Changing Rules of Employer-Owned Life Insurance

The purchase of life insurance by your corporation is considered by many as one of the best risk management tools for any one of the following reasons:

  • Key Person life insurance to indemnify the business against financial loss in the event of a death;
  • To help finance the cost of employee benefit plans;
  • To help fund the purchase of a business interest under a Buy Sell agreement.

If you are considering purchasing corporate-owned insurance (COI) or already own it, It is imperative you understand how the rules have changed.

The Pension Protection Act provides that death benefit proceeds may be subject to income tax unless specific employee notices and consent requirements have been met.  However, certain exceptions apply.  This has all come about due to the Pension Protection Act pertaining to all COI contracts issued after August 17, 2006.

What is an employer-owned contract?  It is defined as a life insurance contract:

  1. Which is owned by a person engaged in a trade or business;
  2. Under which such person or related person (as defined by the law), is directly or indirectly a beneficiary; and
  3. Which covers an insured who is an employee of the trade or business of the applicable policy holder on the date the contract is issued.

As you can see, this definition includes policies where the business is the owner and beneficiary.  What is more difficult to understand is that under the applicable policy holder and related party definitions, a broad group of individuals and entities, such as family members, trusts, and estates, have now been included.

In writing the new law, Congress was aware this broad definition could negatively impact many valid business uses, and thus it included an exception where the employee receives notice of and consents to the following in writing prior to policy issue:

  • The applicable policy holder intends to insure the employee’s life and specifies the maximum face amount for which the employee will be insured at time of issue.
  • The employee consents to being insured, and agrees that such coverage may continue after he or she terminates employment.
  • The applicable policyholder will be the beneficiary of the death proceeds paid.

These consent requirements are a mandatory first step in avoiding taxation of the death benefits.  Unfortunately, the Notice and Consent is not the only requirement.  Employer-owned contracts must also fall within one of the follow exceptions:

A)   The first exception is based on an insured’s status:

a.  If the insured was an employee at any time during the 12 month period prior to death, or

b.  If the insured was a director, a highly compensated employee, or a highly compensated individual at the time the contract was issued.

B)   The second exception is based on who receives the death proceeds:

a.  If the amount is paid to a family member of the insured;

b.  If the amount is paid to an individual other than an applicable policyholder, who is the designated beneficiary of the insured;

c.  If the amount is paid to a trust established for the benefit of a family member or designated beneficiary;

d.  If the amount is paid to the estate of the insured; or

e.  Where the policy proceeds are used to purchase an interest in the applicable policyholder from such family member, beneficiary, trust or estate.

In addition to all of the above, annual reporting of any employer-owned contracts for each year the contracts are owned is required.  The annual reporting is done on IRS form 8925, and is attached to the policyholder’s tax return.  The form requires the following:

  • The number of employees at the end of the year;
  • The number of employees insured under such contracts;
  • The total amount of insurance in force under such contracts;
  • The name, address, taxpayer identification number of the applicable policyholder as well as the type of business; and An attestation that valid consent has been obtained from each insured, or where all consents have not been obtained, the number of insureds for whom such consent was not obtained.

Thus, as you can see, it is critical that documentation be maintained which proves that you have met all of the notice and consent requirements in a timely manner.

Life insurance can still meet the necessary business needs of a company, but in order to have a successful plan, the rules must now be followed very carefully.