May 15, 2009

17 Questions and Answers about Notice and Consent and Employer-Owned Life Insurance

Photo by Luiz Fernando Pilz [Update: The IRS on May 22, 2009, released Notice 2009-48 that provides answers to many questions about employer-owned life insurance. See the article on this website for analysis of that Notice.]

This article answers common questions about the Notice and Consent requirements you must satisfy to avoid paying tax on employer-owned life insurance. The last 5 questions talk about what you can do if the form was not signed (or it wasn’t done right).

An earlier article defined employer-owned life insurance (EOLI) and said the general rule is that the death benefit paid from EOLI (other that the cost of the policy) is taxed as ordinary income. All rules need an exception and this one is no different.

The first part of the exception say you can avoid that tax if you get a Notice and Consent form signed. If the form is not in proper form or is not signed before the policy is issued, the death benefit will be taxed – even if you do everything else right.

As a reminder, for life insurance is employer-owned if (1) the insured is a US citizen or resident, (2) the policy was issued after 8/16/2006, (3) the owner (actual or, perhaps, by attribution) is a business, (4) the owner or a related person/business is the beneficiary, and (5) the insured was an employee of that business/related person when the policy was issued. If even one condition fails, the policy is not EOLI and the death benefit remains income tax free.

1. What do I have to do to satisfy the Notice and Consent requirements?

Basic tests

It must be in writing.
It must be in place before the policy is issued.

Notice

The applicable policyholder (owner or a related person) intends to apply for life insurance covering the employee’s life
The maximum amount of insurance for which the employee could be insured
The applicable policyholder will be a beneficiary “of any proceeds” from the policy.

Consent

The employee agrees to be insured.
The employee agrees the employer may keep the policy even after the employee retires, quits, is fired or is laid off.

2. Whose responsibility is it to get the form signed

The law does not say. Ask who benefits the most if it’s done right – or who is hurt the most if it is not. Who will get the tax bill? That is the ‘applicable policyholder‘ – the policy owner or a related person/business. Usually this is the business buying the policy.

3. Does the IRS have a Notice and Consent form?

No.

4. So, where do I get the form?

Many insurance companies have one – but are quick to say they’re providing it only for the convenience of their customers. Those that do not have a form usually say it is not their responsibility. Don’t assume an insurance company’s form will do the job. Ask the business’ attorney to make that call.

5. Why do some insurance companies ask for (or require) a copy of the Notice and Consent?

Tax reporting. They feel it will help when it comes time to tell the IRS if the death benefit is taxable.

6. Who needs to sign the form?

The statute doesn’t say the form must be signed – or dated for that matter. But it’s hard to prove to the IRS that the notice and consent were given before the policy was issued if it’s not both signed and dated.

7. Does the Notice and Consent need to be a single document?

The law is silent. It’s probably okay to have several pieces of paper as long as, taken together, they satisfy all the requirements. But remember that the day will come when the IRS asks you to prove you’ve met the requirements. Is it easier to keep track of a single piece of paper over the years? Or several pieces of paper?

8. When is a policy ‘issued’?

Again, the law doesn’t say. Is it when the insurance company approves the policy? When you meet the delivery requirements? Or maybe it is when you pay the first premium and the policy becomes effective? We do know, however, that if you sign the form when you apply for the policy, you’re going to satisfy the legal requirements. Just do it.

[Update: Notice 2009-48 issued on May 22, 2009, says the issue date is "generally" the date on the policy – as long as that date is on or after the date the application was signed. Otherwise it is the later of (1) the date on the application, (2) the "effective date" of the policy, or (3) the date on which the policy was formally issued. For more analysis see our later article.]

9. What does the language mean that says the form must show “the maximum face amount for which the employee could be insured at the time the contract was issued”?

[Update: See our later article for more analysis on this question resulting from IRS Notice 2009-48 issued on May 22, 2009.]

The intent of this rule appears to be full disclosure to the employee. Congress wants to make sure that rank-and-file employees not only know their employer is buying life insurance on them but also how much.

It’s better to err on the side of caution and use a slightly higher number. Go too high, especially if the insurance is on less ’sophisticated’ employees, and an employer could later face questions of bad faith. I’ve seen some insurance company forms that have the company’s retention limit preprinted on the form. Are you helping the employee if you say the employer can buy as much as $30 million of insurance?

From the employee’s perspective, remember that any insurance an employer buys may affect the employee’s ability to buy personal insurance later.

If the amount applied for changes before policy issue, make sure the new amount is not more than the number on the form. If the form says $1 million and the policy delivered is $1.1 million, you’ve failed the Notice and Consent test.

10. What happens if the ‘maximum amount’ is not filled in.

You fail the Notice and Consent test. The death benefit, other than the cost of the policy, is taxable income. That’s a heavy price for not filling in a blank.

11. Why does the employee need to agree that the coverage may continue after she is no longer an employee?

This statement on the form makes it clear that the employer can keep the policy, pay the premiums and collect the death benefit.

Again think about Congress’ concerns. Rank-and-file employees may understand that their death could cost the employer. At least that’s clear if they are still employed when they die. But will that person feel the same if they are retired? Or have been fired or laid off?

They may not be happy with the idea that they are now worth more dead than alive to their employer. They may feel that if the employer not longer has a financial loss, their family should get the money.

12. Most forms says the employer “will be a beneficiary of any proceeds payable upon the death of the employee.” What if the employer will not get all the insurance money?

The language is in the law. Congress probably should have said “will be a beneficiary of some or all…” But it didn’t.

The underlying intent is that employees understand that the business (and not the employee’s family) will get the insurance proceeds. If the family does get some, that’s okay. But it’s not required.

Remember also that the Notice and Consent form does not determine who the beneficiary is. It’s doubtful (though, given our litigious world, not impossible) that the Notice and Consent is a contract requiring the owner to name any specific beneficiary.

13. If Notice and Consent is not in place before policy issuance, can you get it later if ‘everyone’ agrees?

Congress doesn’t appear to think so. The law says Notice and Consent must be given “before the issuance of the contract…” That doesn’t leave much wiggle room. Unless the IRS provides some leniency when it issues its expected regulations later this year, there may be no way to get the Notice and Consent after the insurance company issues the policy – even if everyone involved agrees.

[Update: Notice 2009-48 issued the week after we published this article confirms there is no way to fix a 'broken' Notice and Consent form. However, the IRS does say it won't challenge good faith efforts to make those fixes as long as the mistakes were inadvertent. See our later article for more analysis.]

14. How do you satisfy the Notice and Consent rule if the company acquires an existing policy?

John owns ABC Corp. He owns several personal life insurance policies bought after 8/16/2006. Last year he had a health scare and is currently not insurable. ABC wants to get a line of credit from MegaBank, but MegaBank says ABC Corp must provide life insurance covering John’s life. MegaBank will not, for whatever reason, accept an assignment of John’s personal policies.

John agrees to sell one of his personal policies to ABC Corp and the business will then give MegaBank their assignment.

That policy is now employer-owned life insurance. John is a US citizen and the policy was issued after 8/16/2006. The owner is a business. It is also the beneficiary – the assignment to Megabank doesn’t change this. John was ABC Corp’s employee when the policies were issued.

There is no Notice and Consent form because John bought the policies personally and it was needed.

Some advisers suggest that before ABC Corp takes ownership of the policy it get a Notice and Consent form signed. Technically that doesn’t work. But it doesn’t hurt and may give you something to talk with the IRS about.

After all, the intent of the statute is to make sure employees are not blind-sided by an employer that buys life insurance without telling the employees. Getting the form signed, even if it is after the policy is issued gives them that notice.

The IRS, in its 2008-2009 business plan, said it plans to issue EOLI regulations. (Item 3 under ‘Insurance Companies and Products’ on page 12). Maybe they will answer this question. [Update: Notice 2009-48 issued on May 22, 2009, doesn't directly address this question. However, you might read into the IRS' discussion of 1035 exchanges and material changes that a Notice and Consent could satisfy the EOLI rules in this kind of situation. See our later article for more discussion.]

15. If Notice and Consent was not given before the policy was issued, can it be signed later and then dated so it complies with the rules?

I’ve heard that question asked. It’s usually asked in a situation where neither the business nor the employees (and sometimes not even the company’s advisers), realized Congress had changed the rules back in 2006. They now want to ‘clean things up’ so the death benefit can be paid tax-free.

The problem is that the law is very specific about when the Notice and Consent has to be in place. It is before the company issues the policy. Once that happens, at least unless the IRS provides leniency in future regulations or other guidance, it just doesn’t seem possible to cure the problem by signing it later.

Sure, you can sign it and date it earlier. But you’d better hope no one asks, after the employee dies, when the form was actually signed or if the date on the form is when it was signed. If you lie at that point, you’re going to find yourself in a lot more pain than just having to pay tax on the insurance.

Congress’ failure to provide a way to cure a defective Notice and Consent may not make much sense when we’re talking about owners or key employees – people who can protect themselves and aren’t going to necessarily be strong-armed by the business. But you can, perhaps, understand that it’s a little different if the insured is a rank-and-file worker who fears the loss of employment if he doesn’t agree to give consent after the policy has already been issued. (Though, I admit, I’m hard pressed to believe that same pressure couldn’t be applied before the policy is issued…)

16. If there is a technical defect in the Notice and Consent, can you fix that defect later?

Only if the ‘later’ is before the policy is actually issued. The IRS may allow some leniency when it issues regulations or other guidance. Otherwise, the law requires that all requirements be in place and proper before the insurance company issues the policy.

17. So, if there’s a problem with the form, how do you fix it?

Current law does not let you go back and correct a ‘bad’ Notice and Consent form if the policy has already been issued. That does not, however, mean you’re left without a solution. Here are two. They may not be very attractive, but they do let you comply with the Notice and Consent rules.

Solution 1: Apply for a new policy. At the same time, sign a new Notice and Consent form. This time, make sure it’s done right. After the new policy is issued, cancel the old policy. It’s probably not a good idea to try to do a tax-free exchange of the old policy into the new one because the IRS might see that a mere continuation of the old one. And, of course, this assumes the employee is still insurable.

Solution 2: If the employee is no longer insurable, ask the insurance company to waive underwriting and issue a new policy. This will probably happen only if you applied for the original policy before 8/16/2006, it was issued shortly after that and you can convince the insurance company that they should have told you about the new law (and hence the notice and consent requirements) but did not. In other words, you say the company had a responsibility to say something but did not.

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