Employer-owned life insurance (sometimes referred to as "EOLI") commonly is used by employers to insure executives and key employees. Such insurance policies provide a ready source of liquidity to pay deferred compensation obligations, to buy back equity from deceased employees or provide employees with key-man death benefits.
Historically, EOLI proceeds, payable upon the death of the insured employee, were presumed to be income tax-free to the employer. However, the Pension Protection Act of 2006 (the "PPA"), reversed this presumption. The PPA added Section 101(j) to the Internal Revenue Code of 1986, as amended (the "Code"), which provides that, unless one of two exceptions applies, effective for policies issued after August 17, 2006, proceeds on employer-owned life insurance, net of premiums and other amounts previously paid on the policy are taxable to the employer. In other words, since 2006 under the PPA, EOLI death benefit proceeds payable to an employer are no longer presumed to be income-tax free.
The Exceptions Under Section 101(j)
This presumption that EOLI proceeds paid to an employer are taxable can be overcome if one of two exceptions under Section 101(j) are carefully followed.
- Notice and Consent Exception. An employer will not be taxed on the death benefit proceeds that are payable on the insured's death if the notice and consent requirements of Section 101(j)(4) (described below) are satisfied, provided that: (i) the insured was an employee during the 12-month period before the date of death; and (ii) at the time the policy was issued the insured was a director, a highly compensated employee under Section 414(q) of the Code or a highly compensated individual under Section 105(h)(5) of the Code of the employer.
The notice and consent exception requires that, before issuance of the policy, the employee must: (i) be notified in writing of the employer's intention to insure the employee and the maximum face amount of the policy that is to be acquired; (ii) provide written consent to being insured, including consent for the coverage to continue after termination of employment; and (iii) be informed in writing that the employer will be a beneficiary of proceeds payable upon the death of the insured.
The notice and consent obtained from an employee may apply to more than one policy, but the policy must be issued before the earlier of: (i) one year from the date the employee's consent is executed, or (ii) the employee's termination of employment. In addition, the notice and consent requirements can be satisfied electronically.
To track the proper tax treatment of EOLI, employers must now file Form 8925 with their tax returns. Among other things, Form 8925 requires that the employer disclose whether it has valid consents from its employees for its employer-owned life insurance.
While there is no mechanism for correcting the failure to satisfy the notice and consent requirements of Section 101(j)(4), the IRS has stated that it will not challenge the applicability of the notice and consent exception if: (i) the employer made a good faith effort to satisfy the requirements; (ii) the failure to satisfy the requirements was inadvertent; and (iii) the failure to satisfy the requirements is discovered and corrected no later than the due date of the employer's tax return for the year in which the employer-owned life insurance policy was issued.
- Exception for Proceeds Paid to Heirs. In addition, to the Notice and Consent Exception described above, the second available exception under Section 101(j) stipulates that, if the EOLI death benefit proceeds are paid to a member of the deceased employee's family or are used to buy back equity in the employer from the deceased employee's family, the proceeds will not be taxable to the employer.
What to Do Now
Employers that will be acquiring life insurance policies to insure their employees should develop appropriate forms for providing the required notice and obtaining proper consent from such employees. For insurance policies previously issued after August 17, 2006, where the employer is the beneficiary of the policy, employers should confirm whether their EOLI qualifies under one one of the two exceptions. Employers should seek advice of counsel if their EOLI does not qualify for the exceptions under Section 101(j). Employers should also confirm with their accountants whether Form 8925 has been properly completed and filed with the employer's tax return.