Key considerations for bank-owned life insurance tax treatment

Bank-owned life insurance (BOLI) policies serve as common investments for financial institutions, often used to offset costs related to losing key employees.

In the current landscape of high-interest rates and narrower margins, some institutions may seek ways to enhance liquidity or reduce expenses. One strategy involves cashing in some of their life insurance policies to access the cash value. However, it’s important to consider the tax implications associated with early termination.

Here are the important considerations your financial institutions should watch for with bank-owned life insurance tax treatment:

BOLI policy tax advantages and considerations

BOLI policies offer several tax advantages for financial institutions.

One of the key benefits of BOLI policies is the tax-deferred growth of cash value. When a financial institution purchases a BOLI policy, the cash value within the policy grows on a tax-deferred basis, allowing the institution to accumulate funds more rapidly.

As a result, BOLI policies have become an attractive option for financial institutions looking to enhance their financial position and provide additional benefits to their employees.

However, while the annual increase in the cash surrender value and the death benefit payout are both tax exempt, the annual premiums are nondeductible. And while these policies provide financial benefits, surrendering a policy before the insured’s death can trigger taxable events.

Early termination and modified endowment contracts

A modified endowment contract (MEC) is a specific classification for life insurance policies. It occurs when the premiums paid on a policy exceed an annual limit set by the IRS.

Once a BOLI policy is deemed an MEC, certain tax advantages associated with regular life insurance policies are lost. MECs are subject to additional taxes and penalties during the insured’s lifetime, including:

• Loss of tax advantages: Once a BOLI policy is classified as an MEC, some of its tax benefits are forfeited. Although the death benefit remains tax-exempt income, MECs become subject to additional taxes and penalties on distributions from the policy.
• Taxable gains: When a policy is cashed out before the insured’s death, any cash value exceeding the premiums paid becomes taxable gains. This means that the accumulated value beyond the original investment is subject to income tax.
• 10% penalty tax: In addition to regular income tax, MECs are subject to a 10% penalty tax on the taxable gains. This penalty discourages early termination and encourages policyholders to maintain their policies until death.

C corporation versus S corporation reporting

C corporations report the 10% penalty assessed on the increase in value of life insurance policies directly on Schedule J of their federal income tax return. The penalty increases their computed federal income tax liability.

In contrast, S corporations pass this additional tax burden to their shareholders. Shareholders then report their share of the gain (including the penalty) on IRS Form 5329, which specifically addresses early distributions from life insurance policies.

Annually, both C corporations and S corporations are required to file Form 8925 if they own one or more employer-owned life insurance contracts issued after August 17, 2006. Form 8925 is attached to the federal income tax each year the policies are owned.

How Wipfli can help

Wipfli’s team of tax professionals understands the unique needs of financial institutions. From the treatment of loan and lease losses to BOLI arrangements, we’re ready to guide you with proactive planning and compliance assistance. Contact us today to learn more about how our specialized tax services can support your organization.