Tax Article - Employer-Owned Life Insurance

It is common knowledge that life insurance proceeds paid upon the death of the insured are generally excluded from taxable income. There are, however, certain exceptions to this rule. In the case of employer-owned life insurance contracts, death benefits that would otherwise be excluded from taxable income under the general rule are, instead, taxable to the employer to the extent such benefits exceed premiums paid by the policyholder for the contract, unless certain requirements are met. This then becomes a trap for the unwary, where a failure to adhere to these requirements results in what can best be described as a parade of horribles.

An employer-owned life insurance contract, as the name implies, is a life insurance contract which is owned by a person engaged in a trade or business and under which such person is directly or indirectly a beneficiary under the contract and covers the life of an insured who is an employee. In order to avoid income inclusion, certain notice and consent requirements must be met before the insurance contract is issued.

Specifically, the employee must be notified in writing that

1. The employer/policyholder intends to insure the employee's life and the maximum face amount for which the employee could be insured at the time the contract is issued.
2. The employee provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment.
3. The employee is informed in writing that the employer will be a beneficiary of any proceeds payable upon the death of the employee.

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In those cases where the employer has a notice and consent, amounts received by reason of the death of an insured who was an employee at any time during the 12-month period before the insured's death or, at the time the contract is issued, was a director, or qualified as a certain highly compensated employee would not be taxable. In addition, amounts received by reason of the death of an insured would not be taxable to the extent the amount is paid to a member of the insured's family, any individual who is the designated beneficiary of the insured under the contract (other than the employer), a trust established for the benefit of any such family member or designated beneficiary, or the estate of the insured. Finally, amounts used to purchase an equity (or capital or profits) interest in the employer from such family members etc. would not be taxable.

These rules apply to life insurance contracts issued after August 17, 2006.

In order to monitor compliance with the notice and consent rules, the IRS recently issued final regulations, effective for tax years ending after November 6, 2008, requiring every policyholder owning one or more employer-owned life insurance contracts to file a return showing for each year that such contracts are owned (1) the number of employees at the end of the year, (2) the number of those employees insured under an employer-owned life insurance contract at the end of the year, (3) the total amount of insurance in force under those contracts, (4) the name, address, and taxpayer identification number of the employer, (5) that the employer has a valid consent for each insured employee (or, if all required consents are not obtained, the number of insured employees for whom consent was not obtained). This information is provided by attaching Form 8925, Report of Employer-Owned Life Insurance Contracts, to the policyholder's (i.e., the employer's) income tax return by the due date of that return.

These provisions are indeed traps for the unwary and careful adherence to the notice and consent requirements is imperative to avoid this parade of horribles.

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