The death benefit proceeds from a life insurance policy are generally excluded from income tax. At the same time, no tax deduction is allowed for premiums paid on any life insurance policy if one is directly or indirectly the beneficiary of the policy.
Businesses find life insurance attractive because it allows for the inside buildup of cash value and the death benefit to be free of income tax. Life insurance owned by a business is commonly referred to as company-owned life insurance (COLI). Life insurance is an efficient approach to addressing the business’s future obligations, which can include:
- Protect against the death of key employees;
- Accumulate cash to fund future obligations under employee benefit plans; and
- Fund buy-sell agreements.
What many business owners do not realize is that IRC Sec. §101(j) (enacted with the Pension Protection Act of 2006 with respect to policies issued after Aug. 17, 2006) subjects death benefit proceeds of an EOLI to income taxation by the employer to the extent the proceeds exceed the premiums and other amounts paid by the policyholder for the policy unless (1) a valid exception applies and (2) notice and consent requirements are satisfied. Unfortunately, many insurance agents sell life insurance to business owners without making them aware of the requirements to avoid the recognizing of taxable income when the insured dies.
Fortunately, there are two exceptions:
- The insured was an employee at any time during the twelve months before their death, or who, at the time the contract was issued, was a director, highly compensated employee or highly compensated individual; or
- The death benefit is paid to certain parties, including a member of the insured person’s family, a beneficiary designated by the insured, the insured’s estate, or the death benefit is used to buy an equity interest in the employer/business from certain parties, included a family member.
While many policies may fall within the above two exceptions, there is another test that must be met. That test is that notice and consent requirements must be met. The notice and consent requirements are met if, before the issuance of the contract, the employee is:
- Notified in writing that the employer intends to insure the life of the employee and the maximum face amount of the policy for which the employee can be insured;
- Provided written consent to being insured under the contract and that such coverage may continue after the insured terminates employment; and
- Informed in writing that the employer will be a beneficiary of any proceeds payable upon the death of the employee.
In addition, you are required to report to the IRS annually on Form 8925 the:
- Number of employees at the end of the year;
- Number of employees insured under an EOLI contract at the end of the year;
- Total amount of insurance in force at the end of the year under such contracts;
- The policyholder’s name, address, and taxpayer identification number and the type of business engaged in; and
- Inclusion of a statement that you have a valid consent from each insured employee or a declaration of the number of insured employees for whom such consent was not obtained.
In order to take advantage of the death benefit exclusion, it is important that all of the applicable requirements are met. If you own an EOLI policy issued after Aug. 17, 2006 and your life insurance agent did not make you aware of the requirements to avoid having the life insurance death benefit proceeds excluded from your company’s taxable income, you need to call your agent. If there is a panicked voice on the other end of the line, you may have an agent who is not familiar with this tax law.
The author wishes to thank Geoffrey F. Forcino, AIF®, a partner with The Philadelphia Group located in King of Prussia, for his contributions to this article.
You should contact your tax advisor to assist you to determine if you meet the IRS’s tests to correct defective notice and consent requirements as outlined in IRS Notice 2009-48 as well as with assistance preparing the documentation and filing the annual IRS Form 8925.
Please be sure to read the disclaimer page on our blog. This blog is for educational purposes only and should not be considered as the rendering of tax, legal, or investment advice.
