Tax Consequences for Employer-Owned Life Insurance
Many companies take out life insurance policies on the lives of their employees. Often the purpose of these policies is to provide a financing mechanism for otherwise expensive employee benefits, such as a deferred compensation package for the founding shareholder or CEO. Other times the policy operates as resource companies can tap to satisfy an obligation to buyout the shares of deceased or retiring shareholders. Regardless of the purposes of the arrangement, recent changes to the Internal Revenue Code have added additional burdens to employers seeking to take advantage of the tax benefits otherwise available to owners of life insurance policies.
As a general rule, the Internal Revenue Code allows taxpayers to exclude benefits received under a life insurance policy, so long as the benefits are received due to the death of the insured (There are special rules for the tax treatment of a "cash surrender" transaction). It should be no surprise, however, that there are several exceptions to this general rule. One exception recently added to the Internal Revenue Code applies to "employer-owned life insurance contracts". This article is meant to serve as an overview of the requirements employers must meet to maintain the tax benefits associated with owning life insurance. The new requirements apply to all "employer-owned life insurance contracts". Before going further, it is necessary to define just what constitutes an "employer-owned life insurance contract".
What is an "Employer-Owned Life Insurance Contract"?
An employer-owned life insurance contract is any life insurance policy which is
1) Owned by an employer;
2) Designates the employer as the beneficiary of the policy; and
3) Covers the life of an employee.
A policy covers the life of an employee if it covers an officer, director, or highly compensated employee (Defined for 2009 and 2010 as any employee receiving more than $110,000 in compensation). For purposes of determining whether the employer owns the policy in question, complicated rules can result in the employer being deemed to own a policy which it does not otherwise own on paper. Policies owned by corporations with the same owners, for example, will be imputed to each other.
Tax Consequences of Employer-Owned Life Insurance Contracts:
As mentioned above, the Internal Revenue Code normally allows beneficiaries to receive life insurance benefit tax-free. The new rule for employer-owned life insurance, however, eliminates this favorable tax treatment unless specific notice and reporting requirements are satisfied. If the employer fails to meet these requirements, it will not be allowed an exclusion for the entire amount of the benefits received under the insurance policy. Instead, the employer will be allowed to exclude only an amount equal to the premiums it had paid for the policy. The excess must be included in the employer's gross income. These rules apply to any insurance policy issued to an employer after August 17, 2006.
The undesirable consequences of the new treatment of employer-owned life insurance policies should be readily apparent. For example, if the employer planned on using the insurance proceeds to fund an employee benefit package or redeem the interests of a deceased shareholder, the funds available for such purposes will be reduced by the income tax liability. The employer may find itself without the funds necessary to satisfy its obligations to its employees or former employees. If the employer defaults on these obligations, it may expose itself to a lawsuit. If the employer makes good on its obligations by using other resources to make up for the income taxes lost, it may deprive itself of funds necessary to satisfy overhead and other operating expenses. These potentially harsh consequences highlight the importance of fitting into an exception from the treatment of employer-owned life insurance policies.
Exceptions for Certain Types of Policies:
A policy will not be subject to the new rules for employer-owned life insurance contract in several circumstances. The first exception focuses on the year preceding the insured's death. If the insured was an officer, director, or highly-compensated employee any time during the year before his or her death, the employer will receive the proceeds tax free. A second exception focuses not on the circumstances at the time of the insured's death, but instead looks at the circumstances at the time the insurance policy was issued. The employer will receive the benefits of the policy tax-free if the insured was a director, highly compensated employee (see above), among the five highest paid officers of the company, a ten percent shareholder, or among the highest paid 35% of employees at the time the life insurance policy was issued.
Another exception allows the insurance proceeds to be received tax free if the proceeds are used to purchase an ownership interest in the employer from the family members of the deceased or a trust established for the benefit of the family members of the deceased. It is common for owners of a business to require the company to purchase the ownership interests of their surviving spouses in the event of their death. This provides the surviving spouse with assets for his or her support for the remainder of their lives.
By granting these exceptions, Congress implicitly recognized the importance of life insurance policies in business, benefit, and estate planning. So long as the employer satisfies the requirements of the exception, it will once again enjoy the life insurance proceeds tax-free. While these exceptions significantly limit the impact of the new rules, they are conditioned on the employer satisfying specific notice and reporting requirements discussed below.
Notice and Consent Requirements:
Before an employer may take advantage of the exceptions from the otherwise adverse tax consequences of holding life insurance contracts on their employees, the employer must notify the employee of the substance of the policy. These requirements must be satisfied before the issuance of the insurance policy. In particular, the employer must
1) Notify the employee, in writing, that it intends to insure the employee's life, and state the maximum face value for which the employee could be valued at the time of the contract;
2) Obtain the written consent of the employee that coverage may continue after the employee terminates employment; and
3) Inform the employee, in writing, that the employer will be a beneficiary of any proceeds payable on the death of the employee.
Because the exceptions are conditioned on the employer satisfying these requirements before the issuance of the life insurance policy, companies and their advisors should ensure they are in compliance with the notice and consent requirements before purchasing life insurance policies on their employees, officers, directors, or shareholders.
Annual Reporting Requirements:
Employers must attach Form 8925 "Report of Employer-Owned Life Insurance Contracts" to the employer's annual income tax return every year it holds life insurance policies on its employees, officers, directors, or shareholders.
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