June 8, 2009

Sailing into Safe Harbors – Keeping Employer-Owned Life Insurance Income Tax Free

Photo by Andrew Conn Most people think life insurance is income tax-free. That is not the general rule for business life insurance that falls under rules Congress created in 2006. To keep it tax-free, you must first meet certain notice and consent requirements. Even then, the insurance can still be taxed if it is not paid in a way that satisfies one of the four ‘safe harbors’ described in this article.

An earlier article was about the general rules of employer-owned life insurance (EOLI) and how EOLI can be a tax trap. Later we wrote about the notice and consent rules. Then we reported on an IRS Notice that answered some (but certainly not all) questions about the new law.

Again, two things must happen to avoid tax on an EOLI death benefit.

  • First, you must satisfy strict notice and consent requirements before the policy is issued.
  • Second, the death benefit must be paid in a way that falls into one of four safe harbors. Two are based on the ‘status’ of the insured employee. The other two are based on who gets the insurance money.

You must satisfy both requirements. If you fail to meet the notice and consent requirements, it’s irrelevant whether or not a safe harbor is available – you will pay tax on the EOLI money (after deducting what you paid for the policy).

Safe Harbor 1: Key Person

The insured is a key person at policy issue.

You cannot know if the other safe harbors are available until the employee dies. Until then, the employer cannot know for sure if the death benefit will be taxable or not.

But you can know, at the time an employer buys a life insurance policy, whether it is covered by this first safe harbor. However, the employer must keep good records. Many years from now, when the employee dies, the employer may have to prove that the insured was a key person decades earlier.

A key person for these purposes is someone who, at the time the policy is issued:

  • Was a director of the employer.
  • Was a 5% or greater owner in the year before policy issue.
  • Received compensation of $95,000 or more (adjusted for inflation).
  • Was one of the five highest-paid officers.
  • Was among the 35% highest paid employees.

Safe Harbor 2: Current Employee

The insured was an employee any time in the 12-month period before death.

Safe Harbor 3: Death Benefit Paid to the Insured’s Heirs

  • A member of the insured’s family (spouse, parents and grandparents, children and grandchildren, brothers and sisters).
  • An individual the insured named (other than the employer).
  • A trust set up for anyone in those first two groups of people.
  • The insured’s estate.

Warning: Although this may avoid income tax on the death benefit, it does create a split dollar arrangement. If the employer owns the policy and the person named as beneficiary is any of these people, the arrangement is, by definition, split dollar. The employee will be taxed on the economic benefit provided by the policy.

Safe Harbor 4: Buy-Sell Funds

Death benefits remain income tax free if used to buy the insured’s interest in the employer (equity, capital or profits) from someone listed in Safe Harbor 3.


We have (at least) one more article in this series on employer-owned life insurance. In a future article we’ll talk about the ‘related party’ rules – rules that have created a fair amount of confusion.

In the meantime, if you have questions or would like to share experiences you’ve had with this wonderful new world of EOLI, please use the comment link below!


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