Life insurance death benefits are normally tax free. However, there is a tax trap to be aware of when purchasing employer-owned life insurance (EOLI), a type of life insurance policy that a company purchases on the lives of its employees, shareholders or owners. IRC Section 101(j) governs EOLI and the potential taxation of these policies.
A benefit of EOLI policies is they can provide a source of funding for employee benefit programs, such as pensions or deferred compensation plans as well as Key Man or Buy Sell agreement funding. By purchasing an EOLI policy on a key employee, a company can receive tax-free death benefits which in turn can be used to fund these programs.
The Internal Revenue Code Sections 101(j) and 60391, enacted on August 17, 2006 as part of the Pension Protection Act of 2006, includes rules with respect to the taxation of death benefit proceeds of an EOLI policy. IRC §101(j) subjects death benefits on employer owned life insurance policies to income taxation, to the extent that they exceed the employer’s basis in the policy, unless a valid exception applies, and notice and consent requirements are satisfied along with reporting and recordkeeping.
Generally, unless an exception applies, the amount of coverage that can be obtained on an employee's life is also limited. The maximum amount of coverage that can be obtained on any one employee is the lesser of the employee's expected death benefit or the total premiums paid on the policy.
Exceptions:
The insured is an employee at any time during the 12-month period before his or her death; or is, at the time the contract is issued, a director or a highly compensated employee.
The death benefit is paid to a member of the insures person’s family, a beneficiary designated by the insured, a trust for a family member or designated beneficiary, or the insured’s estate; or the death benefit is used to buy an equity interest in the employer/business from a family member, a designated beneficiary, a trust for a family member or designated beneficiary or the insured’s estate.
Notice and Consent
The EOLI policy must meet the "notice and consent" requirements. The employer must notify the employee that it intends to purchase an EOLI policy on the employee's life, and obtain the employee's written consent to the policy. The employee must also be informed that the policy may continue after their employment ends. This requirement ensures that the employee is aware of the policy and has given their consent to be covered.
Reporting and Recordkeeping
The law requires businesses to file an annual report with the IRS. Businesses listed as beneficiaries must file Form 8925 with their annual income tax return.
Failure to File
The failure to file the Notice and Consent will cause the death benefit in excess of the basis to become taxable income.
The failure to file the 8925 could subject the policyholder to penalties for failing to file on time a competed tax return.
The good new to all of this is if a policy meets the requirements of IRC Section 101(j), the death benefits paid to the company are generally tax-free. However, any premiums paid by the company for the policy are not tax-deductible.
In conclusion, IRC Section 101(j) provides rules and regulations for the use of EOLI policies. While these policies can provide a source of funding for employee benefit programs, they also have the potential for abuse and controversy. Companies who own EOLI policies or are contemplating purchasing should carefully review the requirements with their advisors.
If you would like to review any EOLI policies you have please contact me at 818-342-9950, barry.boscoe@brightonadvisory.com or feel free to schedule a call using my calendar Link. https://calendly.com/brighton-advisory/30-phone-call?month=2022-08