Plan Ahead for Business Continuity and Your Family's Estate

Your company holds a policy on your life. You want to know whether its payout can help cover your estate’s tax bill. The short answer: the business can receive the key person insurance proceeds, but using them to pay your personal estate tax is a separate step that does not happen automatically.

Whether that step works depends on who owns the policy, who is named as beneficiary, how the company is organized, and how money moves from the company to your estate. Here is each link, in plain words.

The business receives the money, but estate tax is a separate question

A key person policy that the business owns and pays for usually pays its death benefit to the business. The company then holds that money and can use it for business purposes.

The Insurance Information Institute explains that a key employee’s death can cause financial losses to a business. Key person life insurance compensates the business for those losses (Insurance Information Institute guide). Typical uses include covering lost revenue or paying down business debt.

Using that cash to pay your personal estate tax is a different step. The company is one pot of money. Your estate is another. Moving money between them is the link that needs planning, and it should be reviewed before anyone moves it.

A common mistake is assuming the payout automatically covers the estate’s tax bill. The payout goes to the company first. Our key person insurance overview covers the general framework.

When policy proceeds count toward the estate

The estate tax falls on the estate, not on the company. The federal estate tax is payable by the executor or administrator of the decedent’s estate (estate tax liability rules). The executor is the person who manages the estate’s affairs.

When it receives a death benefit, that receipt does not, by itself, settle the owner’s personal tax bill. The company’s money and the estate’s obligation are two different things.

The liability rules also reach beneficiaries. If estate tax is not paid when due, a beneficiary who receives, or has on the date of death, property included in the gross estate under sections 2034 through 2042 (which include life insurance under section 2042) can be personally liable, up to that property’s value at death (estate tax liability rules).

Timing matters too. Estate tax returns must be filed within 9 months after the date of death (IRC § 6075). Cash planning should start well before that deadline, not after the funeral.

Who owns the policy and who is the beneficiary decides where proceeds land

When the business owns the policy and is the beneficiary, the proceeds flow to the business. When the owner personally owns the policy, or the estate is the beneficiary, the proceeds can count in the owner’s estate.

The federal rule is broad. Under IRC § 2042, life insurance proceeds are included in the gross estate to the extent of the amount receivable by the executor as insurance under policies on the life of the decedent. They are also included, to the extent of the amount receivable by all other beneficiaries, when other beneficiaries receive them and the decedent held an incident of ownership at death, alone or together with another person. Under IRC § 2042(2), the term “incident of ownership” includes a reversionary interest (whether arising by the express terms of the policy or other instrument or by operation of law) only if the value of such reversionary interest exceeded 5 percent of the value of the policy immediately before the death of the decedent.

Ownership and beneficiary designations are not permanent. They are set when the policy is issued, and they can often be changed later. That is why the policy should be reviewed alongside the estate plan and the company’s documents.

A frequent problem is a designation set years ago that no one has checked since. The company may have changed, the owners may have changed, or the estate plan may have moved on. The old setup then controls where the money goes.

How the company’s structure changes the path to the estate

The route from company cash to an owner’s estate depends on how the business is organized and taxed. A single-owner LLC, a multi-owner LLC and a corporation each handle ownership and payouts differently.

For corporations, the federal regulation gives a specific rule. When deciding whether a corporation’s incidents of ownership in a policy are attributed to an owner, the regulation treats the owner as the controlling stockholder only if he or she owned stock with more than 50 percent of the total combined voting power at death.

Under 26 C.F.R. § 20.2042-1, proceeds of insurance receivable by the executor or administrator, or payable to the decedent’s estate, are included in the gross estate.

Moving money out of the company is a separate event. A payment from the company to an owner or the estate can be a distribution, a redemption of shares or another payment with its own tax treatment. Those moves should be documented and reviewed before cash changes hands.

Income tax is also a separate question. The IRS states that the general rule is that life insurance death benefits are excluded from gross income for federal income tax, but interest received on the proceeds is taxable (IRS life insurance proceeds FAQ).

Buy-sell agreements and the estate’s need for cash

A buy-sell agreement can use life insurance to fund the purchase of a deceased owner’s interest. That purchase can give the estate the cash it needs, which connects the policy to estate costs.

Federal law also offers a payment option for some closely held business owners. Under IRC § 6166, an executor may elect to pay part or all of the estate tax in 2 or more (but not more than 10) equal installments, provided the decedent was, at the date of death, a citizen or resident of the United States and the closely held business interest meets the statute’s test of more than 35 percent of the adjusted gross estate. The election is the executor’s to make, so it is not automatic.

The buy-sell terms, the valuation method and the funding method should be reviewed together. The agreement sets the price. The policy supplies the money. The ownership decides who collects it.

One mismatch causes real trouble: the agreement says the company buys the interest, but the policy is owned personally. When the documents disagree, the cash may not reach the estate when the family expects. A buy-sell agreement insurance review checks that these pieces line up.

Foreign owners and sole proprietors need extra facts

Facts such as citizenship, residence, or a death outside the United States can change the analysis. A policy owned by a non-U.S. person, or proceeds payable to someone abroad, raises questions that belong in the same review as the rest of the plan.

A sole proprietor has no separate company. The business assets belong to the owner, so the starting point is the owner’s estate, not a company’s balance sheet. That difference changes how the proceeds are read and where they land.

Write these facts down before the first meeting. Dates of birth, residence history, citizenship and the owner’s voting or ownership percentages help show which rules apply.

Questions to bring to a coverage review

Gather the policy and its owner and beneficiary designations. Add the operating agreement or bylaws, any buy-sell agreement, and the most recent estate plan. These documents show who owns what and where the proceeds would go.

NR CPAs & Business Advisors is a Miami CPA firm. Insurance is offered by the firm’s licensed insurance agent, separately from the accounting practice, and the agent is paid commissions by insurance carriers on policies sold. Under Fla. Stat. § 473.3205, a CPA firm that accepts a commission on a product sold to a client must disclose that fact in writing. Under Florida law, a certified public accountant or firm that accepts a commission for the sale of a product or service to a client must disclose that fact to the client in writing, in accordance with rules adopted by the board.

For estate-related coverage questions, see our estate planning life insurance review.

Bring your situation to a coverage review

If your company holds a policy on your life and you’re not sure its proceeds can reach your family or cover estate costs, a coverage review is a good next step. Nischay Rawal is acting as a licensed insurance agent on this question, and our team can walk through your documents with you. Contact NR CPAs & Business Advisors to start the conversation.