By Michael G. Kushner, Esq. Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY
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
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).
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).
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.
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.
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.
By Michael G. Kushner, Esq. Curtis, Mallet-Prevost, Colt & Mosle LLP, New York, NY
All Bloomberg BNA treatises are available on standing order, which ensures you will always receive the most current edition of the book or supplement of the title you have ordered from Bloomberg BNA’s book division. As soon as a new supplement or edition is published (usually annually) for a title you’ve previously purchased and requested to be placed on standing order, we’ll ship it to you to review for 30 days without any obligation. During this period, you can either (a) honor the invoice and receive a 5% discount (in addition to any other discounts you may qualify for) off the then-current price of the update, plus shipping and handling or (b) return the book(s), in which case, your invoice will be cancelled upon receipt of the book(s). Call us for a prepaid UPS label for your return. It’s as simple and easy as that. Most importantly, standing orders mean you will never have to worry about the timeliness of the information you’re relying on. And, you may discontinue standing orders at any time by contacting us at 1.800.960.1220 or by sending an email to email@example.com.
Put me on standing order at a 5% discount off list price of all future updates, in addition to any other discounts I may quality for. (Returnable within 30 days.)
Notify me when updates are available (No standing order will be created).
This Bloomberg BNA report is available on standing order, which ensures you will all receive the latest edition. This report is updated annually and we will send you the latest edition once it has been published. By signing up for standing order you will never have to worry about the timeliness of the information you need. And, you may discontinue standing orders at any time by contacting us at 1.800.372.1033, option 5, or by sending us an email to firstname.lastname@example.org.
Put me on standing order
Notify me when new releases are available (no standing order will be created)