In 2006, a new federal tax law provision was added, stating that under certain circumstances death benefits paid under life insurance policies—for key employees—owned by an employer will be subject to ordinary federal income tax unless specified procedural requirements have been strictly adhered to during the application and underwriting process. This M Intelligence post outlines the issue in detail and clarifies how to avoid adverse tax results.
The General Rule: Death benefits paid with a life insurance policy are not subject to federal income tax, whether or not the policy beneficiary is an individual, business, trust, or estate.
- The Longstanding Exception: An historic exception to this general rule has been the Transfer-for-Value scenario where a policy, prior to the insured’s death, has been sold by the policyholder to a new owner. Scenarios involving this type of sale transaction, as well as applicable exceptions to the rule, are beyond the scope of this post.
- The New Exception: Section 101(j) introduces an additional exception to the general rule, one that creates a more significant consequence than previously existed.
- This new provision, which applies to certain Employer-Owned Life Insurance (EOLI) policies, imposes a far more dangerous tax trap because it does not involve the post-issue transfer of an already existing in-force policy, but instead the commonly encountered situation of business owner(s) taking out coverage on key employees. The 101(j) rule carries with it the risk of a permanent negative impact the policy’s tax benefits, if the proscribed IRS administrative steps aren’t precisely followed during the application process.
EOLI Provisions and Requirements
In addition to the statutory language set forth in Code Section 101(j), a detailed guide has been provided by the IRS in a taxpayer-friendly Q&A format through Notice 2009-48.1 In summary:
- Definition: An EOLI policy is owned by a person or entity engaged in a trade or business, covering an insured U.S. citizen or resident who is an employee at time of policy issue, and under which the business owner is a beneficiary.
- Timing: Included in the scope of the new rules are any EOLI policies issued after August 17, 2006, or older policies that are materially modified after that date (e.g. a substantial, underwritten face amount increase or exercise of a policy option).
- The Problem: Although the general tax rule for life insurance extends tax-free treatment to death proceeds, there is an exception for EOLI policies that have not followed a specific procedure before the policy is issued. The government’s purposein penalizing EOLI with adverse taxation was to rectify abuses perceived from the irresponsible use of business life insurance, such as wholesale coverage of non-key, rank-and-file employees for the employer’s profit, or taking out coverage on employees without their knowledge or consent.
- Qualifying for Income Tax-Exempt Death Proceeds:
- Conform to the Section’s Notice & Consent requirements (detailed below), AND
- Meet at least one of the four safe harbors specified in the law:
- The insured is a key person at policy issue—director, 5% or > owner, one of five highest paid, among 35% highest paid, or received at least $95,000 compensation (inflation- indexed).
- Insured was an employee during the 12-month period preceding death.
- Death benefit is paid out to the insured’s heirs (family member, estate, or trust).
- Death benefit is used to purchase insured’s ownership interest in the employer from one of the family member parties listed above.
- Notice & Consent: These requirements are met if, prior to policy issuance, the employee:
- is notified in writing of the employer’s intent to insure, and of the maximum possible amount of insurance,
- provides written consent to being insured and that such coverage may continue after employment termination, and
- is informed in writing that the employer will be a policy beneficiary upon death.
- Annual return filing requirement (Form 8925):2 In addition to closely following the pre-policy issue procedural steps, every policyholder owning EOLI issued after August 17, 2006 must provide on IRS Form 8925 the following information each year the policies are owned:
- the number of the policyholder’s employees at the end of the year,
- the number of employees insured under applicable EOLI policies,
- the total amount of insurance in force under such policies,
- the name, address, and tax ID of the policyholder and type of business in which engaged, and
- that the policyholder has a valid consent for each insured employee (or, if not all obtained, the number of employees for whom consent is not obtained).
Beyond the limited year-of-issue exception, there is no way to correct a post- August 17, 2006- issued keyperson, non-qualified plans-funding, or buy-sell-backing policy if the formal Notice & Consent steps have not been followed in writing. The death proceeds are irrevocably ‘tax-tainted.’
When considering any of these corrective steps to address a post August 17, 2006 policy non-compliantly acquired, a qualified business life insurance professional’s advice should be sought. His or her experience in knowing the rules and working with sophisticated business market carriers is necessary when addressing product defects relating to these complex EOLI procedures.Download PDF | To learn more, connect with an M Member Firm.