Many common business and estate planning arrangements involve employer-owned life insurance (EOLI). Many business owners and professional advisors are unaware that employer-owned life insurance death benefits paid to employers are generally taxable as income. Yes, that is the general rule since the passage of the Pension Protection Act of 2006. Pursuant to Internal Revenue Code §101(j), which provides guidance for the tax treatment of EOLI policies, unless (1) certain exceptions apply and (2) certain notice, consent, and reporting requirements are met for EOLI policies purchased (or materially changed) after August 17, 2006, the death benefits are taxable to the extent the proceeds exceed the employer’s premium payments. Note that §101(j) does not offer any safe harbors. These requirements are intended to discourage arrangements where businesses generate cash flow by insuring the lives of lower-level employees, and in some cases, where the insured had not worked for the company in many years. However, it impacts many business insurance arrangements, such as buy-sell agreements funded by life-insurance, key-person insurance, and executive compensation programs. If a company is expecting a death benefit of, for example, $5 million to fund the buy-out of a deceased shareholder’s ownership interest, giving up 50% of the proceeds to cover the tax liability can be devastating.
Even if an exception applies, notice and consent requirements must be met BEFORE the issuance of the policy. The employee must be notified in writing of the following: (1) that the employer intends to insure the employee’s life, (2) the maximum amount for which the employee could be insured at the time the contract was issued, and (3) the employer will be the beneficiary of any life insurance proceeds payable upon the death of the employee. Thereafter, the employee must provide written consent to being insured under the contract and that the coverage may continue after the employee is no longer employed by the policyholder.
Mike is an employee of ABC Company. In 2008, the president and owner of ABC Company, Deborah, decided that Mike’s ongoing employment was important to the company’s long-term success. Deborah met with Mike and explained that the company would be purchasing a life insurance policy on Mike’s life. Mike was agreeable and completed everything necessary on his part. Now, if Mike dies, the death benefit, less the company’s basis, would be subject to ordinary income tax because Mike was not provided written notice, Mike did not sign a consent, and Form 8925 was not filed on or before the due date of the company’s 2008 income tax return.
ABC Company could surrender the policy, comply with the notice and consent requirements, purchase a new policy, file Form 8925, and continue to comply with the §101(j) requirements going forward. Or, the company could materially change the contract by purchasing an increase in coverage, complete the notice and consent requirements prior to issuance of the policy, and timely file Form 8925.
However, if Mike acquires a medical condition that leaves him uninsurable, the options above are not helpful. IRS Notice 2009-48 and exceptions to the transfer for value rules may be helpful but these are very case-specific. Using these rules wisely and under the guidance of a professional tax advisor, the parties may be able to find a solution to the problem.
What You Need to Know:
IRC §101(j) applies to employer-owned life insurance policies issued after August 17, 2006, with the exception of policies issued after that date pursuant to a §1035 exchange for a contract issued on or before that date. Note that any material increase in the death benefit or other material change means the contract is treated as a new contract and subject to §101(j). The requirements also apply in situations where the employer may not technically own the policy but may still be considered the policy owner, such as where a trust or other entity owns the policy for the benefit of the employer. EOLI policies include business succession planning and employee benefit arrangements (for example: stock redemption, key-person, non-qualified deferred compensation, etc.).
Keep in mind that §101(j) applies to many EOLI contracts sold or materially changed after August 17, 2006, including key-person insurance, stock redemption buy-sell agreements for employee-shareholders, certain split-dollar arrangements, family LLCs where the insured is also an employee, and deferred compensation arrangements. To avoid income-tax treatment of life insurance proceeds under an EOLI policy, a company should follow the requirements of §101(j): (1) provide the proposed insured employee the required notice and obtain a signed consent from the employee PRIOR TO the issuance of the policy, and (2) file Form 8925 on an annual basis. IRS Form 8925 must be filed with the employer’s income tax return for each tax year during which the employer has EOLI contracts in force.