IRS Issues Changes to Tax Treatment of Employer-Owned Life Insurance
In 2009, the IRS issued Notice 2009-48 that provided clarification on a little-talked about provision in the Pension Protection Act of 2006 regarding the tax treatment of Employer Owned Life Insurance (EOLI). EOLI contracts refer to life insurance contracts that cover the lives of employees in which the company is the owner and beneficiary of all or some portion of the death benefits. Companies use these life insurance contracts for a variety of reasons, including key person protection, buy/sell agreement funding, and nonqualified deferred compensation and benefit arrangements.
Generally, the death benefits associated with life insurance are income tax-free to the beneficiary under the exclusion rule in Section 101(a) of the code. However, the Pension Protection Act of 2006 added Section 101(j) to the code that states that the death benefit of EOLI contracts are taxable (for proceeds above the total of premiums paid) unless the insured employees receive notice of, and consent to, the company’s acquisition of life insurance prior to their issuance. In addition, companies are subject to report certain information with the company’s federal tax return each year the EOLI contracts are owned.
What Does This Ruling Mean?
It means that EOLI contracts issued after August 17, 2006, will have a taxable death benefit. For example, let’s assume a company takes out a policy on a key person, someone who is critical to that company’s success and profitability, for $2 million of death benefit. The company fails to provide and receive proper notification and does not comply with the IRS reporting and filing requirements. The insured individual then dies. The death benefit, $2 million, comes to the company and the company then owes $700,000 in income tax (assuming a 35 percent tax rate). Not exactly what the company had hoped for when they took out the policy.
Who Does This Apply To?
Any and all companies that have EOLI contracts. It could be a privately held company that is funding a buy/sell agreement or a private equity firm that is insuring a key person to protect their investment. Regardless of the reason, any company that has life insurance is affected.
How Does a Company Ensure the Benefit is Tax Free?
Companies need to meet two criteria prior to the issuing of the policy:
- Provide notice to the potential insured on the intent to insure that individual’s life, specifying the maximum coverage e amount
and noting that the company will be the beneficiary of the proceeds and that the coverage may extend beyond the term of the
insured’s employment.
- Receive written consent from the insured employee that they have been notified on these provisions.
Then the company must file Form 8925 annually for as long as they own the policy or policies. The company must also maintain documentation that proves they have met the notice and consent requirements in a timely matter.
Can an Inadvertent Notice and Consent Requirement Be Corrected?
Yes, companies can still meet the notice and consent requirements as long as they made a good faith attempt to satisfy the requirement by maintaining a formal system, the failure was inadvertent, and it was discovered no later than the due date of the tax return for that tax year in which the policy was issued. Once the filing deadline has passed, the company will need to start over with a new policy or make a material change to an existing policy.
In summary, the EOLI rules have not ruled out income tax free death benefits of life insurance, but they do specify requirements must be met. It appears that no advisor, insurance company, CPA, or attorney is stepping up to provide guidance to companies on this issue. This truly is an area where Lockton is providing the leadership, clarity, and direction that our clients need.
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Ron Lottridge
Executive Benefits
Producer
Denver, CO
Tel: 303.414.6116
E-mail: rlottrid@lockton.com |
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Jason Maples
Executive Vice President
Producer
Denver, CO
Tel: 303.414.6101
E-mail: jmaples@lockton.com |
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