Businesses that take out life insurance policies on owners and employees may find the death benefit to be taxable, unless they meet certain requirements at the inception of the policy. Here’s what you need to know.
The Pension Protection Act, which became law on Aug. 17, 2006, imposed specific rules regarding the issuance, maintenance, and reporting of employer-owned life insurance. The rules aren’t particularly complicated, but failure to comply with them could cause the death benefit to become taxable income. The problem is that far too many businesses and their advisors have never heard of IRC Section 101(j) or Form 8925. All it takes is a slight misstep in meeting these requirements to trigger potential tax liabilities on the death benefit and penalties on the policyholder.
Section 101(j) notice and consent requirements
The general rule under Internal Revenue Code (IRC) Section 101(j) for policies issued or materially modified since Aug. 17, 2006, is that death benefits received on employer-owned life insurance (EOLI) contracts are taxable to the employer for any amount above the sum of the premiums paid. Section 101(j) does provide employer/policyholders the ability to receive death benefits without triggering federal income tax if they satisfy two requirements:
- The employer/policyholder provides notice to and obtains consent from the insured at, or before, policy inception. (This can easily be done by having the covered individual sign a “Notice and Consent” form with the application).
- The insured must fall into one of the coverage conditions/exceptions listed in Section 101(j)(2).
The notice and consent must be obtained in writing and disclose:
- The maximum face amount of any life insurance policy that your business intends to take out on you or any other insured employee.
- An explanation that the coverage may continue after the employee/insured terminates employment.
- That the business will be the beneficiary of any proceeds payable under this policy in the event of the death of the covered individual.
Section 101(j) does provide employer/policyholders the ability to receive death benefits without triggering federal income tax if they satisfy two requirements.
Failure to comply with the notice and consent requirements of IRC Section 101(j) will cause the death benefits received in excess of the tax basis in the policy to become taxable income to the business, thereby either diminishing the economic benefit or increasing the cost of the plan or program to which the policy relates. If your business has taken out any policies on you or other executives without a Notice of Consent, the only real remedy is to obtain a new policy and complete the Notice of Consent with the new policy.
Form 8925 reporting of EOLI
In addition to the notice and consent requirements that must be met at the creation of the policy, since 2009, the law has required businesses that take out life insurance policies on owners and executives to file an annual report with the IRS on any employer-owned life insurance contracts. Businesses that are listed as beneficiaries of life insurance policies on owners and executives must include Form 8925 “Report of Employer-Owned Life Insurance Contracts” as part of their annual income tax return.
Failure to comply
The cost for failing to meet the notice and consent requirement and exceptions under 101(j) is clear. The death benefit in excess of the tax basis in the policy is taxable income.
The risk associated with a failure to file Form 8925 is less clear. There is no direct guidance as to the penalty associated with the failure to timely file Form 8925, although such a failure could expose the policyholder to penalties for failing to timely file a complete income tax return.
It’s a little bit ironic that the biggest obstacle to compliance with the notice and consent requirement is that so many businesses don’t know of its existence. Now that you’ve read this far, you’re on notice of the requirement and, armed with that knowledge, you should review any existing employer-owned life insurance contracts at your business to make sure they comply.
If you have any questions about the taxability of employer-owned life insurance contracts, please contact Plante Moran.