Tax Issues With Employer-Owned Life Insurance Contracts
Life insurance can be a very valuable planning tool for business owners. Some employers purchase so-called “key person” life insurance for key executives and/or other personnel who would be difficult to replace. Additionally, amongst co-owners, life insurance can be used to “fund” buy-sell arrangements which are triggered upon the death of an owner. Employer-paid life insurance could also be structured as an additional employee benefit.
One key advantage of employer-owned life insurance policies (also known as corporate-owned life insurance or “EOLI”s) has traditionally been that Section 101(a) of the Internal Revenue Code (“IRC”) excludes from gross income death benefit proceeds received from a life insurance contract.
In 2006, however, Congress enacted legislation to eliminate the tax-free exclusion for EOLI policies. Effective for life insurance contracts issued after August 17, 2006, the income exclusion for death benefits received from an employer-owned life insurance contract is limited to the sum of the premiums and other amounts paid by the policyholder for the contract. In other words, the death benefit(s) in excess of the basis in an employer-owned life insurance policy represent taxable income under IRC Section 101(j).
There are exceptions to the 2006 inclusion rule; there are four situations where life insurance death benefits continue to be tax-free: (i) the insured was an employee of the applicable policyholder at any time during the 12 month period before the insured’s death; (ii) the insured, at the time the policy is issued, is a director, a highly compensated employee per IRC Section 414(q) or a highly compensated individual (using a 35% definition under IRC Section 105(h)(5) ; (iii) the death benefits are paid to a member of the family or other beneficiary of the insured (other than the applicable policyholder) or a trust for the benefit of the family, or to the estate of the insured; or (iv) the death benefits are used to purchase an equity or capital or profits interest in the applicable policyholder from a member of the family of the insured or a trust or the estate of the insured.
These are broad exceptions that cover most, if not all, of the traditional reasons for utilizing EOLI contracts.
One of the most often overlooked issues when it comes to such life insurance is the notice and consent requirements imposed by IRC Section 101. These requirements provide that prior to issuance of the policy, the employee must be notified in writing that the applicable policyholder intends to insure the employee’s life, along with the maximum face amount for which the employee could be insured at the time of contract issuance. The employee must provide written consent to be insured, and consent that the coverage may continue after termination of employment. Finally, the employee must be informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee.
In addition to the notice and consent requirements, every applicable policyholder owning EOLI contracts is required to file an annual return disclosing the following information: (i) the number of employees at the end of the year; (ii) the number of those employees insured under EOLI contracts as of the end of the year; (iii) the total amount of insurance in force under those contracts; (iv) the name, address, and taxpayer identification number of the policyholder and the type of business in which the policyholder is engaged; and (v) that the applicable policyholder has a valid consent for each insured employee, or the number of insured employees for which consent was not obtained. Such reporting is to be made via IRS Form 8925, Report of Employer-Owned Life Insurance Contracts.
EOLI contracts remain a powerful corporate planning tool as well as an attractive employee benefit, so long as the notice and consent requirements are adhered to and reports timely filed by the employer.