Employer-Owned Life Insurance — Tax Trap Waiting to Happen?

True or false? Life insurance is tax-free.

The general income tax rule is that money received from life insurance when the insured dies is not taxable income (though it may be subject to state and federal death taxes). Congress, however, always likes exceptions to the rule and, in 2006, they created one huge exception to this general rule — Internal Revenue Code (IRC) Section 101(j).

If a life insurance policy is “employer-owned life insurance” (EOLI), only the amount paid for the policy is tax-free. The rest is taxed in the highest tax bracket as ordinary income.

The problem is that EOLI can cover policies you and I would not normally think of as “employer-owned.” If your business owns life insurance or if your family will receive life insurance money from a policy either owned by or paid for by a business, the insurance money your family gets may be taxable. That may come as a very unpleasant surprise.

This article begins a series that, over the next several weeks, will talk about employer-owned life insurance and its twists and turns. While Congress’ intent when it created EOLI back in 2006 may have been good, the definitions it used to create EOLI can lead to surprising results. The rules are exacting. It doesn’t matter how pure your intent is. And there’s no lower limit that exempts small policies.

The impetus behind this new class of life insurance was what some have called “janitor” or “dead peasant” insurance. A few large companies were buying life insurance on their worker bees, often without telling them. The companies got all the money from the insurance companies when those “lower level” employees died; families got nothing at a time they needed the money the most. Often those employers would buy insurance on thousands of employees, sometimes under the pretense (real or imagined) that the business would use the death benefits – and sometimes any cash values – to pay for future employee benefits.

Arrangements that are taxed under the EOLI rules

• Creditor Insurance: John Smith and Susan Murphy own Flying Widgets, Inc. John owns 60%. Susan owns the rest. John and Susan have personally guaranteed Flying Widgets’ bank loans. Flying Widgets buys and is the owner of life insurance on both John and Susan. It names Too Big Too Fail Bank beneficiary to the extent of the bank’s loans; Flying Widgets gets the rest.
• Key Person: If either John or Susan die, Flying Widgets will be in deep trouble. The company will have to find someone to do the work John or Susan is doing now. It will also have to assure creditors, suppliers and maybe even other employees that Flying Widgets is financially solid enough to weather the death of a key person. The company buys life insurance on both John and Susan. If either dies, the money will help it hire a replacement (including making up for any loss of productivity while the new person comes up to speed). The money will also bolster the company’s balance sheet. That can help provide assurance to creditors, suppliers and employees who may feel that the cash infusion will help Flying Widgets weather the storm.
• Salary Continuation: Michael is the key salesperson for Flying Widgets. Competitors actively recruit Michael at least once a week. The company wants to keep Michael tied to it. It promises Michael that it will continue to pay his salary to his family for ten years after his death – as long as he is a Flying Widgets employee on the day he dies. To pay for that promise, Flying Widgets buys life insurance on Michael. It is both the owner and beneficiary. If Michael dies, it will use the life insurance to fulfill its promise.
• Split Dollar Arrangement: As a further incentive to keep Michael loyal, Flying Widgets buys another life insurance policy on Michael. The company is the owner and pays the premiums. The beneficiary is split between Flying Widgets and Michael’s family. Flying Widgets’ share will be equal to the premiums it has paid; Michael’s family gets the rest.
• Redemption Buy-Sell: Flying Widgets agrees to buy John and Susan’s stock if either dies. It buys life insurance so it will have cash to do that. The company is both owner and beneficiary of the policies.
• Rabbi Trust: Flying Widgets has a deferred compensation plan for its executives. It sets up a Rabbi Trust to own life insurance and other investments that will help pay for the plan. Flying Widgets is, for tax purposes, the owner of any investments in the trust. The trust owns and is beneficiary of life insurance on John, Susan and others.
• Independent Contractor: Matthew Smith, John’s son, is a computer whiz. Flying Widgets signs a contract with Matthew to take care of the company’s computers. It pays him a lot to do that – so much that if Matthew were a company employee he would be, for tax purposes, a “highly compensated” employee. Because Flying Widgets relies so much on Matthew’s expertise, it almost treats him as a key person. Flying Widgets buys key person life insurance on Matthew. The company is the owner and beneficiary.

Arrangements the probably are not taxed under the EOLI rules

Some say these are taxed as employer-owned life insurance. I don’t think so and will explain why in the next in this series of articles.

• Collateral Assignment Buy-Sell: If Susan dies, John has agreed to buy her stock. So he will have the cash to do that, John buys life insurance on Susan. John is the owner and beneficiary, not Flying Widgets. John pays the insurance premiums out of his personal checking accounting.
• Section 162 Bonus Arrangement: John buys a policy on his own life. He is the owner and his wife is the sole beneficiary. Flying Widgets agrees to pay the premiums and will report those payments as income to John.
• VEBA: To pay for certain employee benefits, Flying Widgets sets up a Voluntary Employee Benefit Arrangement (VEBA). The VEBA buys – and is the owner of and beneficiary of – life insurance on John, Susan and other Flying Widget employees.
• Qualified Retirement Plans: Flying Widgets has a qualified retirement plan. The plan buys life insurance on John and Susan. It is the owner and beneficiary.

Employer-Owned Life Insurance Defined

A policy is EOLI (and therefore taxable) only if it meets all five of the following conditions. If any is not met, the policy is not employer-owned life insurance.

• Citizenship: The insured must be a U.S. citizen or resident.
• Date of the Policy: The policy must have been “issued” after 8/16/2006. A policy issued before then can become EOLI if it was exchanged under Section 1035 after 8/16/2006 for a new policy or there was a material change (death benefit or otherwise). The effective date is not in the statute itself. Instead, you need to look at Section 863(d) of the Pension Protection Act of 2006 — and then realize know that the President signed the bill into law on 8/16/2006.
• Beneficiary: The owner (or someone ‘related’ to the owner) is directly or indirectly a beneficiary of the policy. An indirect beneficiary means the money goes to someone else but somehow benefits the ‘indirect’ beneficiary. An example if money that goes to a bank that pays off a loan. The person who borrowed money from the bank benefits when the loan is paid off by the insurance.
• Insured: The insured must be an employee of the “applicable policyholder” at the time policy is issued. An “applicable policyholder” is the owner of the policy or a “person” related to the owner.
• Owner: The owner must be a business. The statute uses the phrase “a person engaged in a trade or business.” A “person” in IRS-speak is not just an individual. It can be any taxpayer – a corporation, partnership, charity, government body, etc. To make it a little less verbose, let’s replace “a person engaged in a trade or business” with “a business.”

Other than the citizenship test all these conditions can create confusion. That confusion will not end until the IRS issues regulations. (Of course, the IRS may only muddy the water more…)

Applying the Definition

Let’s look at three of the common situations that create employer-owned life insurance. We’ll look at each part of the five parts of the definition and ask if the arrangement fits within the definition. Once you get used to this process, you can apply it to any other arrangement.

Key Person Life Insurance: Flying Widgets buys life insurance on John. It is the owner and beneficiary.

Citizenship: We’ll assume John is a U.S. Citizen.

Date of the Policy: Let’s also assume Flying Widgets bought the policy after 8/16/2006.

Beneficiary: Is the owner (Flying Widgets) a beneficiary of the policy? Yes it is.

Insured: Is the insured (John) an employee of the owner? Yes he is.

Owner: Is the owner (Flying Widgets) a business? Yes it is.

Key person life insurance meets all the definitional requirements of EOLI.

Creditor insurance. Flying Widgets buys insurance on John. It is the owner and the bank is the beneficiary. The insurance company agreed to reduce the insurance benefit each year to match the remaining balance of the loan.

Citizenship: Again we’ll assume John is a U.S. Citizen.

Date of the Policy: We also assume Flying Widgets bought the policy after 8/16/2006.

Beneficiary: Is the owner (Flying Widgets) a beneficiary of the policy? While it may not be a direct beneficiary, it certainly is an indirect beneficiary – and that’s all the law requires.

Insured: Is the insured (John) an employee of the owner? Yes he is.

Owner: Is the owner (Flying Widgets) a business? Yes it is.

Creditor insurance squarely meets the EOLI definition.

Rabbi trust. This is a little more complicated, but not much. Flying Widgets sets up a Rabbi Trust as part of a deferred compensation plan. To answer the definition questions, you need to know a little about trusts and about grantor trusts. You also need to know that a Rabbi Trust is a grantor trust.

A trust is simply a legal arrangement where one person (the trustee) owns legal title to investments for the benefit of someone else (the beneficiary). If a trust is a grantor trust, the person who set up the trust (the grantor) is treated as the owner of the trust even though he does not legally own it. The most common grantor trust is a revocable living trust you set up. While the trust legally owns what’s in the trust, you are taxed on any income the trust has. When Flying Widgets sets up a Rabbi trust, it remains – for income tax purposes –the owner of the life insurance policy the trust buys.

Citizenship: Again we’ll assume John is a U.S. Citizen.

Date of the Policy: We also assume Flying Widgets bought the policy after 8/16/2006.

Beneficiary: Is the owner (Flying Widgets) a beneficiary of the policy? On its face, the trust is the beneficiary. However, because it is a grantor trust, Flying Widgets is the “owner” of the trust and its investments. Yes, in this case, Flying Widgets is a beneficiary.

Insured: Is the insured (John) an employee of the owner? Again we look through the trust to see who the “real” owner of the policy is. For tax purposes, Flying Widgets owns the trust that owns the policy on John’s life. We can therefore say the insured is an employee of the (true) owner.

Owner: Is the owner (Flying Widgets) a business? Again we look through the grantor trust to the real owner – Flying Widgets. So, again we conclude the owner is a business.

Life insurance owned by a Rabbi trust is employer-owned life insurance.

You can run the definition tests on the other arrangements listed earlier and see how they all satisfy each part of the EOLI definition.

Conclusion

There were a second list of arrangements – the ones I said some people believe are subject to the EOLI rules but that I do not. In the next article in this series I will talk about why those arrangements can be confusing and why people reach different conclusions about whether they are covered by the EOLI rules.

Related articles from WalterBristow.com:

1. Sailing into Safe Harbors – Keeping Employer-Owned Life Insurance Income Tax Free
2. IRS Answers Questions about Employer-Owned Life Insurance
3. 17 Questions and Answers about Notice and Consent and Employer-Owned Life Insurance
4. IRS Rules on Taxation From Sale of Life Insurance to Investors
5. Critical Events, Critical Planning in the Life of a Business