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Question: What is the corporate alternative minimum tax, and how does it affect key person life insurance?
Answer: The corporate alternative minimum tax has the potential to apply only to C corporations. Pass-through entities, such as partnerships, S corporations or proprietorships are not affected by the corporate AMT.
The corporate AMT is calculated as follows:
Alternative Minimum Taxable Income (AMTI)
Available Exemption Amount
AMT Rate of 20%
Small corporations are exempt from the corporate AMT. Small corporations are defined as
- Corporations in their first year of existence, or
- A corporation that has always been a small corporation AND whose average annual gross revenues for any three consecutive tax year periods did not exceed $7.5 million. For the first three years of a new corporation’s existence, the average annual gross revenues must not exceed $5 million for it to meet the small corporation test.
Since the corporate AMT was imposed in 1986, one of its purposes has been to force those C corporations showing profit to their shareholders to pay at least some federal income tax. Rather than to force Congress to come up with a specific list of AMTI adjustments, the corporate AMT creates a big bucket of additions to AMTI within the ACE.
Income that would otherwise be exempt from income tax typically gets included in a company’s ACE. For life insurance professionals, the following two adjustments are particularly relevant:
- The annual growth in a company-owned life policy’s cash value is included in ACE, and
- The difference between a company-owned policy’s cash value and any death benefit paid in a given year will also be included in the ACE.
75% of the ACE is included in AMTI, the effective maximum AMT tax rate on corporate life insurance cash value growth or death benefit is 15%.
Here’s an example.
Franklin Fabrication, Inc., is a closely held C corporation owned 50% by Steve Carothers and 50% by Ron Mallory. The company has averaged $10 million in revenues over the last five year period. The company’s taxable income in 2011 was $100,000, generating a regular income tax liability of $22,250.
Ron died in 2011. The corporation owned $5 million of term life insurance on his life, which was paid to the corporation to fund an entity purchase buy-sell agreement.
Since all of the death benefit was term insurance, there is no need to subtract cash value from the death benefit for AMT calculation purposes. All $5 million is added to the company’s ACE. Assuming no other AMTI adjustments, AMTI is calculated as follows:
Regular taxable income of $100,000
ACE adjustment which is 75% of $5,000,000 death benefit equals $3,750,000
Exemption amount is $0 because the tentative AMTI is more than $310,000
Income of $3,810,000 subject to corporate AMT
The AMT tax rate is 20%. Multiplying the AMTI of $3,810,000 by 20% yields a alternate minimum tax result of $762,000. The AMT is substantially higher than the regular income tax, so the corporation must pay the AMT amount.
Since life insurance—especially a policy’s death benefit—can have a substantial impact on a C corporation’s AMT, life professionals should recommend that their C corporation clients should
- Use entities that are not C corporations for needed key person life insurance if such entities are available,
- Structure buy sell agreements for C corporations as cross-purchase plans to avoid having the death benefit included in the ACE adjustment, and
- Where substantial key person life insurance is needed, consider having the client purchase extra life insurance death benefit to offset the potential corporate AMT.
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