Late last week the IRS provided some answers to questions about the 2006 law that taxes most of the death benefit of business-owned life insurance. IRS Notice 2009-48 answers many questions. It leaves others unanswered and raises yet others.
If you own or advise a business, it’s important to know what employer-owned life insurance is and the rules you need to follow to keep the death benefit income-tax free.
- The related party rule does not make a policy employer-owned when it is the business owner and not the business who owns the policy. Hence, cross-purchase buy-sell policies and policies owned by a qualified retirement plan or VEBA are not subject to §101(j).
- Notice and Consent forms are valid for one year after being signed unless the insured’s employment ends before then.
- A single Notice and Consent form can be used to buy multiple policies as long as the total face amount of all the policies is not more than the amount listed on the form.
- Although there is no way to ‘fix’ an invalid Notice and Consent, the IRS will not challenge attempts to fix ‘inadvertent’ mistakes made in good faith.
- The ‘issue date’ of the policy will generally be the date on the policy.
- The Notice and Consent form must specify the face amount “either in dollars or as a multiple of salary, that the [business] reasonably expects to [buy] during the course of the employee’s tenure.”
- Material changes in the policy or death benefit can make a grandfathered policy subject to the EOLI rules. The IRS provided examples (not very helpful) of changes that are not material.
The Notice is effective June 15, 2009. The IRS says it will not challenge earlier good faith efforts to comply with the law as long as they were “reasonable.”
Definition of Employer-Owned Life Insurance
The general income tax rule is that life insurance death benefits are income tax free.
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 as ordinary income.
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. An earlier policy can become EOLI if exchanged under Section 1035 for a new policy or there was a material change (death benefit or otherwise).
- Beneficiary: The owner (or a related person) is directly or indirectly a beneficiary of the policy.
- 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.
Will the IRS use the related person rules to decide owners as well as beneficiaries?
The question comes up because the statute defines EOLI as a policy “owned by a person engaged in a trade or business, and under which such person (or a related person…) is directly or indirectly a beneficiary…”
Does that “related person” language apply to only the beneficiary? Or does it mean that the EOLI definition is satisfied if the owner is a “related person” – such as an individual who owns the business itself?
Example: Josh is the sole owner of ABC Corp. He buys life insurance on his own life to pay the mortgage and educate the kids should he die unexpectedly. He is the owner, pays the premiums out of the family checking account and names his living trust as sole beneficiary. Under the related person rules, Josh and ABC Corp are related persons. John and his trust are also related persons. If you can use the related person rules to attribute ownership, it’s possible to argue this family policy is EOLI because ABC “owns” (by attribution) the policy and is the beneficiary (again by attribution).
The IRS says the EOLI rules don’t apply, for example, when a business owner (rather than the business itself) owns life insurance to fund a cross-purchase buy-sell plan. Also, policies owned by a qualified pension or profit sharing plan or a VEBA sponsored by the business are not EOLI.
Query: The IRS asked “Can a contract be an employer-owned life insurance contract if it is owned not by a person engaged in a trade or business, but by a related person who is not engaged in a trade or business?” That language raises another question. Do the related person rules apply to attribute ownership if the actual owner is a related business? For example, ABC Corp owns all of XYZ Corp. If XYZ Corp buys life insurance on Sarah and Sarah is an employee of both corporations, are both corporations, for purposes of the EOLI rules, owners of the policy?
Is split dollar life insurance subject to the EOLI rules?
Yes. The EOLI rules do apply if the owner is a business and the arrangement otherwise satisfies the EOLI definition.
Caution: The 2002 split dollar regulations define the owner in ways that may sometimes create problems under EOLI – or that may lead to results that are not consistent.
If the policy names two owners, the split dollar rules say the first person named is the owner for split dollar tax purposes. Does that mean that a split dollar plan with a policy owned by an individual and a business could be subject to the EOLI rules if the policy lists the business first but not if it lists the individual first?
The business is always the owner (for tax purposes) in a nonequity plan. Let’s say that Brian buys life insurance on his own life. He is the owner listed on the policy. But ABC Corp agrees to pay the premiums if Brian will assign enough death benefit to ABC so the corporation will get the greater of the premiums it paid and the policy cash value. In other words, Brian has no ‘equity’ in the policy. ABC Corp is treated as owner of that policy under the split dollar regulations.
Does that mean such a split dollar plan – even though John is the named owner of the policy – is subject to the EOLI rules?
Note: Even if a split dollar plan is EOLI, the death benefit may still be tax free. There are several safe harbors that let you escape that taxation. These include amounts paid to the insured’s family, to a beneficiary the insured names (other than the business), or to a trust set up for either of those groups of people. We’ll explore the safe harbors in a future article.
Is a policy owned by a partnership or sole proprietorship be employer-owned life insurance?
Yes. If the policy meets all the other definitions of EOLI, the fact that it’s owned by a partnership (and presumably an LLC, S corporation, or any other pass-through entity) or sole proprietor doesn’t let it escape the EOLI rules.
Note: The IRS does specifically say that a policy owned by a sole proprietor on his or her own life is not EOLI. Benjamin owns his own garage and does business as a sole proprietor. He buys life insurance to pay the mortgage and put the kids through school. His wife does not have to worry about paying tax on the death benefit just because Benjamin didn’t sign a Notice and Consent form.
Comment: There’s more to this question that you might first think. The law defines EOLI as a policy owned by a “person engaged in a trade or business…” With a C corporation or a non-profit, it’s clear the entity is the “person” engaged in trade or business. But is it also clear if the “person” is a pass-through entity like partnerships and LLCs? Those businesses don’t pay income tax themselves. Instead, they pass their taxable income through to the actual owners. If an EOLI “person engaged in trade or business” is the actual taxpayer, pass-through entities wouldn’t be subject to the EOLI rules. Likewise, the actual taxpayers in those situations wouldn’t be subject to the EOLI rules because they are not the employer. Therefore, the IRS had to say that pass-through entities are subject to EOLI.
For purposes of the EOLI rules, when is a policy “issued”?
Generally, the issue date is the date on the policy – as long as that date is on or after the date the application was signed.
Comment: The concern about the date on the policy being on or after the date the application was signed probably reflects a concern about dating a policy to “save age.” Because life insurance premiums increase with age, sometimes it makes financial sense to apply for insurance today but ask the company to issue the policy as of four months ago when you were, for insurance purposes, a year younger. If that happens, the date on the policy could be before the date on the application.
The issue date is important for two reasons. First, the notice and consent requirements must be satisfied before policy issue. Second, a policy is EOLI only if, at policy issue, the insured was an employee of the owner or a related person.
For EOLI purposes, the IRS says in its Notice, a policy is treated as issued on the later of three dates:
- The date on the application, or
- The “effective date” of the policy, or
- The date on which the policy was formally issued.
Suggestion: Avoid debate on what this means. Sign the Notice and Consent form when you sign the life insurance application.
Comment: The IRS still hasn’t answered the question. The “date on the policy” is easy enough. So is the “date on the application.” But what is the “effective date” of the policy and what does “formally issued” mean? Is it when underwriting is finished the company approves the application and says it is willing to issue a policy? Is it when all delivery requirements are met? When the first premium is paid?
Comment: What about temporary insurance? Sometimes you can put insurance in force by paying the first premium when you sign the application. The IRS says you can satisfy the notice and consent requirements anytime between then and when the company “formally” issues the policy.
Caution: If there is a material change in the policy (including a material increase in the death benefit), that change can effectively create a new policy requiring a new Notice and Consent form.
Is the term “employee” limited to common law employees?
The EOLI rules define employee broadly. It certainly includes someone who gets a W-2 from the business. But it also includes an officer, director, and highly compensated employee – whether they get a W-2 or not. Don’t be confused by the mention of “highly compensated employees.” The term includes someone who is not now an employee but who was “highly compensated” when he separated from service. It also includes someone who was “highly compensated” any time after age 55 even if they are not now “highly” compensated. Employees also include partners and members of an LLC, etc. even though they don’t get a W-2.
How soon must the business buy an employee’s interest to qualify for the buy-sell safe harbor?
It must be by the due date of the business’ tax return (which includes extensions).
Example: ABC Corp owns an EOLI policy on Susan, one of its shareholders. ABC Corp’s tax year ends on June 30. Susan dies on July 1, 2009. To qualify for the buy-sell safe harbor, ABC must buy Susan’s shares before September 15, 2010 (or the due date of its extension).
Notice and Consent Requirements
Do you need a Notice and Consent form signed for an owner-employee of a wholly-owned corporation?
Yes. There is no exception from notice and consent just because the business has only one owner.
The IRS says even if the owner has actual knowledge that the business is buying life insurance on her life (and therefore presumably has given consent), you still need that written Notice and Consent form. The IRS says this “avoids factual controversies that otherwise could result where, for example, the sole owner of a corporation delegates financial matters to an employee.”
Do you need written notice and consent if an employee irrevocably transfers an existing life insurance policy to the business?
No. The insurance company forms the employee must sign shows she knows (1) the business is “buying” insurance on her life, (2) how much insurance the business is getting, and (3) the business will be a beneficiary.
Note: If the “employer subsequently increases the face amount of the contract”, the IRS says the business must get a written Notice and Consent form for the new amount. This implies the form is needed only if the business applies to the insurance company for a larger face amount – not if the larger face amount is from increasing cash values, etc.
Query: Does this also apply if the business buys the policy originally? If it later asks for an increase in the death benefit, do you need to get a new form signed? The IRS later in the Notice says a material increase in death benefit is treated as a newly issued policy.
How long is a Notice and Consent form valid – that is, how quickly must the insurance company issue the policy?
A Notice and Consent form is valid only for one year after it is signed. If the insured’s employment ends before then, the form is valid only until the last day of employment.
Note: Together with the next question, this means that if the business buys a second policy within that year (and the combined face amounts are not more than the face amount listed on the form), the original Notice and Consent form is enough.
If the business buys more than one policy on an employee, is a separate Notice and Consent form required for each policy?
Note: The total face amount of all the policies cannot be more than the amount listed on the Notice and Consent form. For example, if an employee signs a valid Notice and Consent form for $1 million of employer-owned insurance, it doesn’t matter whether there is a single $1 million policy, whether there are two $500,000 policies or four $250,000 policies. Also, the business could buy a $500,000 policy now and another $500,000 policy six months from now. Remember that a Notice and Consent form is only valid for one year – only added policies “issued” within that year are covered.
Can you satisfy the notice and consent requirements electronically?
Yes. The IRS has issued rules for filing electronic W-4s. Those same rules apply here. And, of course, all elements of the notice and consent must be in the electronic form.
The system must (1) ensure the information received by the employee is the same as the information sent by the employer; (2) make it reasonably certain the person accessing the system is the employee for whom notice and consent is required; (3) include a process for electronic signature or other means of formally recording the employee’s consent to being insured; and (4) allow the production of a hard copy of the electronic Notice and Consent form if the IRS asks for it. It also has to include a statement that, to the best of the employer’s knowledge, the required notice was provided to the employee and the employee consented to being insured.
Is it enough to tell an employee that the face amount may be “the maximum face amount for which the employee could be insured” at the time the contract is issued?
No. The Notice and Consent form must give the face amount “either in dollars or as a multiple of salary, that the [business] reasonably expects to [buy] during the course of the employee’s tenure.”
Comment: The use of the phrase “employee’s tenure” is confusing because the IRS has already said a Notice and Consent form is only valid for, at most, one year.
Caution: I’ve seen Notice and Consent forms that has the face amount preprinted with the insurance company’s retention amount. Based on this Notice, that is not a valid Notice and Consent form.
Again the IRS says if you sign a Notice and Consent form for a set amount and then later (within a year?) the business wants to buy more, you must sign a new form if the total face amount of existing insurance plus the new insurance is more than the amount on the existing form.
Query: Does this mean that increases in face value from policy growth could undo a Notice and Consent form? For example, Katie signed a Notice and Consent form for $1 million. Her employer, ABC Corp, bought a $750,000 policy. Later that year it applies for a new $250,000 policy. By the time the new policy is ready to be issued, the face amount of the existing policy has increased to $750,010. The total face amount of the two policies will be more than $1 million.
If somehow or another a mistake was made on a Notice and Consent form, how do you fix it?
You can’t. The statute “does not contain a provision for correcting an inadvertent failure to satisfy the notice and consent requirements.”
Nevertheless, the IRS says it won’t challenge fixing an ‘inadvertent’ mistake if you meet all the following conditions:
- The business made a good faith effort to satisfy the requirement, “such as by maintaining a formal system for providing notice and securing consents from new employees.”
- The failure to satisfy the requirements was, in fact, inadvertent.
- You correct the mistake before the due date of the business’ tax return for the year the policy was issued.
Comment: So, what’s an ‘inadvertent’ mistake? You didn’t know you had to sign the form? The insurance company form was bad? Your insurance agent didn’t tell you? You didn’t ask your attorney or accountant? You asked them but they’d never heard of EOLI?
Caution: If the employee dies and you later discover problems with the Notice and Consent form, that’s one problem you can’t fix. The law requires the employee sign the form – something he obviously can’t do.
Section 1035 Exchanges and Grandfathered Policies
The EOLI rules apply to policies issued after August 17, 2006. However, policies issued before then lose their grandfathered status in two situations:
- The older policy is exchanged for a policy under Section 1035.
- There is a “material change” or a “material” increase in death benefit.
What is a “material change” that makes a pre-8/18/2006 policy lose its grandfathered status?
Unfortunately, rather than answering the question, the IRS tells us that changes are not material.
These are not material changes.
- Increases in death benefit that occur because of either the operation of § 7702 or the terms of the existing contract (as long as the insurer’s consent to the increase is not required).
- Administrative changes.
- Changes from general account to separate account or from separate account to general account.
- Changes because of the exercise of an option or right granted under the contract as originally issued.
What is a “material” increase in death benefit that makes a pre-8/18/2006 policy lose its grandfathered status?
Again, rather than answer the question, the IRS tells us what a “material” increase is not. These are not “material” increases in death benefit:
- An increase needed to keep the contract in compliance with § 7702.
- An increase because policyholder dividends are used to buy paid-up additions.
- An increase in a variable policy caused by market performance or policy design.
When does a Section 1035 make an existing policy lose its grandfathered status?
There must be a material change in the contract or a material increase in death benefit.
Note: The IRS does specifically say that a change in the insurance company is not a material change.
Do you need a new Notice and Consent form when you do a Section 1035 exchange of an EOLI policy that was issued after 8/17/2006?
No – as long as the existing Notice and Consent form “remains valid” and the exchange does not cause either a material change in the policy or the death benefit.
Comment: The use of “remains valid” presumably refers to the face amount. An increase in the face amount of the policy might not in and of itself be a material increase, but it could cause the amount to be more than the amount stated on the Notice and Consent form.
Information Reporting under Section 6039I and Form 8925
Code Section 6039I and Form 8925 require that every applicable policyholder owning 1 or more employer-owned life insurance contracts issued after August 17, 2006, provide the following information showing for each year the contracts are owned:
- The number of employees of the applicable policyholder at the end of the year;
- The number of those employees insured under such contracts;
- The total amount of insurance in force at the end of the year under such contracts;
- The name, address, and identifying number of the applicable policyholder and the type of business in which the policyholder is engaged; and
- A statement that the applicable policyholder has a valid consent for each insured employee (or, all such consents are not obtained, the number of employees for whom such consent was not obtained).
Are there circumstances that might require more than one taxpayer to file Form 8925 for the same EOLI policy?
A-17. No. Only the policy owner must file Form 8925.
Comment: This question came up because Section 6039I requires that a return be filed by “every applicable policyholder owning 1 or more employer-owned life insurance contracts issued after the date of enactment.” The law says an “applicable policyholder” is generally the owner of the employer-owned life insurance contract. However, “applicable policyholder” includes certain related businesses. That leads to the question of whether a related business must also file Form 8925. The IRS notes that a related person, however, is not the actual policy owner and it is “[o]nly the applicable policyholder ‘owning 1 or more employer-owned life insurance contracts’ [that] is required to file Form 8925.”