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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)

Minus

Available Exemption Amount

Multipled by

AMT Rate of 20%

Equals

AMT

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

Plus

ACE adjustment which is 75% of $5,000,000 death benefit equals $3,750,000

Minus

Exemption amount is $0 because the tentative AMTI is more than $310,000

Equals

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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