Editor: Michael D. Koppel, CPA, PFS
In general, proceeds from life insurance policies are tax free under the general exception rules in Sec. 101(a). This general rule changed when Sec. 101(j)(1) was added with the enactment of the Pension Protection Act of 2006, P.L. 109-280. The new section limits the amount of tax-free treatment a person (which can be any type of entity) can receive from the proceeds on an employer-owned life insurance (EOLI) contract. The amount that is considered tax free is limited to the total amount of premiums paid and other amounts paid by the life insurance policyholders, leaving the remaining proceeds taxable. This eliminates the tax-free treatment for EOLI on the total amount of the proceeds afforded under the general exclusion rules in Sec. 101(a).
Sec. 101(j)(3)(A) defines an EOLI contract as a contract that is owned by a person (this includes business entities) engaged in a trade or business under which that person is directly or indirectly a beneficiary under the contract, and that covers the life of an insured employed in the trade or business at the time the contract is issued. It also includes split-dollar arrangements, defined under Regs. Sec. 1.61-22(c)(1) as an insurance policy where two or more persons are named as policy owners of a life insurance contract.
Despite being defined as EOLI under Sec. 101(j)(1), an insurance arrangement can still qualify for the general exclusion under Sec. 101(a) if the EOLI conforms with the notice and consent procedures prescribed under Sec. 101(j)(4). Failure to obtain timely notice and consent will result in the insurance proceeds becoming taxable (proceeds less total premiums paid or other related expenses) and not subject to the general exclusion. Therefore, it is very important that all new policies meet the notice and consent requirements before the policy is issued. To meet those requirements, the employee must:
- Be notified in writing that the policyholder intends to insure the employee’s life and the maximum amount of such policy.
- Provide written consent to being insured under the contract and that the coverage may continue after the insured’s employment is terminated.
- Be informed in writing that the policyholder will be the beneficiary of any proceeds upon the death of the insured.
If a company and the employee meet these notice and consent requirements, Sec. 101(j)(1) will not apply to any amounts received by reason of the death of an insured if he or she was an employee at any time during the prior 12 months or if the insured was a director or a highly compensated employee as defined in Sec. 414(q) or a highly compensated individual as defined in Sec. 105(h)(5) (except that 35% is substituted for 25% for this test). This also will not apply to amounts paid to a member of the family (within the meaning of Sec. 267(c)(4)) of the insured, a trust that is for the family’s benefit, the insured’s estate, or any individual who is the designated beneficiary of the insured under the contract (other than the applicable policyholder) or if the proceeds were used to purchase the insured’s equity position.
These new rules apply only to insurance contracts issued after August 17, 2006. Policies that were already in place before this date are grandfathered as to the general exclusion under Sec. 101(a), and the limitations imposed by Sec. 101(j) (1) do not apply. However, if a taxpayer has an existing policy that was grandfathered and makes a change in the death benefit or any other material change in the policy, the taxpayer has created a new contract that requires notice and consent. If notice and consent is not in place prior to the insurance policy modification, any net proceeds from this policy (gross proceeds less total premiums paid or other amounts paid) will be taxable.
Notice and Consent Requirement Burdens
This requirement creates a significant burden in obtaining the notice and consent prior to the issuance of any policies and/or modifications. The IRS has said that it would not challenge the exception to the exclusion limitation for an inadvertent failure to satisfy the notice and consent requirements if the policyholder has made a good-faith effort to satisfy these requirements. This good-faith effort would include having a formal system to provide notice and securing consent. The failure should have been inadvertent, discovered, and corrected no later than the due date of the tax return for the year the policy was issued. However, consent cannot be corrected after the insured’s death. This corrective remedy is provided within Notice 2009-48, Q&A-13.
In addition, all policyholders of contracts issues after August 17, 2006, must attach to their tax return Form 8925, Report of Employer-Owned Life Insurance Contracts. This is an information disclosure that requires the policyholder to report insurance information, including the total number of employees the company has insured, the number of employees that were issued policies after August 17, 2006, and the total amount of insurance in force at the end of the year. In addition, this form asks specifically whether the policyholder has a valid consent for each employee that was issued a policy after August 17, 2006, as well as the number of employees for which the taxpayer does not have consent. The policyholder must file Form 8925 every year with its income tax return.
In Notice 2009-48, the IRS provides additional guidance regarding EOLI contracts in a question-and-answer format. In these Q&As, the IRS defines an EOLI contract and employee, goes into detail on how to satisfy the notice and consent requirements, and provides information on the transition rule and Sec. 1035 exchanges.
These rules, which are related to Sec. 101(j)(1) because they apply to insurance contracts issued after August 17, 2006, will become more important in future years as claims are made to collect on these contracts. If the employer and the employee do not meet the notice and consent requirements, the tax-free treatment of the proceeds from these new policies will be in jeopardy.
Michael Koppel is with Gray, Gray & Gray, LLP, in Westwood, MA.
Unless otherwise noted, contributors are members of or associated with CPAmerica International.
For additional information about these items, contact Mr. Koppel at (781) 407-0300, or firstname.lastname@example.org.