If your company owns life insurance policies on your executives or any key people for that matter, you need to be aware of the potential tax ramifications and the requirements to avoid taxation of benefits. Important changes have taken place in the last few years that can significantly impact the taxation of corporate owned life insurance. The information below is designed to inform you of the IRS regulations that have been implemented over the last few years and what is needed to comply with these IRS requirements so that policy proceeds avoid needless taxation.*
Pension Protection Act of 2006 and Life Insurance Taxation
On August 17, 2006, President George Bush signed tax legislation containing provisions that significantly impact key man and other employer owned life insurance purchased after August 17, 2006. The legislation, known as the COLI (Corporate Owned Life Insurance) Best Practices Act (which is part of the Pension Protection Act of 2006), includes the proposed IRC Section 101(j). Under this proposed law, life insurance death benefits for business-owned life insurance policies issued after the effective date of August 17, 2006 are income taxable (to the extent the death benefit exceeds the employer’s premiums) unless certain requirements are met.
This new legislation applies to all employer-owned policies issued after August 17, 2006 and includes policies used for key man insurance, stock redemption plans, Corporate Owned Life Insurance and Supplemental Executive Retirement Plans (among others). It may also extend to collateral assignment (economic benefit) regime split dollar and split dollar loans. With this law, all situations where an employer will have full or partial ownership of a insurance policy that is issued after August 17, 2006, regardless of the purpose of the policy, will need to meet certain requirements and follow specific guidelines to avoid potential taxation.
Avoiding Taxation of Key Man Life Insurance
In order to prevent policy proceeds (death benefits) from being income taxable, both of the following requirements must be met:
1. Notice and Consent Requirements:
a) The employee must be notified (in writing), prior to the life insurance policy being issued, that the employer intends to buy a policy on his/her life and disclose what the maximum face amount that is being applied for on his/her life is;
b) The employee must provide written consent to being insured and agree that the employer may choose to keep the policy in force even after the employee separates employment; and
c) The employee must be notified in writing that the employer is the beneficiary of all or part of the death benefit proceeds.
Under the COLI Best Practices Act, unless the employer provides written notice and obtains the employee’s written consent prior to the issuance of the policy, the death benefit of the life insurance policy will be taxable from day 1. Notice and consent may not be obtained after the life insurance policy is issued to remove this taxable death benefit status.
2. Once the “Notice and Consent Requirements” are met, there are two “Exceptions” to the rule taxing death proceeds payable to an employer, one of which must be met:
a.) Exception #1:
1) The insured was an employee at any time during the 12-month period before the insured’s death OR
2) The insured was a Director or “highly compensated employee” at the time the contract was issued.
b.) Exception #2:
Any amount received by the employer as a result of the insured’s death is paid to:
1) A family member of the insured;
2) A designated beneficiary of the insured under the contract other than the employer;
3) A trust established for the benefit of a family member, other designated beneficiary, or the insured’s estate; or
4) A family member, designated beneficiary, trust, or estate in exchange for any interest they hold in the corporation / employer (i.e. buy-sell agreement).
If both the “Notice and Consent Requirements” and one of the “Exceptions” above are met, Corporate Owned Life Insurance proceeds would be received income tax free if the policy death benefits would otherwise be eligible for favorable tax treatment.
COLI Best Practices Act- Reporting Requirements
All employers are required to report annually all corporate-owned life insurance policies to the IRS. The annual reporting requirements imposed under the IRC Sec. 6039I include:
1) The total number of employees at the end of the year;
2) The number of employees insured under COLI arrangement at the end of the year;
3) The total amount of insurance in force on all insured employees at the end of the year; and
4) The employer’s name, address, tax payer identification number and type of business, and
5) A statement of valid consent for each insured employee (or, if all required consents are not obtained, number of insured employees for who consent was not obtained).
The IRS requires this reporting annually on Form 8925 ” Report of Employer-Owned Life Insurance Contracts.” It is a simple form and must be completed to comply with IRS Code. You should consult your CPA or professional tax advisor immediately for more information on Form 8925 and the IRS reporting requirements.
If proper record keeping and reporting is not maintained, any and all key man life insurance policy proceeds or other corporate owned life insurance death benefits may be subject to income taxation
In Conclusion
Corporate Owned Life Insurance Policies including key man insurance policies issued after August 17, 2006 may have death benefits that are subject to income taxation if certain requirements are not met. The Pension Protection Act of 2006, which includes the COLI Best Practices Act, includes provisions that have significant consequences for key man and other employer owned insurance purchased after August 17, 2006. You need to understand the Notice and Consent requirements and well as the Exceptions and Record Keeping and Reporting requirements and comply with the IRS so that key man insurance policy proceeds avoid needless taxation. Unfortunately, if you have a key man policy issued after August 17, 2006 and you have not been compliant, your best bet to avoid potential income taxation may be to scrap your current policy and start over!
* All of the above tax information is for information purposes only and is provided to explain the basic tax treatment of life insurance based on the Internal Revenue Code. Any individual or entity considering any life insurance policy should consult with their own CPA or tax/legal advisor that understands their particular tax circumstances and the rules governing their state. In no way is this information intended to be tax or legal advice.