A 2006 change in tax law caused employer-owned life insurance benefits to become taxable if the employer lacks the correct documentation.
Many businesses own life insurance on employees and owners, and designate the business as beneficiary of the policy. They do this in order to protect the entity from the loss of a key person or to provide funding for a buy-sell agreement.
In general, when death benefits on these policies are collected, they are free of income tax. “A tax law change in 2006 can cause employer-owned life insurance benefits to become taxable,” notes Nick Houle, a private client tax partner. “If the business doesn’t have the proper paperwork, it can be hit with income tax on the death benefits.”
Historically, Section 101 of the Internal Revenue Code has treated death benefits from life insurance as free of income tax, whether the policy is owned by an individual or a business. But in 2006, Congress modified the law to potentially eliminate the tax-free treatment of employer-owned life insurance (EOLI) policies.
This EOLI treatment extends to any insurance owned by a business entity, where the entity is also the beneficiary of the death benefits. These rules can include a business insuring an independent contractor such as a director, but it does not reach a sole proprietor carrying insurance on his or her life.
These rules apply to business-owned life insurance policies issued after August 17, 2006, whether it is a newly purchased policy or one acquired in an exchange of an older policy. Older policies that would otherwise be exempt can also become subject to these rules if there is a material increase in the death benefit or other material change in the policy.
“Congress wrote these rules into the tax code in order to prevent abuses,” comments Dudley Ryan, a CliftonLarsonAllen tax partner for manufacturing and distribution. “Some businesses were insuring rank-and-file employees without their consent.” The abuse involved using a life policy on an employee to gain tax-free compounding of the cash value, where the business had no particular need to insure the life of that worker.
Exceptions to EOLI taxation
A business-owned life insurance policy can remain exempt from income tax — even if it is a post-August 17, 2006, contract — if it can meet two criteria:
- The insured is an employee in the 12 months preceding death, or is a director or highly-compensated employee, or the death benefits are used to fund a buy-sell agreement, and
- Prior to issuance of the policy, the insured individual was notified in writing of the business’ intent to insure the individual’s life, and the individual provided a written consent to be insured.
“Most business-owned insurance is either key person protection or used to fund a buy-sell agreement,” notes Houle, “and will meet the first of these two exceptions. The key to preventing taxation of the death benefits is to have the written notice and consent paperwork in place.”
In many cases, the insurance agent that places the life insurance coverage will help implement the written notice and consent requirements. But that may be overlooked, or the business may simply be increasing the death benefit of an existing policy, in which case the modified contract is now subject to the written notice and consent requirement. Ultimately, the business itself has a responsibility to ensure that it is compliant with this tax law provision.
IRS ruling assists businesses
The IRS recently issued a private ruling allowing a business that had initially missed the notice and consent requirement to clean up the paperwork with the necessary signatures after the fact.
“That guidance provides some important relief where key persons or owners were involved in having the business insure their lives and were fully involved in the transaction,” observes Ryan. Businesses that have insurance on the lives of employees and owners should carefully check that they are compliant, especially where material increases in death benefit might have occurred.
How we can help
It is important that your CliftonLarsonAllen tax preparation team be informed about any EOLI. The annual tax return of the business must contain disclosure with regard to compliance under these rules by including IRS Form 8925, Report of Employer-Owned Life Insurance Contracts.
Contact your CliftonLarsonAllen tax advisor if you have life insurance policies that may be subject to these rules, or if you have any questions regarding this topic.