California Life-Only & Accident and Health AgentLife InsuranceHard
A business owner is setting up a Buy-Sell Agreement for their company, which will be funded by life insurance policies on each of the partners. The agreement specifies that upon the death of one partner, the surviving partners will use the life insurance proceeds to purchase the deceased partner's share of the business from their estate. What is the primary tax implication for the surviving partners regarding the death benefit received from these policies?
- AThe death benefit is typically considered taxable income.
- BThe death benefit is deductible as a business expense.
- CThe death benefit is generally received income tax-free.
- DThe death benefit is subject to capital gains tax.
Show answer & explanationAnswer & explanation
Correct answer: C. The death benefit is generally received income tax-free.
In most cases, life insurance death benefits, when paid to a named beneficiary, are received income tax-free at the federal level, regardless of whether they are for personal or business purposes (like funding a Buy-Sell Agreement). The purpose of the benefit (to buy out a share of the business) does not change its tax-free status as a death benefit.
Why the other options are wrong
- A. This is incorrect; death benefits are typically income tax-free.
- B. Life insurance premiums are generally not deductible, and the death benefit is not a deductible expense for the recipient.
- D. Capital gains tax applies to the sale of assets, not usually to the receipt of a death benefit.
Taxation of Life Insurance Death Benefits
The rules governing how death benefits from life insurance policies are treated for federal income tax purposes.
- Generally received income tax-free by the beneficiary.
- Applies to both personal and business-funded policies.
- Interest earned on retained proceeds may be taxable.
Memory trick: Premiums aren't deductible, but death benefits are usually tax-free.