Recently the IRS issued a notice providing guidance on employer-owned life insurance contracts under Internal Revenue Code §101(j), which was added in 2006 by the Pension Protection Act. Life insurance proceeds generally are not included in the recipient’s gross income. However, under §101(j), the proceeds excluded from gross income of an employer (and certain related persons) that owns life insurance on an employee’s life cannot exceed the sum of the premiums and other amounts paid by the employer for the contract unless certain requirements are met. For this purpose, the IRS defines an “employer-owned life insurance contract” as a life insurance contract that is owned by an employer (a “person engaged in a trade or business”) under which the employer is a beneficiary, and that covers the life of an insured who is an employee on the date the contract is issued. “Ownership” is defined broadly such that the rules are not limited to traditional corporate owned life insurance (“COLI”) but also may extend to “key man” insurance and certain split-dollar life insurance arrangements.
The IRS previously finalized regulations that require an employer to file Form 8925 for each year that it owns any such life insurance contract. The new notice also provides guidance on the requirements that must be met for the full life insurance proceeds to be excludable from the employer’s income. In all cases, the following notice and consent requirements of §101(j) must be met. Before the policy is issued, an employee must: (i) be notified in writing that the employer intends to insure the employee’s life and of the maximum face amount for which the employee could be insured when the contract is issued; (ii) provide written consent to being insured under the contract, including consent that such coverage may continue after the insured terminates employment; and (iii) be informed in writing that the employer will be a beneficiary of any proceeds payable upon the employee’s death.
If these initial requirements are met, then the proceeds are fully excludable if the insured either was an employee at any time during the 12-month period before death or was a director, highly-compensated employee or highly-compensated individual when the contract was issued. The full exclusion also applies any amount received because of the death of an insured to the extent that mount paid to or used to purchase an equity (or capital or profits) interest from a family member of the insured, an individual who is a designated beneficiary, a trust established for the benefit of a family member or designated beneficiary, or the estate of the insured.
These new rules apply to contracts issued after August 17, 2006, other than a contract exchanged under Code §1035 for a contract issued on or before that date. However, a new contract will be subject to the rules described above if there is a material increase in the death benefit or other material change.
This new guidance is effective as of June 15, 2009. However, the IRS will not challenge any good-faith efforts made before that date so long as the interpretation of the rules was reasonable.