On May 26, 2009, Treasury issued Notice 2009-48, which provides additional guidance regarding the treatment of employer-owned life insurance contracts under Section 101(j) of the Internal Revenue Code of 1986, as amended (the "Code"), and the recordkeeping and return requirements under Section 6039I of the Code. Employer-owned life insurance contracts generally refer to life insurance contracts that cover the lives of a company’s employees and with respect to which the company is the owner and beneficiary of all or some portion of the death benefits. Companies may invest in these employer-owned life insurance contracts for a variety of reasons, including (i) key man life insurance coverage, (ii) funding various qualified and nonqualified deferred compensation and benefit arrangements, and (iii) funding the payment obligations associated with certain buy-sell agreements.
Generally, the death benefits payable under a life insurance contract are tax-free under the exclusion rule in Section 101(a) of the Code. However, this exclusion does not apply to employer-owned life insurance contracts unless the insured employees receive notice of, and consent to, the company’s acquisition of life insurance contracts prior to their issuance. In addition, companies that purchase employerowned life insurance contracts are subject to ongoing obligations to report certain information with the company’s federal tax return each year the employer-owned life insurance contracts are owned. These requirements, as well as the additional guidance provided by Notice 2009-48, are discussed in more detail below.
Section 101(j) of the Code, as added by the Pension Protection Act of 2006, limits the amount of death benefits payable under an “employer-owned life insurance contract” that may be received by a company on a tax-free basis to the sum of the premiums and other amounts paid by the company for the contract. An “employerowned life insurance contract” is a life insurance contract that:
- is owned by a person engaged in a trade or business and under which that person (or a related person) is directly or indirectly a beneficiary under the contract; and
- covers the life of an insured who is an employee with respect to the trade or business of the company that is either the actual policy owner or that bears a certain relationship to, or is engaged in a business that is under common control with, the policy owner (collectively referred to as the “applicable policyholder”), on the date the contract is issued.
Sections 101(j)(2)(A) and 101(j)(2)(B) of the Code provide several exceptions to the general exclusion limitation rule under Section 101(j)(1) if an employer-owned life insurance contract meets certain notice and consent requirements. Specifically, these exceptions provide that the income exclusion limitation under Section 101(j)(1) of the Code does not apply to:
- any amount received by reason of the death of an insured who, with respect to the applicable policyholder, was an employee at any time during the 12-month period before the insured's death or is, at the time the contract is issued, a director, a highly compensated employee (defined as any employee who (A) was a 5-percent owner at any time during the year or the preceding year or (B) for the preceding year, had compensation in excess of $110,000) or a highly compensated individual (defined as an individual who is (A) one of the company’s five highest paid officers, (B) a shareholder who owns or is deemed to own more than 10 percent of the stock of the company, or (C) among the highest paid 35 percent of all employees); or
- any amount received by reason of the death of an insured to the extent that: a. the amount is paid to a member of the family of the insured, any individual who is the designated beneficiary of the insured under the contract (other than the policyholder), a trust established for the benefit of any member of the family or designated beneficiary, or the estate of the insured; or b. the amount is used to purchase an equity (or capital or profits) interest in the policyholder from any person described in (a) above.
Notice and Consent Requirements
If the death benefits received by the company qualify under one of these exceptions, then the company will be eligible to receive the full amount of death benefits payable under an employer-owned life insurance contract on a tax-free basis, but only if the company complies with the following three notice and consent requirements prior to the issuance of the life insurance contract:
- the company must notify the employee in writing that the company intends to insure the employee's life, and of the maximum face amount for which the employee could be insured when the contract is issued;
- the company must inform the employee in writing that the company or a related person will be a beneficiary of any proceeds payable upon the death of the employee; and
- the employee must provide written consent to being insured under the contract, and that the coverage under the contract may continue after the employee terminates employment.
Reporting and Recordkeeping Requirements
Section 6039I of the Code requires that a company owning one or more employer-owned life insurance contracts issued after August 17, 2006, file Form 8925 with the company’s tax return, indicating the following information for each year that the contracts are owned:
- the number of employees of the company at the end of the year;
- the number of those employees insured under the employer-owned life insurance contracts at the end of the year;
- the total amount of insurance in force at the end of the year under those contracts;
- the name, address and taxpayer identification number of the company, and the type of business in which the company is engaged; and
- that the company has a valid consent for each insured employee (or, if all required consents are not obtained, the number of insured employees for whom consent was not obtained).
In addition, the company must also keep whatever records may be necessary for purposes of determining whether the requirements of Sections 101(j) and 6039I of the Code are met.
Notice 2009-48 provides additional guidance regarding the application of Sections 101(j) and 6039I of the Code to employer-owned life insurance contracts, including guidance addressing the definition of a life insurance contract, exceptions to the general rule limiting the amount of death benefits that may be excluded from the policyholder’s gross income, the satisfaction of the notice and consent requirements, and the information reporting requirements. The guidance provided by Notice 2009-48 for each of these topics is set forth below.
Definition of Employer-Owned Life Insurance Contract. For purposes of defining the term “employer-owned life insurance contract” under Section 101(j)(3) of the Code, Notice 2009-48 provides the following guidance:
- A contract is an employer-owned life insurance contract only if it is owned by a person engaged in a trade or business. For these purposes, an insurance contract that is owned by an owner of an entity engaged in a trade or business (such as a policy owned by a shareholder of the employer to fund a cross-purchase buy/sell agreement) or by a qualified plan or VEBA that is sponsored by an entity that is engaged in a trade or business, would not be considered an employer-owned life insurance contract.
- A contract that is subject to a split dollar arrangement is an employer-owned life insurance contract if the contract is owned by a person engaged in a trade or business. However, the exclusion limitation under Section 101(j)(1) of the Code should not affect companies that maintain split dollar arrangements that entitle the company only to a portion of the death benefits not exceeding an amount equal to the sum of the premiums and other amounts paid by the company for the life insurance contract.
- Ownership of a life insurance contract by a partnership or sole proprietorship does not prevent the contract from being treated as an employer-owned life insurance contract. A life insurance contract that is owned by a sole proprietor on his or her own life is not, however, an employer-owned life insurance contract.
Exceptions to the General Rule Limiting Income Exclusion. Section 101(j)(2) of the Code provides several exceptions to the application of Section 101(j)(1) of the Code, which limits the amount of death benefits that may be received by a company on a tax-free basis from an employer-owned life insurance contract. For purposes of applying these exceptions, Notice 2009-48 provides the following guidance:
- Generally, the issue date of a contract is the date on the policy assigned by the insurance company, which is on or after the date the application was signed. Solely for purposes of applying the aforementioned exceptions to the income exclusion limitation under Section 101(j)(1) of the Code, an employer-owned life insurance contract is treated as “issued” on the later of (1) the date of application for coverage, (2) the effective date of coverage, or (3) the formal issuance of the contract. In addition, an employer-owned life insurance contract may be treated as a new contract, and thus newly “issued,” by reason of a material increase in death benefit or other material change in the contract. However, the following changes are not treated as material changes for purposes of determining whether an existing contract is treated as a new contract: (1) increases in death benefit that occur as a result of either the operation of Section 7702 of the Code (death benefit increases are sometimes made to maintain the requisite balance between the death benefit and cash values as mandated under Section 7702 of the Code) or the terms of the existing contract (provided the insurer's consent to the increase is not required); (2) administrative changes; (3) changes from general account to separate account or from separate account to general account; or (4) changes as a result of the exercise of an option or right granted under the contract as originally issued.
- For purposes of qualifying under the exception applicable to the use of death benefits for the purchase of equity interests from the insured’s heirs, the payment for the equity interests must be paid by the due date, including extensions, of the tax return for the taxable year in which the applicable policyholder receives the death benefit under the contract.
Satisfaction of the Notice and Consent Requirements. The notice and consent requirements discussed above must be met in order to avoid the application of the general rule under Section 101(j)(1) of the Code. With respect to these notice and consent requirements, Notice 2009-48 provides for the following:
- Notice and consent is required by an owner-employee of a wholly-owned corporation, actual knowledge alone cannot substitute for the statutory requirement that notice and consent be “written.” This requirement is intended to avoid factual controversies that could otherwise result where, for example, the sole owner of a corporation delegates financial matters to an employee.
- The actual transfer of an existing life insurance contract by an employee to an employer is sufficient to satisfy the requirements that the employee be notified in writing of the intention to insure and the maximum face amount of insurance, that written consent be secured, and that the employee be notified that the employer will be a beneficiary upon his or her death. However, if the employer subsequently increases the face amount of the contract, for example, written notice and consent must be secured to establish the requisite notice to the employee and consent to the new face amount of the contract.
- In order to prevent the expiration of an employee's consent with respect to a life insurance contract on his or her life, the life insurance contract must be issued before the earlier of (1) the expiration of the one-year period beginning on the date the consent was executed, or (2) termination of the employee's employment with respect to the trade or business of the applicable policyholder. Once obtained, it is not necessary to provide further notice or renew an employee’s consent with regard to an existing contract, unless one or more terms of the contract are materially changed.
- A single consent may apply to more than one employer-owned life insurance contract. For example, if an applicable policyholder notifies an employee that it intends to insure the employee’s life for a maximum $1million face amount and the employee consents in writing, the applicable policyholder may purchase multiple contracts that provide for the $1 million face amount in the aggregate.
- The notice and consent requirements may be satisfied electronically so long as the system for electronic notification and consent includes the elements set forth in Section 101(j)(4) of the Code (notification of intention to insure and maximum face amount, consent to insurance and continuation after termination of employment, and notification that an applicable policyholder will be a beneficiary of any proceeds payable upon the employee's death). In addition, the system must (1) ensure that the information received by the employee is the same as the information sent by the employer; (2) make it reasonably certain that the person accessing the system is the employee for whom notice and consent is required; (3) include a process for electronic signature or other means of formally recording the employee's consent to being insured; and (4) permit the production of a hardcopy of the electronic notice and consent upon request by the Internal Revenue Service and a statement that, to the best of the employer's knowledge, the required notice was provided to the employee and the employee consented to being insured.
- The requirement that the employee be notified in writing of the maximum face amount of life insurance requires the disclosure of a face amount of life insurance, either in dollars or as a multiple of salary, that the applicable policyholder reasonably expects to purchase with regard to the employee during the course of the employee's tenure. Additional notice and consent is required to the extent that the aggregate face amount of the contracts insuring the employee’s life exceeds the amount to which the employee was notified of, and consented to.
- Although Section 101(j) of the Code does not contain a provision for correcting an inadvertent failure to satisfy the notice and consent requirements, the Internal Revenue Service will not challenge the applicability of an exception to Section 101(j)(1) based on an inadvertent failure to satisfy the notice and consent requirements if the following conditions are met: (1) the applicable policyholder made a good faith effort to satisfy those requirements, such as by maintaining a formal system for providing notice and securing consents from new employees; (2) the failure to satisfy the requirements was inadvertent; and (3) the failure to obtain the requisite notice and consent was discovered and corrected no later than the due date of the tax return for the taxable year of the applicable policyholder in which the employer-owned life insurance contract was issued.
Informational Reporting Under Section 6039I of the Code. Section 6039I of the Code and Form 8925 require that every applicable policyholder owning one or more employer-owned life insurance contracts issued after August 17, 2006, provide certain information to the IRS for each year the contracts are owned. Notice 2009-48 provides that for purposes of determining the “applicable policyholder” that must comply with these reporting obligations, the only entity that must file the Form 8925 is the one that is the actual owner of the policy (even though other entities that are related to that owner otherwise fall within the definition of an “applicable policyholder”).