ownership rights in the policy, the court conceded that the proceeds were life insurance proceeds but said that they also were in the nature of dividends and under such circumstances, the dividend provisions of the tax law would prevail.<a href="#_ftn6" name="_ftnref6">6</a> The U.S. Court of Appeals for the Sixth Circuit reached an opposite conclusion in the Ducros case. There, a policy was owned by a corporation and individual stockholders were named as revocable beneficiaries in the policy. The court held that the proceeds received by shareholders directly from the insurance company were life insurance proceeds and, therefore, tax-exempt.<a href="#_ftn7" name="_ftnref7">7</a> The IRS has announced its refusal to follow Ducros as precedent in disposing of similar cases.<a href="#_ftn8" name="_ftnref8">8</a> Revenue Ruling 61-134 states that it is the position of the IRS “that life insurance proceeds paid to stockholders of a corporation are taxable as dividends in cases where the corporation uses its earnings to pay the insurance premiums and has all incidents of ownership including the right to name itself beneficiary, even though the corporation does not name itself beneficiary and, therefore, is not entitled to and does not in fact receive the proceeds.” The same principle should apply if proceeds of a corporate owned policy are payable directly to an insured employee’s beneficiary, although the proceeds ordinarily would be taxable compensation rather than dividends. Nonetheless, a Technical Advice Memorandum has held that proceeds of a corporate owned and paid for life insurance policy naming as revocable beneficiary the wife of the insured-stockholder were not dividends because she was not a stockholder and the estate-stockholder was not a beneficiary. The proceeds were not income in respect of a decedent, but rather were life insurance death proceeds received tax-free under IRC Section 101(a).<a href="#_ftn9" name="_ftnref9">9</a> Assuming, but not deciding on, the validity of Treasury Regulation Section 20.2042-1(c)(6) ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="319">319</a>), the Tax Court has held that where a corporation owned insurance on the life of a controlling stockholder and where the beneficiary named by the corporation was the insured’s wife, who owned stock in the corporation, death proceeds were not taxable to the beneficiary as a dividend but were excludable from her income as proceeds of life insurance under IRC Section 101(a)(1).<a href="#_ftn10" name="_ftnref10">10</a> In the case of an S corporation, each shareholder increases basis in the stock by the share of the death proceeds received by the corporation, whether taxable or not. In the event a closing of the books election is made under IRC Section 1377(a)(2) for a cash basis S corporation, the basis increase will be allocated to the surviving shareholders rather than apportioning some of the basis increase to the decedent’s shares.<a href="#_ftn11" name="_ftnref11">11</a> Thereafter, any distribution of proceeds should be determined to be compensation or a distribution with respect to stock as if it were a regular C corporation ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="294">294</a>). Where insurance is used to fund a stock redemption agreement, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="307">307</a>. <div class="refs"> <hr align="left" size="1" width="33%"> <a href="#_ftnref1" name="_ftn1">1</a>.     Rev. Rul. 71-79, 1971-1 CB 112. <a href="#_ftnref2" name="_ftn2">2</a>.     Essenfeld v. Commissioner, 311 F.2d 208 (2d Cir. 1962). <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 101(a). <a href="#_ftnref4" name="_ftn4">4</a>.     Doran v. Commissioner, 246 F.2d 934 (9th Cir. 1957). <a href="#_ftnref5" name="_ftn5">5</a>.     Rev. Rul. 59-184, 1959-1 CB 65. <a href="#_ftnref6" name="_ftn6">6</a>.     Golden v. Commissioner, 113 F.2d 590 (3d Cir. 1940). <a href="#_ftnref7" name="_ftn7">7</a>.     Ducros v. Commissioner, 272 F.2d 49 (6th Cir. 1959). <a href="#_ftnref8" name="_ftn8">8</a>.     Rev. Rul. 61-134, 1961-2 CB 250. <a href="#_ftnref9" name="_ftn9">9</a>.     TAM 8144001. <a href="#_ftnref10" name="_ftn10">10</a>.   Est. of Horne v. Commissioner, 64 TC 1020 (1975), acq. in result, 1980-1 CB 1. <a href="#_ftnref11" name="_ftn11">11</a>.   But see Let. Rul. 200409010. </div></div>