Life Insurance for Business Owners: Tax-Efficient Strategies in the U.S.

Life insurance isn’t just about providing for loved ones after death – it can be a powerful tax planning tool for business owners. By strategically using life insurance, owners of sole proprietorships, partnerships (LLCs), and corporations can address succession, reward key people, protect the business, and even supplement retirement, all with significant tax benefits. This report explores how different business structures leverage various life insurance policies (term, whole life, universal life) for tax efficiency. We’ll examine key strategies – funding buy-sell agreements, executive bonus plans, key person insurance, estate tax planning, and using life insurance for retirement income – detailing the tax advantages and potential drawbacks of each. Tables and examples are included to compare policy types and summarize the benefits of each strategy.

Tax Advantages of Life Insurance: An Overview

Life insurance enjoys unique tax-favored treatment under U.S. law, which forms the foundation of these strategies. Notably, the death benefit paid to beneficiaries is generally income-tax freeinvestopedia.com. No matter the amount – whether a $50,000 policy or $50 million – your beneficiaries won’t owe income tax on life insurance proceedsinvestopedia.com. (This contrasts with inherited IRAs or annuities, which often come with income tax obligations for heirsinvestopedia.com.) However, if the insured person owns the policy at death, the payout is counted as part of their estate for estate tax purposesinvestopedia.com. With a current federal estate tax exemption of about $14 million per individual in 2025 (set to drop to roughly $7 million in 2026 absent new legislation)bristertaxlaw.com, most small business owners today aren’t subject to estate tax – but those with larger estates or planning for future tax law changes must consider this in their strategy.

Life insurance with a cash value (such as whole life or certain universal life policies) also offers living tax benefits. Cash value grows tax-deferred inside the policy – no taxes are due on interest, dividends, or investment gains as they accumulatenationwide.com. Policy owners can access this cash value through withdrawals or loans, often tax-free if done properlyinvestopedia.cominvestopedia.com. For example, you can withdraw up to your basis (the amount you paid in premiums) with no tax, and you can borrow against the cash value without triggering income tax – the loan is not treated as taxable income as long as the policy stays in forceinvestopedia.com. This means a life insurance policy can serve as a source of funds (for retirement income, emergencies, business needs, etc.) without immediate tax, and any remaining loan balance is simply deducted from the death benefit when you dieinvestopedia.com. Important: If loans and withdrawals aren’t managed carefully, the policy could lapse, causing the accumulated gains to become taxable all at onceinvestopedia.com. Still, with prudent use, these tax features make permanent life insurance a versatile planning tool.

In short, life insurance offers a triple tax advantage: (1) premiums are paid with after-tax dollars but grow tax-deferred inside the policynationwide.com, (2) policy loans or withdrawals can provide tax-free cash flow during lifeinvestopedia.com, and (3) the death benefit delivers a tax-free lump sum to beneficiariesinvestopedia.com. Business owners can harness these benefits in various ways to meet business planning goals in a tax-efficient manner, as we explore below.

Types of Life Insurance Policies and Their Uses

Business planning can utilize different types of life insurance, primarily term life, whole life, and universal life. Each has distinct features that make it suitable for certain strategies:

• Term Life Insurance: Term insurance covers a fixed period (e.g. 10, 20, or 30 years) with no cash value. It is affordable and ideal for temporary needsbristertaxlaw.com. For example, term is often used to cover debts or a buy-sell obligation expected to exist only for a certain timebristertaxlaw.com. If the insured doesn’t die during the term, the policy simply expires with no payout or residual value. There are typically no special tax benefits beyond the basic tax-free death benefit (since no cash value accumulates). Term premiums are usually lower, making it cost-effective to get high coverage for critical periods (such as until a loan is paid off or until a key retirement date). However, term policies eventually expire; renewing at older ages can become prohibitively expensive or impossible if health deterioratesguardianlife.com. Thus, term works best when the insurance need is substantial but temporary or when budget is a primary concern.

• Whole Life Insurance: Whole life is a type of permanent life insurance that covers the insured’s entire lifetime (as long as premiums are paid). Premiums are higher than term for the same death benefit, but part of each payment goes into a guaranteed cash value that builds over time, tax-deferrednationwide.com. Whole life offers fixed, level premiums and the cash value grows at a predetermined or dividend-supported rate, making it a stable asset for long-term planningguardianlife.com. This policy is suited for long-term and lifelong needs – for example, funding eventual estate taxes or providing an inheritance, because the death benefit is guaranteed to be paid out at some point (assuming the policy is kept in force). Whole life’s cash value can be borrowed against tax-free, providing a reserve for opportunities or emergenciesguardianlife.com. Business owners may use whole life to informally fund future obligations (like buyout obligations or executive benefits) while enjoying the policy’s growth. The tax advantages include the tax-deferred accumulation and the ability to take loans without immediate taxationnationwide.comnationwide.com. A drawback is cost – high premiums can strain cash flow, and the internal rate of return on the cash value is moderate due to insurance expenses. Still, for permanent needs and stable growth, whole life is a reliable choice.

• Universal Life Insurance: Universal life (UL) is another form of permanent insurance, but with flexible premiums and adjustable benefits. UL policies can be designed with various interest-crediting strategies. A traditional UL credits a declared interest rate; indexed UL ties crediting to an index (like the S&P 500) with caps/floors; variable UL allows sub-account investments in market funds. In any case, cash value in a UL grows tax-deferred similar to whole lifeguardianlife.com. UL’s flexibility lets owners increase or decrease premium payments within certain limits, which can be useful if a business’s cash flow is unpredictable. Some UL policies can accumulate significant cash value if funded aggressively, offering more upside potential (especially VUL with market-based growth) – though investment-based policies also carry market risk and higher management feesguardianlife.com. Permanent policies (whole or UL) are often favored for strategies where longevity and cash value matter: e.g., funding a buy-sell for as long as the business exists, providing a source of loans to the company, or supplementing retirement for the owner. They cost more, but they ensure coverage will be in place whenever death occurs, which is vital for estate liquidity plans or long-term buyoutsguardianlife.com.

To summarize these differences, the table below compares key features:

Both whole life and UL are forms of permanent insurance – the choice often comes down to preference for fixed guarantees (whole life) versus flexibility and potentially greater growth (UL). Term vs. Permanent: Many business plans use term insurance for short-term risks and permanent insurance for enduring needs. For example, an owner might buy a 20-year term policy to cover a bank loan or a younger partner’s buyout, but use a permanent policy to eventually provide estate liquidity or fund a buy-sell that will be needed whenever they diebristertaxlaw.combristertaxlaw.com.

Impact of Business Structure on Life Insurance Strategy

Business structure (sole proprietorship, partnership/LLC, S corporation, C corporation) affects how life insurance strategies are implemented and taxed:

• Sole Proprietorship: The business and owner are one and the same, so any life insurance on the owner is essentially a personal policy. Premiums for a sole proprietor’s own life insurance are not tax-deductible, as they are considered personal expenses (the IRS disallows deducting personal life insurance)nationwide.com. However, a sole proprietor can still use life insurance for business purposes – for instance, to ensure funds to pay off business debts or provide for the family if the owner dies. A policy on the owner can act like “key person” coverage, giving heirs cash to close the business and settle obligations without distress salesguardianlife.com. Life insurance can also facilitate estate planning for a sole proprietor: since the business doesn’t continue without the owner, a policy can provide for the owner’s family or fund a planned sale or succession (perhaps a key employee could use insurance proceeds to buy the business from the estate). For employees of a sole prop, the owner may provide group life or even an executive bonus plan as an employee benefit (those premiums could be deductible as a compensation expense if the business is not the beneficiary)nationwide.com. But for the owner themselves, sole proprietors generally get no tax break for life insurance – the benefit comes on the back end (tax-free death benefit or loans), not upfront deductions.

• Partnerships and LLCs (taxed as partnerships): In a partnership or multi-member LLC, the business is a separate entity, but it doesn’t pay its own income tax (profits and losses flow through to partners). Life insurance is commonly used to fund buy-sell agreements between partners or to protect against the loss of a key partner or employee. Premiums paid by the partnership for policies on partners are usually not deductible (because the partnership is typically a beneficiary or the partner’s family is – making it a capital or personal expense, not a business expense). If the partnership pays and owns a policy on a partner (as in an entity purchase buy-sell or key person plan), the premiums are paid with after-tax dollars (reducing the partners’ taxable income allocation, effectively each partner bears a share of the cost). The death benefit, however, is received tax-free by the partnership, and that tax-exempt income increases the capital accounts/basis of the partners who ultimately benefitguardianlife.com. One drawback in a partnership entity-owned policy is that the surviving partners do not get a step-up in cost basis for the deceased partner’s share when the business interest is redeemed using insurance proceeds – a key difference we’ll discuss under buy-sell agreementskitces.com. For this reason, many partnerships opt for cross-purchase arrangements (each partner owns insurance on the others) despite administrative complexity. Partnerships cannot use traditional corporate benefit plans for their partners (partners aren’t W-2 employees), so executive bonus plans don’t provide the same tax advantage for partner-owners. If a partnership were to pay a “bonus” to a partner to buy life insurance, that bonus is generally treated as a guaranteed payment or distribution – deductible to the partnership but also taxable to the partner, resulting in no net tax benefit to the owner. In fact, advisors note that a Section 162 executive bonus plan “does not offer any tax benefit for business owners if the business is an S-corp, partnership or LLC taxed as partnership”robertsandlawson.com. However, for non-owner employees of an LLC/partnership, an executive bonus plan can be used normally (the partnership can deduct the bonus as compensation, and the employee is taxed on it)robertsandlawson.com. In summary, partnerships should structure life insurance plans carefully: use cross-purchase to maximize basis benefits, and understand that any “benefit” given to an owner through the business (like paying their policy premium) will flow back to them as taxable income or reduced equity, yielding no magic tax savings.

• S Corporations: S-corps are pass-through entities like partnerships (profits taxed to owners), but they can have W-2 employees (including owner-employees). Life insurance usage in S-corps is similar to partnerships in many ways. Buy-sell agreements among S-corp shareholders often favor cross-purchase for the same reasons (basis step-up for survivors and avoiding potential entity-level complications). If the S-corp owns policies on shareholders (entity redemption plan), the premiums are not deductible and the death proceeds come into the corporation tax-free. That tax-free income increases the S-corp’s accumulated adjustments account and shareholder stock basis, but the surviving shareholders don’t get a new cost basis in their shares since the corporation redeemed the deceased’s shareskitces.com. Additionally, just as with partnerships, paying premiums for an owner’s policy through the S-corp doesn’t really save taxes – the corporation can deduct it as compensation only if it’s treated as a bonus to the owner, in which case the owner is taxed on it (essentially the same outcome as just paying personally). A benefit of S-corps is that executive bonus plans can be implemented for owner-employees in a straightforward way (since owners drawing a salary are treated like employees for compensation). The S-corp can bonus an amount to the owner, deduct it, and the owner picks up that amount in taxable W-2 income, then uses it to pay the policy premium. But because the S-corp’s deduction lowers the pass-through income to that owner anyway, this usually provides no net tax advantage for an S-corp owner (it’s effectively moving taxable income from K-1 into W-2 form). As one insurance advisor put it, a 162 bonus plan works great for non-owner key employees in any entity, but for owners in an S-corp or partnership, “the plan does not offer a tax benefit” (since you’re essentially bonusing yourself your own pass-through profits)robertsandlawson.com. Still, S-corps can use life insurance in creative ways: e.g., an S-corp might fund policies on key employees as a selective benefit (deducting the bonus paid) or own key person insurance on a vital employee/shareholder (to protect the company’s value). Keep in mind S-corp owners (over 2% shareholders) are treated similarly to partners for some fringe benefits – for instance, any company-paid group life insurance over $50k is taxable to the owner – but this doesn’t change the fundamental tax treatment of life insurance premiums (no deduction if the company is beneficiary).

• C Corporations: C-corps are separate taxable entities (paying corporate tax on profits). This allows some unique opportunities and considerations for life insurance. A C-corp can pay an executive bonus to any employee (including an owner-employee) to fund a life insurance policy and deduct that bonus as a business expense under IRC §162bolicoli.comrobertsandlawson.com. The employee is taxed on the bonus as compensation, but ends up owning a policy with cash value and a personal death benefit. For non-owner employees, this is purely a benefit; for owner-employees, it’s essentially a way to withdraw profits as a taxable bonus and get them into a personal policy. Depending on the tax rates, this could be advantageous if the corporation’s tax rate is lower than the individual’s, or if the goal is to accumulate cash value outside the company. C-corps also commonly use company-owned life insurance (COLI) to informally fund obligations like deferred compensation or to insure key people. Premiums for corporate-owned life insurance are not deductible (unless it’s providing an employee benefit where the employee, not the company, is the beneficiary)keypersoninsurance.comguardianlife.com. The death benefits from a COLI policy are generally received tax-free by the corporation, which can then use those funds for the intended purpose (buy out shares, pay a deferred comp promise, cover losses, etc.). One tax nuance: corporations must comply with IRC §101(j) (the “employer-owned life insurance” rules) when insuring employees. This means obtaining the employee’s written consent before policy issuance and meeting certain notice requirements, or else the death benefit in excess of premiums can become taxable income to the companykitces.com. (These rules were put in place to prevent abuses of corporate-owned policies on employees.) Assuming compliance, the tax-free death benefit can provide a corporation a large influx of cash at a critical time with no income tax due – a major advantage. C-corps do need to consider the alternative minimum tax (AMT) in some cases (in prior law, large life insurance proceeds could trigger corporate AMT adjustments, though post-2017 corporate AMT is largely repealed for small/medium corporations). Another consideration: if a C-corp receives life insurance proceeds and distributes them as dividends to shareholders, those dividends would be taxable to the shareholders. But if the corporation uses the money for a stock redemption (buying out the deceased owner’s shares), that can often be structured to avoid dividend treatment (qualifying instead as a sale/exchange for the estate). Overall, C-corps have more flexibility to use company funds for life insurance (since there’s a separate corporate tax to potentially save), but they also face the possibility of a double tax (corporate and then personal) if not coordinated. Thus, careful planning is needed to ensure the strategy delivers a net benefit.

In summary, all business types can benefit from life insurance planning, but the mechanics differ. Pass-through entities (LLCs, partnerships, S-corps) typically use life insurance to protect value and provide liquidity (buyouts, key person, estate liquidity), without expecting an upfront tax deduction for premiums (except for true employee benefit situations). C-corps may derive a current tax deduction by structuring premiums as compensation (bonus plans) but still can’t deduct premiums where the corporation is the beneficiary. The real payoff comes when death benefits arrive tax-free, or when cash values are accessed tax-advantaged, to meet a business need. Each of the following strategies leverages those tax-free proceeds or accumulations in different ways to meet specific goals.

Funding Buy-Sell Agreements with Life Insurance

Buy-sell agreements are contracts that arrange for the sale of a business owner’s interest upon death, disability, or other trigger events. Life insurance is a common funding method for buy-sell agreements, because it instantly provides liquidity when an owner dies – exactly when funds are needed to buy out that owner’s share. Without insurance, the surviving owner(s) or the business might not have the cash to purchase the shares from the deceased’s estate, potentially leading to a forced sale or unwanted new partners (like the deceased owner’s family). Life insurance ensures the buy-sell plan can be executed smoothly: the remaining owners or the business get cash, and the deceased owner’s heirs get fair compensation for the business interestbristertaxlaw.com.

There are two primary structures for buy-sell life insurance funding: cross-purchase and entity purchase (redemption) agreements:

• Cross-Purchase Agreement: Each business owner buys a life insurance policy on the other owner(s). When one owner dies, the surviving owner(s) receive the insurance payout and use it to buy the deceased’s ownership share per the buy-sell contract. For example, if two partners each own 50% of a company valued at $1 million, each can own a policy on the other for $500,000. If Partner A dies, Partner B collects $500k tax-free and pays that to A’s estate in exchange for A’s 50% stock – leaving B as 100% owner without having to spend personal or business cashkitces.com. The tax advantages of a cross-purchase are: (1) Death benefits are income-tax free to the survivors (as life insurance proceeds)bristertaxlaw.com, and (2) critically, the surviving owners get a step-up in tax basis for the shares they acquire. Because each surviving owner personally purchases the deceased’s interest at fair value, their cost basis in those shares is now equal to the purchase pricekitces.com. This can reduce capital gains if the business is sold later. In contrast, an entity redemption (below) often does not give owners a basis step-up. Cross-purchase plans also avoid the insurance proceeds becoming entangled with the company’s assets – the money goes directly to the buyer (survivor) and then to the seller’s estate. Drawbacks: Cross-purchase agreements can be cumbersome when there are multiple owners. Each owner needs to hold policies on each co-owner, which means the number of policies grows exponentially as owners are added. For n owners, you might need n×(n–1) policies. kitces.com In a 3-owner business, that’s 6 policies; with 5 owners, 20 policies; with 10 owners, a whopping 90 policies – each to be maintained and adjusted as ownership changes! This complexity can be impractical for large groups.

As the number of owners increases, a cross-purchase buy-sell agreement becomes exponentially more complex to insure. Each dot represents an owner and each line a life insurance policy on one owner payable to another. A 3-owner company requires 6 policies, 5 owners need 20, and 10 owners would involve 90 separate policieskitces.com.

Beyond administrative burden, cross-purchase plans can create premium inequities: if owners are of different ages or health status, the younger/healthier ones pay relatively low premiums to insure an older partner, while the older partner faces very high premiums to insure the younger onekitces.com. The business could even out this cost disparity by compensating owners for premiums (via bonuses or adjusted distributions), but that adds complexity and tax reporting (the reimbursements would be taxable to the owners)kitces.com. Additionally, if an owner leaves or the agreement is terminated, transferring ownership of the policies among owners can be tricky – it must be handled carefully to avoid triggering taxable events (transfer-for-value rule). There are advanced solutions, such as using a “life insurance LLC” to hold all policies for the owners as a trusteed cross-purchase, which can simplify administration and avoid transfer-for-value issuesdurfeelawgroup.comdurfeelawgroup.com. But in general, cross-purchase works best for smaller firms with few owners (or for larger firms if a special trustee or LLC is used to consolidate policies).

• Entity Purchase (Redemption) Agreement: Here, the business entity itself buys a life insurance policy on each owner (often equal to that owner’s equity value). When an owner dies, the company receives the insurance proceeds and uses them to redeem (buy back) the owner’s shares from the estate. The end result is similar – the surviving owners’ percentage ownership increases because the deceased’s shares are canceled – but the mechanics and tax results differ. Entity-funded agreements are simpler to administer for multiple owners: the business only needs one policy per ownerkitces.com. For example, a corporation with five shareholders would take out five policies (one on each shareholder’s life, payable to the company). This avoids the tangled web of cross-owned policies and is a major reason larger companies favor the entity approachkitces.com. Also, premium costs are borne by the company, which effectively spreads the economic burden among all owners according to their ownership (since the cost may reduce the company’s profits). There’s no issue of one owner paying more for another’s policy – the company pays all, typically from pre-dividend dollars. Tax-wise, the insurance premiums are not deductible to the business (life insurance used for this purpose is a capital expense). The death benefit comes into the company income-tax free, usually at the precise amount needed to fulfill the buyout. However, the surviving owners do not get a basis step-up in their shares because they didn’t personally purchase any additional shares – they simply own a larger percentage of the company after the redemption. Their original basis remains, effectively “stretching” over a larger ownership stake, which can mean a bigger taxable gain if they sell in the futurekitces.com. Another consideration: if the business is a corporation, life insurance proceeds might slightly affect its tax attributes. Although the proceeds are tax-exempt, in a C-corp they may increase earnings & profits (which can affect the ability to pay dividends without tax). And for an S-corp or partnership, the proceeds, being tax-exempt income, increase the owners’ basis in the entity (which is actually a good thing as it may allow more post-tax distributions). One critical requirement for entity-owned policies is compliance with IRC §101(j) (mentioned earlier). The company must have the insured executive/owner’s written consent before policy issuance and meet notice requirements, or else a portion of the death benefit could be taxablekitces.com. Fortunately, this is a simple one-time paperwork matter in practice.

The biggest new concern with entity redemption plans came from a recent legal development: Connelly v. IRS (2023-2024). In this case, the IRS successfully argued (and the U.S. Supreme Court agreed) that when a company receives life insurance proceeds and uses them to buy out a deceased owner’s shares, those insurance proceeds increase the value of the business for estate tax purposeskitces.comkitces.com. In Connelly, a majority owner died and the company’s $3.5 million insurance payout was used to redeem his shares for $3 million (per a buy-sell agreement). The estate reported the shares’ value at $3 million, but the IRS said the company was actually worth $3 million plus the $3 million insurance it received (minus what it paid out) – resulting in a higher estate valuation and nearly $890,000 in additional estate taxes owedkitces.com. The Supreme Court upheld this, essentially saying life insurance proceeds to a company aren’t “free” from estate tax if they boost the company’s value in the estate. This outcome alarmed many practitioners because it means a standard entity buy-sell funded with insurance could inadvertently inflate an owner’s taxable estate. It’s a nuanced issue (applying mainly if the decedent owned a large portion of the company), but the planning implication is to be careful with entity agreements for owners whose estates might be taxable. Some strategies to avoid this problem include using cross-purchase agreements or the above-mentioned Life Insurance LLC (which is treated as a partnership that avoids the estate inclusion issue by preventing proceeds from benefitting the decedent’s own estate)durfeelawgroup.comdurfeelawgroup.com. Planners now often revisit clients’ buy-sell structures in light of Connelly. For many small businesses, if estate tax isn’t a concern (estate under the exemption), this issue may be moot. But for larger estates, cross-purchase or a trust-owned policy might be safer to ensure the insurance money doesn’t inadvertently increase estate tax.

Choosing cross-purchase vs. entity: Cross-purchase offers the tax basis step-up and avoids company-level entanglements, whereas entity purchase is administratively easier, especially as the number of owners grows. Some agreements even switch structure over time (e.g., start as cross-purchase when there are two owners, but allow a conversion to an entity plan if there are later many owners or if owners are very unequal in age). In some cases, businesses use a hybrid approach: for example, each owner might own their policy, but they agree to have the company be able to buy the policy or redirect it if someone leaves (to avoid transfer-for-value issues). Or an LLC is created specifically to own all the policies (a “trusteed buy-sell” or “insurance LLC” approach) to combine the simplicity of one-policy-per-owner with the tax benefits of cross-purchasedurfeelawgroup.comdurfeelawgroup.com.

Tax summary for buy-sell funding: Premiums for life insurance (whether cross or entity) are paid with after-tax dollars (no deduction), but the payout is tax-free when needed most, providing crucial liquiditybristertaxlaw.com. In a cross-purchase, the surviving owners use that tax-free money to acquire shares (and get basis step-up) – no taxes on the exchange itself either, since typically it’s treated as purchase/sale of a capital asset for cash (and the estate often doesn’t have a gain due to step-up in decedent’s stock basis to fair value at death). In an entity redemption, the corporation or LLC uses the tax-free cash to redeem shares. That redemption might be structured to avoid dividend treatment for the estate (to be treated as a sale or exchange under IRC §302, certain conditions must be met, often it’s not a problem if it’s a complete termination of the shareholder’s interest). The key tax advantage here is preventing a liquidity crisis and preserving business value without incurring debt or selling assets, all financed by tax-free life insurance proceedsbristertaxlaw.combristertaxlaw.com. The downside is simply that life insurance premiums are not deductible – but that’s a small price to pay compared to the potentially enormous benefit at an unpredictable time.

Example: Imagine a family-owned LLC with two members, each owning 50%. The company is worth $2 million ($1M each share). They sign a cross-purchase buy-sell and each takes out a $1M term life policy on the other. One owner unexpectedly dies; the survivor collects the $1M death benefit tax-free, pays it to the deceased’s family for their company share, and thereby becomes 100% owner of a now $2M-valued business – all accomplished seamlessly because the cash was available exactly when neededkitces.com. The deceased’s family receives the $1M in cash (free of income tax) instead of an illiquid 50% business interest, and the survivor can continue the business without outside interference. No loans had to be taken, and no assets sold. The only “cost” was the insurance premiums paid over the years (non-deductible). If, instead, the LLC had done an entity redemption plan, the LLC would own the $1M policy on each member. After one’s death, the LLC gets $1M and pays it to the estate for the share. The outcome is similar, but for tax: the surviving member’s basis in the company remains whatever it was originally, whereas in the cross-purchase scenario the survivor had effectively invested an additional $1M (via the insurance payout) to acquire the other half, giving a stepped-up basis in that portion. Depending on future plans, that could be significant (e.g., if they later sell the business, less taxable gain in cross-purchase scenario). This example shows why cross-purchase is often preferred for smaller setups, while entity purchase is chosen for practicality in larger ones despite the basis trade-off. In either case, life insurance funds the succession plan in a tax-efficient waybristertaxlaw.com, ensuring the business continuity and liquidity when it’s most needed.

Executive Bonus Plans (Section 162 Plans)

An Executive Bonus Plan, also known by its tax code reference Section 162 plan, is a strategy for companies to compensate key individuals by paying for a life insurance policy on their behalf. The company bonuses an amount to a key employee, who then uses that money to pay the premium on a personally owned life insurance policy. The arrangement provides the employee with valuable life insurance protection (and potential cash value), while the company treats the bonus as a tax-deductible compensation expensebolicoli.comrobertsandlawson.com. In essence, it’s a way to selectively reward and retain key people with a benefit that has tax advantages for both parties: the company deducts the cost, and the employee receives life insurance (with all its tax-free benefits) largely at no out-of-pocket cost (aside from any tax on the bonus).

Under a basic Section 162 plan: the employer decides who participates and how much to bonusrobertsandlawson.com (unlike qualified retirement plans, it can be selective – you might do this just for one or two top executives without having to include everyone). The company pays the insurance premium as a bonus, which is taxable income to the employee and reported on their W-2robertsandlawson.com. Because it’s taxable, the bonus amount must be “reasonable” compensation for the service provided (to be deductible), but typically this is not an issue when it’s truly for key employeeshenssler.com. The employee then owns the life insurance policy – ownership stays with the employee (or a trust they designate), not the employerbolicoli.com. This means the employee can name their own beneficiary (usually their family) to receive the death benefit, and they have rights to the policy’s cash value (with some exceptions if there’s a temporary restriction, discussed below)bolicoli.combolicoli.com.

From the company’s perspective, the advantage is straightforward: the bonus (premium) is fully tax-deductible as an ordinary business expense (as long as total compensation is reasonable)bolicoli.comrobertsandlawson.com. This contrasts with the company paying for a life insurance policy that it owns – those premiums would not be deductible. Here, because it’s structured as additional compensation to the employee, it qualifies as a deduction. The plan is simple to implement – it doesn’t require IRS approval or complex filings like a qualified retirement plan wouldrobertsandlawson.com. There’s no nondiscrimination rule requiring you to cover lower-paid workers; you can selectively reward key executives as you see fitbolicoli.com. The executive bonus plan is also flexible: you can increase, decrease, or stop bonuses any time (subject to employment agreements). It effectively gives a golden-handcuff benefit to the employee: they get a life insurance policy that can accumulate cash and ultimately benefit their family, which incentivizes them to stay with the company.

From the employee’s perspective, they receive a paid-up life insurance policy (or one with ongoing premiums paid by the company). They do have to pay income tax on the bonus amount (since it’s W-2 income)robertsandlawson.com, but often the employer will “double bonus” – i.e., pay an extra amount intended to cover the recipient’s tax liability, so the employee nets out with no cost. In a Double Bonus Plan, the company gives, say, enough to pay the premium and the taxes on that total bonus, leaving the employee with the policy free and clearbolicoli.com. That extra amount is also deductible. The result is the employee is not out of pocket for either the premium or the tax. For example, if the premium is $10,000 and the employee is in a 32% tax bracket, the company might pay about $14,700 – $10k goes to premium, and ~$4.7k goes to the IRS (the tax on $14.7k of income), leaving the employee with the net $10k benefit. The employee ends up owning a potentially sizable life insurance benefit with little or no personal expense.

A potential twist is the “Restricted” Executive Bonus (REBA), also called a Controlled Executive Bonus arrangementbolicoli.com. Since the employee owns the policy outright in a basic plan, one concern for the employer is that the employee could quit the company and still keep the life insurance (the company has no recovery – it was a true bonus). To encourage retention, the employer and employee can sign an agreement that places a temporary restriction on accessing the policy’s cash value for a certain number of years. This is typically done via a collateral assignment on the policy: if the employee tries to surrender or withdraw cash before a specified date, the employer is entitled to recover some or all of the bonus paid. Effectively, the policy is “vested” over timebolicoli.com. If the employee stays until the agreed date, the restriction is lifted and they have full control; if they leave early, the agreement might allow the employer to recoup its bonuses or the cash value (though in practice, enforcement can be tricky). This creates “golden handcuffs” – the employee has an incentive to stay until vested to gain full benefitsbolicoli.com. Even with a restricted bonus, the tax treatment remains: the bonus is taxable (and deductible) in the year paid. The restriction is just a contractual condition.

Tax advantages for the employer: The entire bonus is tax-deductible (just like a salary or cash bonus would be)bolicoli.com. This reduces the company’s taxable income (important for a C-corp paying its own taxes, or for an S-corp/LLC where owners want to reduce pass-through income). Meanwhile, the company doesn’t have to pay payroll taxes on a pure bonus beyond Medicare/Social Security, etc., as required (life insurance bonus is just additional cash comp for payroll tax purposes). There’s no further IRS funding requirement or compliance testing – it’s not a qualified plan, so it avoids complexities like ERISA or contribution limits. Also, unlike a deferred compensation plan, the company doesn’t have to book a future liability; it’s just expensing compensation in the current year.

Tax advantages for the employee: The employee is taxed on the bonus, yes, but the life insurance policy’s growth and payoff are tax-advantaged. The policy’s cash value grows tax-deferred inside, and the employee can later take loans/withdrawals tax-free for supplemental retirement income if desiredbolicoli.combolicoli.com. The death benefit will be paid to their beneficiaries income-tax free as wellbolicoli.com. In other words, the plan essentially transmutes taxable current compensation into a tax-sheltered asset for the future. The employee’s out-of-pocket cost is only the tax on the bonus (which, if not covered by a double bonus, means the employee does pay something, but that can be minimal relative to the benefit received)robertsandlawson.com. And if the employer does a proper double bonus, the employee has zero net cost, aside from maybe reporting the amounts.

One limitation: Because this is plain compensation, owners of pass-through entities see no net tax benefit in bonusing themselves. As noted earlier, if you own an S-corp or LLC and do a Section 162 plan on yourself, the corporation’s deduction just reduces your K-1 income. You pay tax on the W-2 bonus instead, and end up in essentially the same position (except you’ve converted pass-through income into salary income, which could even cost more in payroll taxes). So this strategy is mostly useful either for C-corp owner-employees or for non-owner key employees in any companyrobertsandlawson.com. C-corp owners might gain by shifting earnings to a deductible bonus if the corporation would otherwise pay 21% tax on retained earnings – better to bonus it out and have it taxed to the owner (at their rate) but end up in a policy. Still, the core use case is typically key executives, not majority owners, in small companies.

Drawbacks and considerations: The primary drawback for the company is that it does not recover the bonus. Unlike a loan or a deferred comp plan where the company might get back cash value later, here the bonus is pure compensation. If the executive dies, the death benefit goes to the executive’s family, not the companybolicoli.com. The company must be content that the benefit to them is indirect (employee loyalty and having a key person feel rewarded/protected). If the executive leaves early, and especially if there was no restrictive agreement, the company has no recourse – the employee walks away with the life insurance policy (the company essentially gave a parting gift). Even with a REBA, at best the company can get back maybe the cash surrender value (which might be much lower than premiums paid in early years due to surrender chargesrobertsandlawson.com), and only if the agreement was structured enforceably. So, there’s risk of loss if the employee doesn’t stay, although that’s inherent in any bonus or salary paid. Another drawback: the employee’s bonus is taxable compensation, so to give a meaningful benefit, the company might end up grossing up the amount (double bonus) which increases the cost. For example, to net a $10k premium benefit in a 35% tax bracket, the company might pay ~$15.4k so the employee can pay ~$5.4k tax and net $10k to the policy. That’s 54% more cost than the policy premium itself. Granted, it’s deductible, but it still cash-outlay. So the company needs to be willing to pay that price to make the employee whole. Additionally, payroll taxes apply on the bonus amount (Social Security up to the wage base, Medicare with no cap), which slightly increases cost. And while life insurance isn’t subject to 401(k) or other limits, some highly compensated employees might not want more taxable income if it triggers phase-outs or higher brackets – though usually the trade-off is worth it for them to get the insurance funded.

From the employee side, one should remember that the policy is theirs – which is a benefit (control) but also means responsibility. If the policy has ongoing premiums, and if the company ever stops paying the bonus (say the company falls on hard times or the employee leaves), the employee would need to decide whether to keep paying the premiums out-of-pocket to maintain the policy. If not, the policy could lapse. Therefore, it’s wise to structure it with permanent policies that can be paid-up or have flexibility. Many executive bonus arrangements use whole life or universal life policies because of their cash value (which can later be a source of supplemental retirement income)bolicoli.com. These policies typically require consistent funding, so the plan is often made with a long-term commitment in mind (e.g., the company intends to bonus $X per year for, say, 10 or 15 years). The employee should also trust the employer’s commitment; if the benefit is not contractually guaranteed, a change in company fortunes or leadership might end the bonuses. However, because the policy is in the employee’s name, even if the company stops, the employee at least owns what’s been paid in so far (including any cash value).

There are no direct estate tax drawbacks since the employee owns the policy (it will be in their estate like any life insurance they own, unless they choose to have a third-party owner like an ILIT). One more consideration: the reasonableness of compensation. If the plan is used for owner-employees of a C-corp, the IRS could scrutinize if the “bonus” is excessive as a way to extract profits (particularly for a closely-held C-corp). As long as total pay is in line with the owner’s role, this is usually fine, but it’s a point of caution for tax planning (excessive compensation to owner could be reclassified as dividend, losing the deduction). For rank-and-file employees this is rarely an issue.

Example: A small C-corporation wants to reward a key manager, Alice, and provide a long-term incentive for her to stay. The company bonuses $20,000 each year to Alice under a Section 162 plan. She pays income tax on this (let’s say $6,000 in tax), leaving $14,000 net which she uses to pay the premium on a $1 million whole life policy on her life. The company deducts the full $20k as a salary expense, saving perhaps $4,200 in corporate taxes (assuming a 21% rate). Effectively, the company’s after-tax cost is $15,800. Alice’s family gets the protection of a $1M death benefit from day one. Over time, the policy builds cash value; after 20 years, it might have significant cash that Alice can tap for retirement income (tax-free via loans). If she stays with the company for, say, 10+ years of bonuses, the policy could even become self-sustaining. If Alice dies while employed, her family gets $1M tax-free – an immense benefit essentially financed by her employer. The company, unfortunately, does not get that money back (they would have to find and train a new manager, but presumably the plan helped retain Alice as long as it did). From Alice’s perspective, she paid some tax each year but gained a substantial asset. From the company’s perspective, they got to deduct the cost and hopefully retain a valuable employee (and they didn’t have to offer a formal pension or profit share to do it – they could target just Alice with this plan). If Alice had left early, since the policy belongs to her, she’d take it along. If the company had used a restricted bonus agreement with a 5-year vesting, and she left after 3 years, that agreement might say she owes back some cash value – but realistically, enforcement might result in a negotiation or the company could forgive it.

In summary, an executive bonus plan turns taxable compensation into a life insurance benefit. The key tax benefits are the company’s deduction and the policy’s tax-free buildup and payoutbolicoli.combolicoli.com. It’s simple and flexible, making it popular for small businesses that want to provide something akin to a “company-funded life insurance” or additional perk to owners or key employees without the complexity of qualified retirement plans or split-dollar arrangements. The main downsides are the cost (it’s an outright benefit expense) and lack of employer control once executedbolicoli.com. Table 1 below summarizes the pros and cons:

Table 1: Executive Bonus (Section 162) Plan – Tax Benefits vs Drawbacks

Overall, the Section 162 executive bonus plan is a win-win on taxes when used appropriately: the company writes off the expense and the employee gets a tax-favored asset. It’s particularly popular for small businesses that might not want the complexity of split-dollar or deferred comp arrangements but still desire to leverage the tax-free build-up of life insurance to reward key people.

Key Person Life Insurance

Every business has certain individuals who are crucial to its success – a “key person” could be a founding owner, a top executive, a star salesperson, or someone with unique expertise or relationships. Key Person Life Insurance (formerly often called “key man insurance”) is a policy a business takes out on the life of such an individual to protect the company financially if that person were to die unexpectedly. The business owns the policy, pays the premiums, and is the beneficiary of the life insurance. If the key person dies, the company receives the death benefit. This infusion of cash can be essential to cover the costs of finding a replacement, offset lost revenues or profits, reassure creditors and customers, and keep the business stable during a difficult transitionbristertaxlaw.com. It’s essentially a form of business continuity insurance.

Typical scenarios where key person insurance is used:

• A sole proprietor might insure themselves so that if they die, there’s money to settle business debts and perhaps provide severance to employees or wind down operations without insolvencyguardianlife.com. (In this case, the sole proprietor’s estate or trust might be the beneficiary to use the funds for business-related purposes, or they may have the business as a named beneficiary if set up accordingly.)

• A partnership or small company insures a partner or lead employee whose death would financially strain the firm. For example, if one partner is the technical genius and the other is the finance/sales brain, each might be the “key person” to the other’s success – the business can own policies on each so it has funds if one dies to either buy out that person’s interest (if there’s overlap with a buy-sell arrangement) or cushion the loss.

• A business with significant loans or investors may be required by the lender/investor to carry life insurance on key people. Often, banks require insurance on a founder or owner equal to the loan amount, with the proceeds collaterally assigned to the lender guardianlife.com. In case of death, the lender is paid first from the death benefit, ensuring the loan is covered guardianlife.com.

• Companies whose reputation or client base is tied to one person (say, a consulting firm where clients only trust the founder) use key person insurance to provide working capital if that person dies, giving time to manage client perceptions, hire talent, or even dissolve the business in an orderly way if needed.

• Buy-Sell agreement tie-in: Key person insurance and buy-sell funding often overlap. In a partnership with a buy-sell, each partner might own a policy on the other (cross-purchase), which covers both needs: it provides the buyout funding (directly benefiting the surviving partner) and effectively provides cash to the business indirectly by stabilizing ownership. In an entity redemption plan, the company-owned life policy serves as both key person coverage and buy-sell funding. Thus, buy-sell funding (discussed earlier) is a specific application of key person insurance for ownership transfers.

Tax treatment of key person insurance: Premiums paid for key person life insurance are not tax-deductible as a business expense. guardianlife.com The IRS does not consider life insurance on an officer or employee an “ordinary and necessary” business expense if the business is the beneficiary; it’s more like a capital investment or a contingency reserve. Therefore, the company pays premiums with after-tax dollars. However, if the company follows the rules (notably the IRC 101(j) consent requirements for policies issued after 2006 on employees), the **death benefit is received income-tax free by the company guardianlife.com. That is a significant benefit: the company might receive, say, a $1 million lump sum exactly when needed and not owe federal income tax on those proceeds. (One caveat: while not taxable as income, in a C-corp, the proceeds could subtly affect things like corporate AMT or future tax if not planned, but those issues are generally minor or no longer applicable to most after the corporate AMT repeal for small companies.)

Because premiums aren’t deductible, some companies consider alternative structures (such as an executive bonus plan) if they want a deduction. But with key person insurance, the goal is typically to protect the business, so the company must be the beneficiary, which precludes a deduction. It’s a “pay now with after-tax dollars to potentially receive a much larger tax-free sum later” proposition.

It’s worth noting that cash value in a permanent key person policy is also an asset of the company that grows tax-deferred. If the company purchased a permanent life policy (whole or UL) on a key employee, over time it builds cash value that the company could potentially borrow against tax-free for other needs guardianlife.com. This is an often overlooked aspect: the company could treat the policy as a sort of emergency reserve or even a supplemental funding source (some businesses do this instead of taking loans – borrowing from the policy’s cash value, which does not require bank approval or affect credit)guardianlife.com. Of course, any loans outstanding reduce the death benefit if not repaid. But this flexibility can be attractive, effectively giving the business a line of credit from the policy’s value. That said, most small businesses use term insurance for key person needs because it’s cheaper, and they primarily want the protection during the working years of that person. If the person retires or leaves, term insurance can often be ended or allowed to lapse (or, in some cases, transferred to the insured if appropriate). If a permanent policy is used and the key person leaves or retires, the company might surrender it for cash (taxable as a gain) or transfer it to the insured (which could be a taxable compensation event for the insured equal to the policy’s value). These possibilities should be considered in advance.

Key person vs. executive bonus vs. buy-sell: To clarify, key person insurance typically refers to insurance for the benefit of the company itself (company is beneficiary) to offset losses, whereas an executive bonus plan is insurance for the benefit of the employee and their family (employee is beneficiary) as a comp perk. In some cases, a company might do both for the same person: e.g., have a policy where the company is the beneficiary for part of the death benefit (to protect the firm) and the employee’s family is the beneficiary for another part (e.g., a split-dollar or supplemental plan). But straightforward key person insurance is purely about protecting the business’s financial health. Buy-sell insurance is tied explicitly to ownership transfer, which often overlaps with key person (since owners are usually key people), but the distinction is that key person proceeds can be used for any corporate need (paying bills, hiring temps, paying off debt, stabilizing stock value, etc.), not just buying stock from heirs.

Tax and financial advantages of key person coverage:

• Lump-sum liquidity for the business, tax-free: The death proceeds give the company a cash injection without adding to taxable income guardianlife.com. This can be critical to the business's survival. For a small cost (premium paid with after-tax dollars), the company gets perhaps a 10x or 20x payoff when needed. This is arguably a tax-efficient form of self-insurance. If the company tried to self-fund a contingency reserve, it would build that reserve with after-tax earnings anyway, and the interest on the reserve would be taxable each year. Life insurance leverages those dollars and shelters the buildup (cash value growth is tax-deferred inside the policy), guardianlife.com.

• Confidence for creditors and investors: Knowing the company has key person coverage can reassure lenders and stakeholders that a sudden death won’t result in financial collapse. Often, simply having insurance in place can improve loan terms or even be required. While this isn’t a direct tax advantage, it’s a financial advantage attributable to the policy.

• No estate tax to key person’s family: Since the company is the beneficiary, the death benefit isn’t going to the deceased’s estate (though indirectly it supports the business which might be part of the estate’s value). However, if the key person is also an owner, the increase in business value from insurance could, as the Connelly case showed, end up increasing the estate’s value. But if it’s a non-owner key employee, their estate sees no direct addition from a policy the company owns. The company uses the money for business needs.

• Cash value as a corporate asset: If permanent insurance is used, the cash surrender value is recorded as a balance sheet asset. It grows tax-deferred, and loans against it are not taxable. This is a way to accumulate a side fund that can be tapped for various needs without tax friction, unlike, say, investing that money in stocks or bonds, where gains produce taxable income annually. Some corporations, especially large ones (banks are well-known for this with “BOLI” – bank-owned life insurance), invest significant amounts in life insurance to informally fund obligations such as deferred compensation because of its tax-deferred growth feature.

Drawbacks and risks:

• No tax deduction for premiums: The cost of key person insurance is borne entirely with after-tax dollars. guardianlife.com For a C-corp, that means the premiums are paid out of profits taxed at 21%. For an S-corp/partnership, it means the owners pay tax on income that’s then used to pay premiums. This is the trade-off for the later tax-free benefit. Usually, the benefit far outweighs the premium cost if the policy pays out, but of course, one hopes the key person doesn’t die prematurely. So it could be seen as an expense that in the best case scenario (no death) yields no direct return – except the peace of mind and other intangible benefits.

• Insurance costs and insurability: For older or less healthy key persons, premiums can be high or coverage limited. A business might want to insure a 70-year-old founder, but the cost could be steep, or they might not qualify for enough coverage. This can be a limiting factor – sometimes alternatives like a robust succession plan and savings are needed if insurance isn’t feasible.

• Death benefit doesn’t replace the person: It gives money, but the company still faces the loss of expertise/relationships. Some small businesses never truly recover from the loss of a visionary, insurance notwithstanding. Insurance can’t solve that; it only buys time and money to attempt to rebuild.

• **Potential taxable benefit to the insured? Usually, the value of employer-paid premiums for life insurance where the employer is the beneficiary is not considered taxable income to the insured employee (unlike group term policies that benefit the employee’s family). It’s just the company protecting itself. However, one must ensure the arrangement is purely business-focused. If any part of the benefit is intended for the employee’s family, it should be structured accordingly and taxed appropriately (e.g., as a bonus). Also, under IRC §101(j), the insured employee must be notified and consent, and generally should be a high-ranking or highly compensated individual for the death benefit to remain tax-free to the company beyond paid premiums. Most key person policies fit these criteria, but it’s a compliance step not to overlook kitces.com.

• If the key person leaves the company, the policy is owned by the company, which can keep it or not. If the person retires or moves on, the company might decide to surrender the policy for the cash (which could cause a taxable gain to the company if cash value exceeds what was paid in premiums). Or the company could transfer the policy to the person as part of a severance or buyout. Transferring ownership to the insured can trigger tax consequences: generally, the insured would have to report the policy’s cash value (or a portion thereof) as income upon transfer. Alternatively, the company might maintain it if there’s still a need (less likely if the person is gone). These complexities mean the company should periodically review whether it makes sense to continue paying premiums if the key person’s status changes.

Example: A small tech firm has a top-tier lead developer responsible for its flagship product. The company buys a $1,000,000 key person term life policy on her, costing perhaps $1,500/year. The premium is not deductible. Sadly, she dies unexpectedly. The company receives the $1,000,000 death benefit tax-free, which it uses to hire contracting developers, expedite recruitment for a replacement, and cover the loss in productivity (and perhaps to reassure investors that the project will continue). Without the insurance, the company might have collapsed or had to seek expensive loans to survive this period. With the insurance, they had a financial cushion to adapt. Alternatively, if she had left the company for a new job a year later, the company could cancel the policy at no further cost (since it was term) – the only “loss” would be the premiums paid. That’s a small price for the protection they needed during that time. If the policy had been a permanent one with cash value and she left after years, the company might decide whether to keep it (for example, by repurposing it to insure another key person through a policy change, or cash it out and potentially face tax on the gain).

Another example: A manufacturer with a long-time CEO takes out a whole life policy on the CEO as key person. Over 20 years, the policy accumulates $200k cash value. The company might borrow against this cash value to finance a new opportunity, effectively using the policy as collateral for a loan to itself (this loan isn’t a taxable event), guardianlife.com. The interest on the policy loan goes to the insurer, but the company may consider it preferable to a bank loan. If the CEO dies during that period, suppose the policy is $ 2M. The company receives $2M tax-free, and if there is a $100k outstanding loan, the insurer pays off the loan and gives the net $1.9M to the company. If the CEO retires, the company could use some of the cash value to fund a retirement bonus or buyout for the CEO (though transferring the policy to the CEO might be a nice gesture, and the CEO would then pay tax on the transfer value). The point is, permanent key person insurance can double as a corporate asset.

Key person insurance’s role is often not about tax savings on the premium side (since there are none), but about the tax-free payoff that provides a lifeline when it counts. In that sense, it’s similar to how one views personal life insurance – you don’t deduct your personal policy premiums, but you know your family gets a tax-free benefit. The business is simply insuring against an economically catastrophic event and using the tax code’s favourable treatment of life insurance to do so.

Finally, ensure that for any employer-owned life insurance, you comply with the “notice and consent”: inform the key person in writing and get written consent before the policy is issued, and satisfy the requirements that the insured was an employee/director at some point in the 12 months before death or similar criteria (which is usually the case). This way, the full death benefit stays tax-free to the businesskitces.com. Companies should keep that documentation on file.

Life Insurance for Estate Tax and Business Succession Planning

For business owners, estate planning and business succession are tightly connected. Upon the death of a business owner, there can be significant estate taxes due (if the estate’s value exceeds the exemption) and serious questions about how to provide continuity for the business. Life insurance is an invaluable tool for creating liquidity and facilitating wealth transfer in a tax-efficient way, especially when much of the owner’s wealth is tied up in an illiquid business.

Why liquidity matters: Suppose a business owner has a very successful company – on paper it’s worth $20 million, but most of that value is in equipment, real estate, and goodwill. If the owner dies, the IRS will include that $20M in the owner’s taxable estate. Even with a $14M exemption, a portion of that value exceeds the exemption and is subject to a 40% federal estate tax. The estate might owe millions in taxes, due generally within nine months of death. Where does that cash come from? If most assets are locked in the business, the estate might have to sell the business or its assets quickly (potentially at a fire-sale discount) to raise cash, or borrow money (if they can). This is where life insurance shines: a policy can provide a tax-free death benefit that the estate or a trust can use to pay estate taxes and other costs, preventing the forced sale of the business. In essence, life insurance can convert illiquid business value into liquid cash at precisely the moment it’s needed.

Irrevocable Life Insurance Trust (ILIT): A common strategy for larger estates is to own life insurance through an ILIT. An ILIT is a trust specifically set up to own one or more life insurance policies on the grantor (the business owner, in this case) outside the grantor's estate. Because the trust owns the policy and is also the beneficiary, the death benefit is not counted in the insured’s estate for estate tax. The trust can then use the insurance proceeds to provide liquidity – often by purchasing assets from the estate or loaning money to the estate – so that estate taxes and expenses can be paid. For business owners, an ILIT might be structured to buy shares or interests of the business from the estate, effectively accomplishing a succession transfer and providing cash to the estate. Meanwhile, the business interest passes to the heirs (perhaps those active in the business) without being reduced by taxes, since the tax was paid from the insurance proceeds. ILITs are especially useful for high-net-worth individuals or those with illiquid estates (like family businesses), bristertaxlaw.com. As a bonus, the ILIT can manage and distribute the insurance proceeds according to the owner’s wishes, providing control from beyond the grave.

Example use case: The owner of a manufacturing company expects an estate tax bill. He sets up an ILIT which purchases a $5 million permanent life insurance policy on his life. He makes annual gifts to the ILIT (within the annual gift tax exclusion or using some of his lifetime exemption) to cover the premiums. When he dies, the policy pays $5M to the ILIT income-tax free, and because he didn’t own the policy, that $5M is not included in his estate. The ILIT trustees can then lend $5M to the estate or directly pay the estate’s $5M tax bill (depending on how it’s structured). This prevents the business from being sold or heavily leveraged to pay taxes. The heirs can keep the company running. Without the insurance, the heirs might have had to liquidate a portion of the business or its assets to pay the tax, potentially destroying the business’s viability. With insurance, essentially pennies on the dollar (the premium outlay) funded the estate tax payment with discounted dollars (death benefits that were both outside the estate and free of income tax), bristertaxlaw.com.

Even if the estate tax isn’t a factor (for smaller businesses under the exemption), life insurance still helps in succession and inheritance equalization. For instance, consider a family where one child works in the business and another does not. The parents’ estate plan might leave the business to the child who’s involved (so the business continuity is preserved) and use a life insurance policy to leave an equivalent value of cash to the other child, so both are treated fairly. This avoids forcing siblings into co-ownership when only one is interested/competent, or splitting assets in a way that harms the business. The life insurance creates a “separate pot” of money to balance things out, again in a tax-efficient way (the death payout can be structured to be outside the estate if needed, or at least will be tax-free to the beneficiary if inside the estate below the exemption).

Estate tax leverage: Life insurance in estate planning can provide significant leverage. Premiums are paid over time, often from annual income or through gift exclusions. The payoff can be many times larger, and crucially, it arrives precisely when liquidity is needed. It essentially pre-funds the estate’s liquidity needs at a discount. For example, paying $50k/year in premiums for a $5M policy for 10 years ($500k total outlay) to secure $5M tax-free at death is a trade many owners gladly make, versus risking a forced sale of a company worth far more.

However, there are important considerations and drawbacks:

• If using an ILIT, the arrangement is irrevocable. Once you transfer a policy to an ILIT or have the ILIT buy one, you can’t easily change your mind (you don’t own it, the trust does). You also can’t tap the cash value for personal use – that policy is now for the benefit of the trust beneficiaries only, bristertaxlaw.com. The trust must be carefully drafted to allow flexibility (for instance, some ILITs include provisions that can essentially terminate the trust if estate tax laws change drastically). Also, when an ILIT buys a new policy, the underwriting is just like any other – insurability matters; the trust typically uses gifts you give it to pay premiums.

• If you have an existing life policy and transfer it to an ILIT, you have to survive at least three years after the transfer for the death benefit to be excluded from your estate. (This is a tax rule to prevent deathbed transfers purely to avoid estate tax.) If you die within 3 years of handing over a policy to a trust (or any person), the death benefit is pulled back into your estate. So, ideally, business owners start planning early while healthy. Alternatively, an ILIT should purchase a new policy rather than transferring an old one, if the 3-year window is a concern.

• Premiums as gifts: When you pay premiums into an ILIT, the premiums are treated as a gift to the trust. Typically, trusts are structured with “Crummey powers,” which give beneficiaries a temporary right to withdraw contributions, thereby qualifying the contributions for the annual gift tax exclusion (currently $17k per beneficiary per year, as of the mid-2020s). As long as it is done correctly, an owner can often pay quite a bit in premiums without incurring gift tax by using exclusions and their lifetime exemption. But it is something to manage with a competent estate planner. If significant premiums are needed beyond what exclusions cover, it starts using up the lifetime gift/estate exemption (which is fine – better to convert it into life insurance that won’t be taxed at death).

• Cost and health: Older business owners or those in poor health might find life insurance premiums high or coverage unavailable. In such cases, other tools (such as Section 6166 estate tax deferral for businesses, buy-sell agreements with junior partners, etc.) may be needed. But even expensive insurance can make sense if liquidity needs are extreme.

• Estate tax laws can change: The current high exemption is slated to drop in 2026, as mentioned on bristertaxlaw.com. Congress could also change rates or other rules. Life insurance provides a measure of certainty – it’s a contract that will pay a defined amount regardless of tax law changes. If the exemption drops to ~$7M, many more business owners will fall into the taxable estate, increasing the importance of insurance planning. If Congress extends or raises the exemption, some insurance bought for estate taxes might prove less needed – but even then, it still provides inheritance or business buyout funding (or can be repurposed, e.g., cancelled if truly unnecessary).

• Using insurance in buy-sell vs. estate liquidity: Coordination is key. If an owner has a buy-sell with partners funded by insurance and personal estate tax insurance, ensure they work together and are not at cross-purposes. For example, if a buy-sell removes the business interest from the estate in exchange for cash, the estate might need less additional liquidity (or vice versa). Similarly, if an owner relies on the company redemption to pay estate tax, that could conflict with Connelly issues. Often the best approach is a multi-prong plan: a buy-sell to handle business succession (so heirs get value for the business interest) and an ILIT policy to handle estate taxes on overall estate including perhaps the value of the business or other assets.

Case study example: John, 65, owns a successful winery (held through an LLC) valued at $15 million, plus other assets valued at $ 5 million. He has two children: one works at the winery; the other does not. He expects that, if the estate tax exemption is $7M, his estate might owe about $5M in estate tax (roughly 40% of the $13M over the exemption, simplified). John sets up an ILIT and gifts money each year to pay premiums on a $5M second-to-die life insurance policy on him and his wife (survivorship policy since estate tax will hit after both pass, and it’s cheaper than insuring one life). The ILIT names the non-business child as the primary beneficiary (to equalize the inheritance) and permits loans to John’s estate. Upon death, the $5M pays out tax-free investopedia.combristertaxlaw.com. A portion is lent to the estate to pay the IRS, and the non-business child effectively inherits the remainder. Meanwhile, the winery is transferred to the child who is active in the business, intact and debt-free. The estate tax is paid without affecting the business or burdening the successor. Tax outcome: John’s enormous illiquid asset (winery) was preserved by using life insurance proceeds that were outside his estate. In essence, he “tax-effectively” transferred an additional $5M to his heirs that the IRS couldn’t touch bristertaxlaw.com. The premiums might have cost John about $100k per year for 10 years (total $1M outlay), but leveraged to $5M at death when needed, a good trade in his view.

In summary, life insurance in estate and succession planning provides: liquidity, certainty, and tax-efficiency. It turns a potentially devastating estate tax or liquidity crunch into a solvable problem by injecting cash at the right time. It keeps family businesses in the family, rather than on the auction block to pay Uncle Sam. And by using trusts and careful ownership structuring, it can avoid both income and estate taxes on the payout, bristertaxlaw.com. The drawback is the commitment to premiums and the rigidity of trusts, but with proper planning, the benefits far outweigh these costs for many business owners. As one resource put it, “Properly structured, life insurance provides tax-efficient liquidity—essential for business owners with illiquid estates.”bristertaxlaw.com

Life Insurance as a Retirement Planning Tool for Business Owners

Beyond protection and estate considerations, permanent life insurance can double as a retirement planning vehicle – often termed a Life Insurance Retirement Plan (LIRP) when used this way. For business owners who may already maximize their 401(k) or who seek tax-diversified income sources in retirement, a life insurance policy’s cash value can be a source of tax-free supplemental income. Essentially, the owner deliberately overfunds a cash value life policy during working years (within IRS limits to avoid it becoming a Modified Endowment Contract) and later withdraws or borrows from the accumulated cash value to help fund retirement. This strategy leverages the policy’s tax-deferred growth and tax-free loan features as a personal “nest egg” that also provides a death benefit.

Tax advantages of life-insurance-based retirement planning:

• Tax-deferred growth: Money inside a life insurance policy grows without yearly taxation (investopedia.com). This is similar to a traditional IRA or 401(k) in terms of deferral, except there are no required minimum distribution rules for life insurance and no contribution limits beyond what the policy can technically accept under MEC limits. You can allocate quite large sums to a policy relative to other accounts (often only constrained by needing a minimum death benefit to meet insurance tax law requirements). For someone who believes their investments will perform well and that tax rates might rise, investing more in a tax-deferred environment is valuable.

• Tax-free distributions: If structured properly (non-MEC policy), you can first withdraw your basis (premiums paid) tax-free, and then take policy loans against the remaining cash value, which are not income-taxable as they are loans. Effectively, one can withdraw much of the cash value without triggering income tax, as long as the policy remains in force until death (at which point any outstanding loans will reduce the death benefit). This results in tax-free income in retirement – a considerable advantage when traditional 401(k)/IRA withdrawals are fully taxable. By using policy loans, many retirees keep their reportable income low, which can help avoid higher tax brackets or additional taxes on Social Security benefits and Medicare surcharges, Investopedia reports. In essence, it’s like a Roth IRA (after-tax in, tax-free out) but without formal contribution limits or income phase-outs. In fact, life insurance is sometimes called a “rich person’s Roth” for that reason.

• No age restrictions: Unlike retirement accounts which often penalize withdrawals before age 59½ and mandate distributions after age ~73, life insurance cash value can be accessed at any age without penalty bolicoli.com (barring any surrender charges early on). This can provide flexibility for early retirees or those who want to phase into retirement.

• Contribution amounts are flexible and potentially high: As long as the policy isn’t overstuffed to become an MEC, one can put in substantial premiums. There’s no statutory cap like the $(IRA) or $(401k) limits. The cap is practical – how much insurance can you justify and afford – but for high-income owners looking to save more on a tax-advantaged basis, life insurance can absorb a lot of dollars. “Nearly unlimited” contributions are possible if the policy is structured with a minimal death benefit relative to premium (to meet the IRS’s cash value accumulation test or guideline premium tests)bolicoli.com. This is beneficial for those who want to shift after-tax money into a tax-sheltered growth vehicle beyond what Roth IRAs (with income limits) or 401(k)s allow.

• Additional benefits: The life insurance component provides a death benefit (with no income tax) for heirs, which can serve as a “self-completing” retirement plan. If the person dies early, the death benefit can support the surviving family or even provide an inheritance greater than what the person could have saved. Also, many policies offer optional long-term care or chronic illness riders, which means the policy can also serve as a pool of funds for long-term care expenses, paid out tax-free in many cases if the insured qualifies (this triple-duty as retirement income, long-term care funding, and death benefit has been highlighted by financial experts at theamericancollege.edu). Business owners might appreciate the flexibility, since long-term care costs can threaten retirement security, and an insurance-based plan can help address that.

Drawbacks and cautions:

• No upfront tax deduction: Unlike contributions to a traditional 401(k) or SEP IRA, premiums paid into a life insurance policy are after-tax; there’s no immediate tax break. This is effectively like Roth-style saving (tax now, not later). For some business owners, a combination strategy works: contribute the maximum to deductible plans for upfront savings, then allocate additional funds to life insurance for tax-free benefits later. If cash flow is limited, the lack of a deduction can make it harder to commit to funding the policy than with a pretax plan.

• Costs of insurance: Life insurance has internal costs (mortality charges and expenses) that can be higher than, for example, the low fees of a 401(k) index fund. Part of your premium goes toward the death benefit and the insurer’s profit. These costs, especially in early years or if the policy isn’t held long-term, can eat into returns. Essentially, the “savings potential is limited by cost of death benefit” – you have to buy some amount of insurance to get the tax benefits, and that cost drags on the investment portion. Over a long horizon, well-structured policies can still yield decent net returns, but likely not as high as an aggressive stock portfolio would in a taxable account. It’s a trade-off between lower net growth vs. tax-free treatment. Business owners often use life insurance as the conservative portion of their portfolio – not to beat the stock market, but to provide steady, tax-advantaged growth and protection.

• Complexity and commitment: To make this work, one must commit to a multi-year funding strategy. Stopping premiums too early can diminish the results or even cause a lapse. Accessing cash through loans must be done carefully. If one takes large loans and then doesn’t manage the policy, there’s a risk the policy could lapse in later years – at which point, all those loans could become immediately taxable (essentially recapturing all deferred gains as income). It requires ongoing monitoring or working with an advisor to ensure the policy remains in force (e.g., adjusting the face amount or paying some interest). If done right, one can avoid ever paying tax on the gains, but if done wrong (policy lapses or is surrendered with loans), there can be a significant tax hit, investopedia.com. Also, accessing too much cash reduces the death benefit, which may be acceptable if the goal is primarily income, but one must balance goals (e.g., keep some death benefit for a surviving spouse).

• Investment limitations: In a whole life or fixed UL, your returns are based on fixed interest or insurer dividends – often conservative. In a Variable UL, you get investment subaccounts, but they carry fees and sometimes offer fewer choices than an open market account. It was mentioned that an LIRP can have “potentially fewer investment options,” and you might not get the same performance as a broad investment portfolio. So if you’re very investment-savvy, you might chafe at the constraints.

• Policy design and MEC: The policy must be designed to stay just under the IRS limits for Modified Endowment Contracts (MECs). A MEC loses the favourable loan treatment (any loans/withdrawals from a MEC are taxable to the extent of gains, akin to annuity taxation, and possibly penalized if under 59½). So you have to be careful not to overfund too quickly or with a single premium that is too high without adjusting the death benefit. Good insurers and agents will ensure compliance, but it’s a technical aspect that needs to be monitored whenever changes are made (e.g., reducing the death benefit or skipping premiums can inadvertently MEC-ify a policy). Once a MEC, always a MEC – so avoid that if the goal is retirement income.

• Creditor protection: One minor point: in some states, cash-value life insurance offers strong creditor protection (e.g., in Florida, it’s virtually untouchable in a lawsuit; in other states, it varies). For a business owner, building cash in life insurance might shield assets from potential business liabilities, which is a side benefit. But that’s outside the tax scope (though it is a legal benefit of this strategy).

In practice, many business owners use this to diversify their retirement savings. They may have a 401(k)/IRA (taxable on withdrawal), Roth assets (tax-free), and life insurance cash value (tax-free). This mix can give flexibility to manage taxes in retirement – for example, in a high-income year or if taxes rise, they can draw more from the life policy and less from the IRA to stay in a lower bracket. As Prudential puts it, life insurance can help “gain more control of your taxes in retirement” by providing tax-free sources of funds prudential.com.

Example: Maria, a 45-year-old business owner, has maximized her company's 401(k) contributions. She wants to save an additional $30,000 per year for retirement and prefers a tax-free income source. She buys a cash-rich indexed universal life policy with a death benefit set to stay within IRS limits for her contributions. She plans to pay $30k/year until age 65. By then, the policy’s cash value might have grown substantially (depending on index returns, perhaps to something like $800k–$1M). Starting at 65, she begins taking annual policy loans of $60,000 to supplement her other retirement income. These loans are not reported as taxable income (they’re just borrowing her own money), investopedia.com. Thus, she can have an additional $60k in tax-free cash flow each year, which might help her stay in a lower bracket for her other income and avoid IRMAA (Medicare surcharges). If she passes away at, say, 90 with outstanding loans, the life insurance death benefit (originally $1.5M, reduced by the outstanding loans) will pay off the loan balance and still deliver, for example, $500k to her heirs, all tax-free. The result: she got the equivalent of a large “Roth” account without formal contribution limits. The drawbacks: she committed $30k/yr post-tax for 20 years (no tax deduction on that, whereas if she had put it in a pretax plan, she’d have saved taxes upfront). And if the policy underperforms or if she isn’t careful, taking $60k/yr could jeopardize the policy later in life – she’d need periodic reviews to adjust loan amounts or perhaps reduce the death benefit to lower cost, etc. But with proper management, it works as intended.

It’s also worth mentioning that for business owners, there’s a potential to use the business to help fund life insurance for retirement. One could argue that this crosses into executive bonus or split-dollar arrangements. For instance, a business might pay the premiums on a policy, and then later the owner takes over the policy at retirement (with some tax consequences). A more straightforward approach is the owner takes profits as distributions or salary and personally funds the policy. If it’s a C-corp, consider using an executive bonus (deductible to the corporation) to fund the policy. This would indirectly have the business pay for it with pre-tax corporate dollars, taxed to the owner as income, with the balance sheltered going forward. Some owners also consider putting life insurance inside a qualified plan (this is possible in defined benefit or some profit-sharing plans up to certain limits – often called 412(i) plans or just incidental life insurance in a plan). That can give a deduction on contributions used to buy life insurance, but the plan must include that policy value in the participant’s taxable distribution at retirement (minus some basis), and there are IRS limits on how much of a plan’s assets can be life insurance. Given the complexity, this route is less common nowadays, except in specifically defined benefit plan designs for small firms.

In summary, using life insurance for retirement is a strategy to create a tax-free income stream and legacy asset. The tax advantages are the tax-deferred buildup and tax-free withdrawals/loans, which can keep one’s retirement tax bill low investopedia.combolicoli.com. The disadvantages include a lack of upfront deduction, insurance costs, and the need for careful long-term management. Many advisors suggest it’s most appropriate for those who: (1) have extra cash flow beyond qualified plan limits to save, (2) have a need or desire for life insurance coverage as well, (3) have a long time horizon to allow cash value to grow, and (4) are in a relatively high tax bracket now or expect higher taxes later. Business owners often check all these boxes. When integrated correctly, a life insurance retirement strategy can complement traditional retirement plans by providing tax diversification and serving as an informal nonqualified benefit plan for the individual or key employees.

The table below (Table 2) highlights the key tax features of various life-insurance-based strategies covered, for easy comparison:

Table 2: Life Insurance Strategies for Business Owners – Tax Benefits & Drawbacks