You are here: Home > IRS > IRS Developments

IRS Confirms That Non-Deductible Life Insurance Premiums Do Not Increase Amount That S Corporations That Were Once C Corporations Can Distribute Tax-Free

- by Roger McEowen

September 26, 2008

The IRS has issued a Revenue Ruling stating that the payment of non-deductible life insurance premiums do not decrease the Accumulated Adjustments Account (AAA) of an S corporation.  That's the account that tracks cumulative S corporation income and the amount is reported on Schedule M-2 with Form 1120-S.  S corporation distributions are treated as first coming out of AAA, and if the S corporation used to be a C corporation, the distributions are taxable if there is no AAA left (if the S corporation used to be a C corporation).  So how does the AAA work?  Well, it is increased for S corporation taxable items, but is reduced by taxable losses and expenses (such as expense method depreciation - which is a biggie in 2008).  It's also decreased for permanently non- deductible expenses, but it is not impacted by tax-exempt income and related expenses.  Those items increase basis of the shareholders' stock in the S corporation.  That's what prevents tax-exempt income from being taxable when a shareholder computes gain or loss on the sale or liquidation of the shareholder's interest in the S corporation. 

IRS has now confirmed that the payment of non-deductible life insurance premiums does not decrease AAA, but decreases shareholder basis.  That's a no- brainer that leaves one wondering why IRS even bothered issuing the Revenue Ruling.  Maybe some practitioners were confused on the issue. 

Unfortunately, IRS left an issue on the table - how to treat the payment of life insurance premiums if the life insurance policy becomes taxable.  That can happen if the S corporation either cashes out the policy or its value exceeds the cumulative premiums that have been paid.  In that case, the excess of the surrender proceeds over cumulative premiums that have been paid (and any surrender proceeds) would be taxable income and would increase AAA.  It would have been nice if IRS had stated its position on that issue.  Rev. Rul. 2008-42, 2008-30, I.R.B. 1.