Historically, proceeds received by an employer from a company-owned life insurance policy upon the death of an employee were not taxable under Internal Revenue Code (Code) Section 101(a). However, Code Section 101(j) added by the Pension Protection Act of 2006 (Act) constitutes a major change from the prior law.
Under Code Section 101(j), insurance proceeds (in excess of premiums paid) received from an employer-owned life insurance contract (EOLIC), are taxable unless (1) the EOLIC qualifies under a prescribed safe harbor, and (2) certain notice, consent and reporting requirements are met.1 Effective June 15, 2009, the Internal Revenue Service (IRS) issued Notice 2009-48 to provide much needed guidance and clarification regarding the application and operation of the Act.2
WHAT IS AN EOLIC?
An EOLIC is a life insurance policy (1) owned by an “employer” or “related person” (policyholder) engaged in a trade or business which is the direct or indirect beneficiary of the policy, and (2) insuring the life of an “insured” who is an “employee” of the policyholder when the policy is issued.3
Many types of life insurance policies owned by a business on its employees would be considered an EOLIC, and therefore subject to the Act, including key-person insurance, insurance funding buy-sell arrangements (except as discussed below), and split-dollar insurance (for the portion of proceeds payable to the employer or related person). Notice 2009-48 specifies that a policy insuring the life of the sole owner of a corporation or other entity, and a policy that is owned by a grantor trust (e.g. rabbi trust), assets of which are treated as assets of a grantor that is engaged in a trade or business, are each considered an EOLIC. However, a policy owned by an owner of an entity engaged in a trade or business (such as for purposes of financing the purchase of any equity interest of another owner), or by a qualified plan or VEBA that is sponsored by an entity engaged in a trade or business, is not considered an EOLIC.
“Employer” includes any individual, sole proprietorship, partnership, association, corporation or other entity.
“Employee” means the following individuals: (1) common law employees; (2) officers; (3) directors; and (4) “highly compensated employees” as defined under the qualified plan rules of Code Section 414(q) (5% owners and employees with compensation in excess of $110,000 for 2009 and 2010).4 Notice 2009-48 specifies that an owner, officer or director of a policyholder need not be employed or receive any payment for services to be treated as an “employee” under Code Section 101(j).
“Insured” means any individual covered by an EOLIC who is a resident or citizen of the United States.5
“Related person” means any individual, sole proprietorship, partnership, association, corporation or other entity that: (1) is engaged in a trade or business under common control with the employer within the meaning of Code Section 52(a), (b); or (2) bears a relationship to the employer specified in Code Section 267(b) or 707(b)(1) (e.g., (i) a family member of the employer including ancestors, lineal descendants, spouse, and siblings, (ii) an individual or entity owning more than 50% of the employer, (iii) a member of the same controlled group as the employer, (iv) an entity where the same person owns more than 50% of such entity and the employer). 6
There are two safe harbor exceptions under Code Section 101(j).7 If either safe harbor exception is met, and the notice, consent and reporting requirements are met, the EOLIC proceeds received by the policyholder upon death of the employee will not be taxable.
A. Insured’s Status. The insured’s status can be described by either of the following: (1) the insured was an employee of the policyholder at any time during the 12-month period preceding the insured’s death; or (2) at the time the EOLIC was issued, the insured was a director, highly compensated employee (as previously defined), one of the five highest paid officers, or a “highly compensated individual” as defined in Code Section 105(h)(5) (one of the five highest paid officers or among the 35% highest paid employees) of the policyholder.8
B. Payments to Insured’s Heirs. The EOLIC proceeds received by the policyholder are: (1) paid to a member of the insured’s family (as defined by Code Section 267(c)(4), including ancestors, lineal descendants, spouse and siblings); (2) paid to a trust established for any such member of the insured’s family or beneficiaries; (3) paid to the estate of the insured; or (4) used to purchase an equity (or profits) interest in the policyholder from any person described in items (1) through (3).9 Notice 2009-48 specifies that the amounts used to purchase an equity interest must be paid by the due date, including extensions, of the tax return for the taxable year of the policyholder in which the policyholder is treated as receiving a death benefit under the EOLIC.
NOTICE, CONSENT AND REPORTING REQUIREMENTS
If either safe harbor exception is met, a policyholder must also follow the notice, consent and reporting requirements set forth below to ensure the EOLIC proceeds are not taxable.
A. Notice and Consent. The following requirements must be met before the EOLIC policy is issued: (1) the policyholder must notify the insured in writing that the policyholder intends to insure the individual’s life under an EOLIC and that a policyholder will be the beneficiary, and stating the maximum face amount of the coverage when issued; and (2) the insured must give the policyholder written consent to being insured under the EOLIC and that coverage may continue after employment is terminated for any reason.10
Notice 2009-48 specifies that: an EOLIC is deemed “issued” on the later of the date of application for coverage, effective date of coverage, or formal issuance of the policy; for notice and consent to be effective, the EOLIC must be issued before the earlier of one year after the consent is executed by the employee or the date of termination of the employee’s employment; and notice of the maximum face amount of life insurance requires a disclosure either in dollars or as a multiple of salary that the policyholder reasonably expects to purchase during the course of the employee’s tenure.
B. Reporting. The policyholder is required to file an annual return (Form 8925) with the IRS showing: (1) the number of employees employed by the policyholder at the end of the year; (2) the number of employees insured under EOLIC’s at the end of the year; and (3) an acknowledgement that the policyholder has a valid consent for each insured (and if applicable, the number of insured’s from whom consent has not been obtained). Notice sent and consent obtained should be retained for the life of each insured and the audit period for tax returns afterwards.11
EFFECTIVE DATE AND ENFORCEABILITY
EOLIC’s issued after August 17, 2006 are subject to the Act. In addition, an EOLIC issued on or before August 17, 2006 will become subject to the Act if there is a material increase in the death benefit or other material change made to the policy after August 17, 2006. Notice 2009-48 clarifies that the following changes are not treated as material changes: (1) increases in death benefit that occur as a result of either the operation of Code Section 7702 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. Thus for example, a death benefit increase does not cause a contract to be treated as a new contract if the increase is necessary to keep the contract in compliance with Code Section 7702, or if the increase results from the application of policyholder dividends to purchase paid-up additions, or if the increase is the result of market performance or contract design with regard to the variable contract.
In Notice 2009-48, the IRS has agreed that it will not challenge a policyholder that has not met the notice and consent requirements, provided the policyholder has since implemented a formal system for providing notice and obtaining consent in compliance with the Act, and further provided the failure to comply was inadvertent and corrected prior to the due date of Form 8925 applicable to the year in which the particular EOLIC was issued.