IRS Notice Clarifies Tax Treatment of Employer-owned Life
Insurance
By Michael G. Kushner,
Esq.
Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY
INTRODUCTION
The IRS, in Notice 2009-48 (the “Notice”) provided
guidance on the taxation of employer-owned life insurance
(“EOLI”) under Code §§101(j) and
6039I 1 in question and
answer form.2 Although
§101(a) generally excludes from a recipient's income any death
benefits payable due to the death of the insured under a life
insurance policy, §101(j), enacted by the Pension Protection Act
of 2006, limited the exclusion from the policy owner's income for
proceeds payable under EOLI. The Notice is effective June 15, 2009.
The IRS has stated that it will not challenge a taxpayer that made a
good faith effort to comply with §101(j) based on a reasonable
interpretation thereof before then.
Under the general rule of §101(j), EOLI is a life insurance
contract owned by a person engaged in a trade or business where that
person, directly or indirectly, is the policy's beneficiary, and the
policy covers the life of someone who was an employee when it was
issued. The amount excluded from the policyholder's income cannot
exceed the premiums and other amounts the policyholder paid for the
policy, i.e., the policyholder only may recover his basis tax
free; all other proceeds are
taxable.3
Exceptions to §101(j) limits apply to policies that meet
certain notice and consent requirements. The exceptions are based on
either:
(1)
the insured's status as an
employee 4 at any time
during the 12-months before his death or employment as a director,
highly compensated employee or highly compensated individual when the
policy was issued, or
(2)
the extent that death benefits are paid to, or used to buy an equity
interest in the policyholder, from a family member, trust or estate of
the
employee.5
DEFINITION
Under the Notice, EOLI must be owned by a person engaged in a trade
or business. It cannot, for example, be owned by the owner of an
entity engaged in a trade or business or by a qualified plan or VEBA
sponsored by such an entity. EOLI, however, can be owned by a grantor
trust, including a rabbi trust, if trust assets are treated as assets
of a grantor that is engaged in a trade or
business.6
A split-dollar arrangement can qualify as EOLI if it is owned by a
person engaged in a trade or
business,7 except to the extent
any amount received due to the insured's death is paid to a family
member of the insured, a designated beneficiary of the insured or a
trust established to benefit of a family member or designated
beneficiary.8 Policy ownership by
a partnership or sole proprietorship can qualify as EOLI, however, a
policy owned by a sole proprietor on his or her own life
cannot.9
EXCEPTIONS TO GENERAL RULE OF SECTION 101(j)(1)
There are exceptions to §101(j), if certain notice and consent
requirements are met. The rule does not apply:
(1)
if the insured either was an employee at any time during the 12-months
before death or was a director, highly compensated employee or highly
compensated individual when the policy was
issued,10 or
(2)
to any amount received due to the death of an insured to the extent it
is paid to or used to buy an equity (or capital or profits) interest
from a family member of the insured, the insured's a designated
beneficiary, a trust established for the benefit of a family member or
designated beneficiary or the insured's estate
.11
Generally, a policy is “issued” when assigned by the
insurer, which must be on or after the date the application was
signed. EOLI is treated as “issued” on the later of:
(1)
the date of application for coverage;
(2)
the effective date of the
coverage;12 or
(3)
the policy's issuance.
To determine whether a death benefit is subject to inclusion under
§101(j)(1), a taxpayer must determine the availability of the
exception for amounts used to buy an equity (or capital or profits)
interest in the policyholder. Such an amount must be so paid or used
by the due date, including extensions, of the tax return for the
policyholder's tax year in which the policyholder is treated as
receiving a death
benefit.13
NOTICE AND CONSENT REQUIREMENTS
Certain notice and consent requirements must be met to avoid the
application of §101(j)(1); before the policy is issued, the
employee must:
(1)
receive written notice that the policyholder intends to insure the
employee's life and of the maximum face amount for which the employee
could be insured;
(2)
consent in writing to being insured and to coverage continuing after
employment terminates; and
(3)
be notified in writing that a policyholder will be a beneficiary of
the benefit payable upon the employee's
death.14
A wholly owned corporation and its employee-owner are not excused
from the notice and consent rules and nor can actual knowledge alone
cannot substitute for the requirement that the notice and consent be
“written.”15 The
actual transfer of an existing life insurance policy by an employee to
an employer, however, will satisfy the notice and consent
requirements. If the employer later increases the face amount,
however, it must provide written notice and obtain employee
consent.16 For a consent to be
valid, the contract must be issued before the earlier of:
(1)
one-year after the consent is executed, or
(2)
termination of employment with the policyholder.
Employers need not provide further notice or renew an employee's
consent for an existing policy unless, for example, the total face
amount exceeds the amount of which the employee was notified and to
which he previously had
consented.17
If the notice and consent requirements otherwise are met, the fact
that more than one policy is acquired on an employee who executed a
single consent does not prevent the exception from applying. Thus, if
an employee is notified that the policyholder intends to insure the
employee's life for up to $1 million and the employee consents, the
employer can, for instance, buy two EOLI policies, each with a face
amount of $500,000.18
The notice and consent rules can be satisfied electronically if the
electronic system:
(1)
ensures that the information received by the employee is the same as
that sent by the employer;
(2)
verifies that the person accessing the system is the employee;
(3)
includes a process for electronic signature or other means to record
the employee's consent; and
(4)
permits the production of a hardcopy of the electronic notice and
consent upon IRS request, including a statement that, to the best of
the employer's knowledge, the notice was provided to the employee and
the employee consented to being
insured.19
The maximum face amount of the insurance requires a disclosure
either in dollars or as a multiple of salary that the policyholder
reasonably expects to buy during the employee's tenure. Additional
notice and consent must be obtained if the total face amount exceeds
the amount in the original notice and
consent.20
Although §101(j) does not provide rules for an inadvertent
failure to satisfy the notice and consent rues, the IRS has stated
that it will not challenge the availability of an exception to
§101(j) based on an inadvertent failure to satisfy the rules, if:
(1)
the policyholder made a good faith effort to satisfy the rules, such
as maintaining a formal system for providing notice and securing
consents from new employees;
(2)
the failure was inadvertent; and
(3)
the failure was discovered and corrected by the due date of the tax
return for the policyholder's taxable year in which the policy was
issued.
An employee's consent, however, cannot be obtained posthumously,
for example, by his
Executor.21
TRANSITION RULE AND SECTION 1035 EXCHANGES
Section 101(j) applies to contracts issued after August 17, 2006,
except contracts issued after that date as part of a §1035
exchange for a contract issued on or before that date. A material
increase in the death benefit or other material change causes the
contract to be considered a new contract subject to §101(j).
22
Certain changes are not considered material changes in determining
whether an existing policy is treated as a new one under §101(j):
(1)
increases in death benefit occurring solely due to either the
operation of §7702 or in the terms of the existing contract
(provided the insured's consent to the increase is not required);
(2)
administrative changes;
(3)
moving funds from a general account to separate account or vice versa;
or
(4)
changes resulting from the exercise of an option or right granted
under the original contract.
Furthermore, an increase in the policy's face amount results from
applying policyholder dividends to buy paid-up additions, an increase
resulting from market performance or contract design for a variable
contract are not material
modifications.23
Section 101(j) generally does not apply when a policy issued after
August 17, 2006, is exchanged in a §1035 exchange for one issued
on or before that date. In determining when a policy is issued, a
material increase in death benefits or other material change generally
causes the IRS to treat the contract as
new.24 A §1035 exchange that
results in a material increase in death benefit or other material
change (other than a change in issuer) is treated as a new contract
after August 17,
2006.25
INFORMATION REPORTING UNDER SECTION 6039I AND FORM 8925
Section 6039I and IRS Form 8925 require a policyholder owning one
or more EOLI policies issued after August 17, 2006, to provide the
following information for each year a contract is owned:
26
(1)
the number of employees at the end of the year;
(2)
the number of employees covered by EOLI;
(3)
the amount of EOLI in effect at year end;
(4)
the policyholder's name, address and identifying number;
(5)
the employer's type of business; and
(6)
a statement that the policyholder has a valid consent for each insured
employee (or, if all consents have not been obtained, the number of
employees who have not consented).
CONCLUSION
The Notice provides welcome guidance in the area of EOLI. Pending
further guidance, it grants taxpayers relief for prior attempts to
comply with the statute, provided that they were done in good faith.
While §101(j) places certain tax constraints upon EOLI, many
arrangements should remain eligible for excludability under
§101(a) under the Notice.
For more information, in the Tax Management Portfolios, see
Brody, Richey and Baier, 386 T.M., Compensating Employees with
Insurance, and in Tax Practice Series, see ¶5930, Death
Benefits.
1
All section references herein are to the Internal Revenue Code of 1986, as amended, and the Treasury regulations promulgated thereunder, unless otherwise specified.
2
Sections 101(j) and 6039I were added to the Code by §863 of the Pension Protection Act of 2006 (“PPA”), P.L. 109-280.
3
§101(a), (j)(1).
4
Section 101(j)(5)(A) provides that the term “employee” includes an officer, director, and highly compensated employee within the meaning of §414(q). This includes self-employed individuals within the meaning of §401(c)(1).
5
§101(j)(2).
6
§101(j)(3); Notice 2009-48, Q&A-1.
7
Regs. §1.61-22(c)(1).
8
§101(j)(2)(B). Notice at Q&A-2.
9
Notice at Q&A-3.
10
§101(j)(2)(A).
11
§101(j)(2)(B).
12
If EOLI is effective for a limited period before the policy formally is issued, the notice and consent rules can be satisfied during this gap period. EOLI may be treated as a new policy, and thus newly “issued,” if there is a material increase in death benefit or other material change.
13
Notice at Q&A-6.
14
Id.
15
Notice at Q&A-7.
16
Notice at Q &A-8.
17
Notice at Q&A-9.
18
Notice at Q&A-10.
19
Notice at Q&A-11.
20
Notice at Q&A-12.
21
Notice at Q&A-13.
22
P.L. 109-280, §863(d). In the case of a master contract within the meaning of §264(f)(4)(E), however, the addition of covered lives is treated as a new contract only with respect to the additional covered lives.
23
Notice at Q&A-14.
24
P.L. 109-280, §863(d).
25
Notice at Q&A-15.
26
Notice at Q&A-17.
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