Changes that Congress made to the tax law in 2006 are having an impact on small business owners who have employer-owned life insurance on the lives of any employee (including the owner who is an employee). Any employer-owned policy purchased after August 17, 2006 may be subject to income tax on the insurance proceeds. This has been, and will be, shocking news to many business owners.

Small employers rarely can afford to have staff keep track of the law changes that may impact their business. Unfortunately, sometimes they are not aware of changes that can cost them serious tax dollars. That is the case for many small business owners when it comes to employer-owned life insurance purchased after August 17, 2006.

Reasons for EOLI

Small employers have found it advantageous to own life insurance on the lives of select employees. The following are some of the reasons:

? Key man protection

? Deferred compensation planning

? Endorsement split-dollar

? Collateralizing loans

? Non-qualified retirement programs

The new statute will impact all such plans and any other employer-owned arrangement. An “employer-owned life insurance contract” is a policy owned by a “person” engaged in trade or business; the contract insuring the life of an individual who is an employee of the “person” on the date the insurance contract is issued. The “person” can be a sole proprietor, partnership, LLC, S Corporation, C Corporation, etc. The “person” or a “related person” must also be directly or indirectly a beneficiary under the contract. Keep in mind that the “related person” definition applies only to a beneficiary defined by the statute and is not considered an owner of the contract.

The new statute

Congress added Section 101(j) to the Internal Revenue Code in the Pension Protection Act of 2006 in response to the issuing of “janitor” insurance and other employer arrangements wherein the insured employee had not given consent to the life insurance being owned by the employer. The requirements of Section 101(j) include:

General rule

The amount of life insurance benefit excluded from the gross income of the employer (also called the applicable policyholder) shall not exceed an amount equal to the sum of the premiums and other amounts paid by the employer for the contract. The balance of the life insurance benefit is includable in gross income.

Exceptions to the general rule

If the insured employee has been given a proper notice and has signed a proper consent, the general rule will not apply to certain arrangements (a) based on an insured’s status, or (b) based on amounts paid to an insured’s heirs. Even if the policy fits within one of the two exceptions, the proper notice and consent must be completed prior to the issuance of the life insurance contract.

The statute provides no grandfathering or procedure to correct a failure to get a proper notice and consent after the issuance of the policy. Failure to get the proper notice and consent prior to the issuance of the policy causes the general rule to apply, even when the situation falls within the exceptions, based on a literal wording of the statute.

Exceptions based on insured’s status

The entire death benefit will be excluded from gross income, if the insured has received a proper notice and has signed a proper consent, and was (i) an employee at any time during the 12-month period before the insured’s death, or (ii) is, at the time the contract is issued: a director or a highly compensated employee (within the meaning of specific Code sections specified in Section 101(j).

Exception for amounts paid to an insured’s heirs

Any amount received by reason of the death of an insured employee will be excluded from gross income if the insured has received a proper notice and has signed a proper consent, to the extent the amount is paid:

? To a member of the family (see Section 267(c)(4)) of the insured employee.

? To any individual who is the designated beneficiary of the insured (other than the employer).

? To a trust established for the benefit of any such member of the family or designated beneficiary.

? To the estate of the insured.

? To be used to purchase an equity interest in the employer from any person named above (buy-sell arrangement).

New annual reporting of employer-owned life insurance

Added to the Internal Revenue Code was Section 6039I, which requires every employer with employer-owned life insurance issued after August 17, 2006 to annually file IRS Form 8925, setting out required information on employees and on employer-owned life insurance. The form is filed with the employer’s regular tax return on the date the employer files that return.

What agents should be doing now

Agents should review their employer client files to be certain that a copy of the required proper notice and consent forms signed by insured employees are in the file. If not in the file, verify with the clients that they have such notice and consent form, and request a copy for your file. If there is no notice and consent form, for insurance issued on an employee after August 17, 2006, you will need to carefully explain to your clients the potential tax consequences and how new insurance may need to be acquired to prevent the inclusion of the death benefit in gross income.

Naturally, the agent should work very closely with the client’s attorney in making any necessary changes. Your small business clients have relied on you for assistance and will continue to look to you for assistance now and in the future.

F. James Gray, JD, CLU, is a senior advanced sales consultant and marketing counsel for the UNIFI Companies, Bethesda, Md. You can e-mail him at