While a large portion of the new Pension Protection Act relates to qualified plans, a very important provision related to life insurance was also included in the legislation.
The act adds new requirements that employer-owned life insurance contracts must meet for the death proceeds to be excluded from the employer’s income. If these requirements are not met, the death proceeds will be included in income to the extent they exceed the amount paid for the policy (including premiums paid).
One set of requirements is that before an employer-owned life insurance contract is issued the employer must meet certain notice and consent requirements. The insured employee must be notified in writing that the employer intends to insure the employee’s life, and the maximum face amount the employee’s life could be insured for at the time the contract is issued.
The notice must also state that the policy owner will be the beneficiary of the death proceeds of the policy. The insured must also give written consent to be the insured under the contract and consent to coverage continuing after the insured terminates employment.
Another set of requirements regards the insured’s status with the employer. The insured must have been an employee at any time during the 12-month period before his death, or at the time the contract was issued was a director or highly compensated employee. A highly compensated employee is an employee classified as highly compensated under the qualified plan rules of Code section 414(q) (except for the election regarding the top-paid group), or under the rules regarding self-insured medical expense reimbursement plans of Code section 105(h), except that the highest paid 35% instead of 25% will be considered highly compensated.
Alternatively, the death proceeds of employer-owned life insurance will not be included in the employer’s income (assuming the notice and consent requirements are met) if the amount is paid to a member of the insured’s family (defined as a sibling, spouse, ancestor, or lineal descendent), any individual who is the designated beneficiary of the insured under the contract (other than the policy owner), a trust that benefits a member of the family or designated beneficiary, or the estate of the insured. If the death proceeds are used to purchase an equity interest from a family member, beneficiary, trust, or estate, the proceeds will not be included in the employer’s income.
In addition to the fact that many employers may not be aware of the new requirements, there are attribution rules in the act that may make life insurance contracts owned by individuals, who are not themselves business owners, treated as employer-owned. These owners of life insurance contracts may not realize that failing to comply with the notice and consent requirements will cause the death proceeds to be subject to income tax. It could be possible that the shareholders of a closely-held corporation who are all family members (such as a husband, wife, and 2 children) could enter into a cross purchase buy-sell arrangement and all the policies owned by the various family members will be considered employer-owned.
In addition, the act imposes new reporting requirements on all entities (individuals or businesses) owning one or more employer-owned life insurance contracts.
This provision is effective for life insurance contracts issued after Aug. 17, 2006, except for contracts issued as part of a 1035 exchange where there was not a material increase in the death benefit or other material change.