Trap for Employer-Owned Insurance

As a follow-up to my previous wealth tip titled “Employer-Owned Life Insurance,” there may be a cure for the unwary who fell into the trap of IRC §101(j) which became effective August 17, 2006.

You may recall the impact of IRC §101(j) is tax onerous. The issue is the IRS does not offer any safe harbors or do-overs if §101(j) is violated.

An example as to the impact of an employer’s failure in complying with IRC §101(j): ABC Corporation has decided to insure their key employee, Bill, utilizing what is known as key-man insurance. Key-man insurance will effectively allow the company to continue on in the event Bill should die while employed in ABC Corporation. ABC Corporation’s desire to purchase $1,000,000 of life insurance on Bill’s life was agreed to by Bill and all forms, applications, and medical underwriting were completed. Bill, a few years after the purchase of the insurance, experienced a health scare and although he survived he was no longer insurable. If Bill were to pass away, the $1,000,000 death benefit less any premiums paid would be subject to ordinary income tax rates under §101(j) due to ABC’s failure to provide Bill with written notification that ABC intended to insure his life. In addition, ABC’s accountant failed to file Form 8925 on or before the due date of ABC’s income tax return in the year the insurance was first purchased.

ABC Corporation would like to rectify the tax problem, but due to the fact that the IRS does not allow for do-overs, is hard-put as to what to do as the options available are few.

Option 1

The company could surrender the policy, thus starting fresh with a brand new policy and follow the required procedures in order to meet IRC §101(j) going forward; however, in this case, it is not practical since Bill is uninsurable.

Option 2

The company could materially change the contract. Unfortunately, the IRS has not provided any form of clarification as to what constitutes a “material change.” One thought is to increase the policy’s face amount; however, Bill is uninsurable so this option will not work.

Option 3

ABC could look toward the Transfer-for-Value rules wherein if a life insurance contract is transferred, the death benefit in excess of the consideration paid and premiums subsequently paid by the transferee, is income taxable; however, there are exemptions under IRS §101(a)(2)(B) allowing for a policy to be transferred to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation in which the insured is a shareholder. If any of these exceptions are met, the Transfer-for-Value rules do not apply and there will be no taxable income.

In addition, question 8 of IRC Notice 2009-48 states that a transfer of an existing life insurance policy by an employee to an employer satisfies the notice and consent requirements of IRC §101(j). In order to effectuate this potential strategy, ABC would distribute the life policy to Bill for its Fair Market Value (FMV). Since the distribution will be considered compensation, ABC will need to pay Bill a bonus to cover his increased income tax liability. Once Bill owns the policy, he can then become a minority owner of ABC by entering into a tax-free exchange with the company. Lastly, Bill holds the policy for a period of time and then irrevocably transfers it back to ABC Corporation. Since the Transfer-for-Value rules do not apply because Bill is a shareholder of the corporation, the transfer will be tax-free. However, more to our point regarding §101(j), the notice and consent requirements will be considered satisfied pursuant to question 8 of Notice 2009-48. In addition, if form 8925 is then filed on or before the due date of ABC’s next tax return, the corporation will also be in compliance and all death benefits will be received income tax-free.

There are, however, some disadvantages with this strategy.

1. If Bill were to die during the period in which he is holding the policy, the proceeds will be included in his estate and will not be available to benefit the employer for which it was originally purchased.
2. The IRS may also attempt to apply the “Step Transaction Doctrine” which the IRS uses to invalidate transactions when tax-avoidance is the sole motivation. Potentially, since Bill and ABC are in different economic positions before, during, and after the transaction this would be a strong defense against the Step Transaction Doctrine.

Option 4

Both Bill and ABC could consider purchasing interests in the same publically-traded partnership (PTP). The steps would be as follows:

1. ABC distributes the policy to Bill for its FMV and provides a bonus to cover any additional taxes owed.
2. Bill and ABC both purchase interests in the same PTP.
3. Bill irrevocably transfers the policy back to ABC while he and ABC are both holding PTP interests.

Once again, the Transfer-for-Value rules will not apply because ABC is a partner of the insured when Bill transfers the policy back to the corporation. However, this approach may also be attacked under the Step Transaction Doctrine. One possibility to avoid the Step Transaction Doctrine is for Bill and ABC Corporation to purchase their PTP interests over a period of time as opposed to simultaneously. They may also wish to purchase differing amounts, holding them for at least more than one year, and certainly not disposing of them simultaneously. Anybody considering employing this approach or the approach above, must consult their tax advisors prior to engaging in this transaction.

It has been my experience that §101(j) effects more employer-owned life insurance contracts than one might imagine. §101(j) may apply to any of the following:

1. Key-man policies;
2. Stock redemption buy-sell agreements for employee-owners;
3. Certain split-dollar structures;
4. Family limited partnerships and LLCs where the insured also acts as an employee;
5. Deferred compensation;
6. Supplemental employer retirement plans; and
7. 457 Plans.

If you have purchased employer-owned life insurance that is not in compliance with IRC §101(j), then it is imperative you begin to consider the various solutions described above.