Michael Moore’s new film, “Capitalism: A Love Story,” created negative media attention and prompted the introduction of a federal legislation regarding employer-owned life insurance. Rep. Luis Gutierrez, D-Ill., introduced “The Employer-Owned Life Insurance Limitation Act,” which seeks to prohibit employers from establishing or maintaining life insurance policies on employees earning less than $1,000,000 per year.
However, perhaps unbeknownst to Moore and Gutierrez, Congress already curtailed the practice of insuring rank and file employees with the creation of IRC Section 101(j) on August 17, 2006.
The impact of IRC ? 101(j) on employer-owned life insurance has been the subject of numerous articles. Aside from making a material change to the contract (and then complying with the IRC ? 101(j) requirements), the IRC does not offer any safe harbors. What can an employer do to regain the tax-favored status of its policies if they have failed to comply with IRC 101(j)?
The following example illustrates the impact of an employer’s failure to comply with the requirements of IRC ? 101(j) and two potential solutions.
Kevin, Harry & XYZ
Kevin has been an employee of XYZ Corporation for a number of years. Harry is the owner of XYZ and has decided that Kevin’s ongoing employment is essential to XYZ’s continued success. Harry explained to Kevin in October 2006 that he would like XYZ to purchase a $1,000,000 life insurance policy on Kevin’s life to indemnify itself. Kevin was cooperative; he completed all of the necessary forms and went through medical underwriting. In 2008, Kevin survived a health scare. He is back at work after treatment, but is no longer insurable.
Currently, if Kevin passes away, the $1,000,000 death benefit (less the premiums paid) is subject to ordinary income tax rates because XYZ’s Human Resource Department failed to provide Kevin with written notification that XYZ intended to insure his life. And the company’s CPA failed to file Form 8925 on or before the due date of XYZ’s 2006 income tax return.
XYZ may be able to rectify the problem. The company could surrender the policy, start fresh with a new policy and meet the IRC 101(j) requirements going forward. However, this is not practical because Kevin is uninsurable.
The company could materially change the contract. To date, the IRS has not provided clarification on what constitutes a “material change.” However, increasing a policy’s face amount is generally considered to be a material change. In some instances this may be an appropriate solution.
If the policy in question is a universal life policy, and if Kevin were insurable, XYZ could request an increase in the coverage and complete the notice and consent requirements prior to issue. As long as XYZ files Form 8925 on or before the due date of its next income tax return, the company will be in compliance and the death benefit received income tax free. XYZ approaches the issuing carrier and requests an increase of Kevin’s coverage–but is denied.
XYZ is at a loss. However, there may be solutions. Under the transfer for value rules, if a life insurance contract is transferred, then the death benefit (in excess of the consideration paid and premiums subsequently paid by the transferee) is income taxable. However, pursuant to IRC ? 101(a)(2)(B), if the policy is transferred to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder then the transfer for value rules do not apply .
In addition, Question #8 of IRS Notice 2009-48 provides that the transfer of an existing life insurance contract by an employee to an employer satisfies the notice and consent requirements of IRC ? 101(j). Using these rules wisely, the parties might consider one of the following two courses of action that may provide a solution to their IRC ? 101(j) problem:
First, XYZ distributes the life policy to Kevin for its fair market value (“FMV”). Because the distribution of the policy is considered compensation, XYZ also pays Kevin a bonus to cover his increased income tax liability. Second, Kevin becomes a minority owner in XYZ by entering into a tax-free exchange with the company. Finally, Kevin holds the policy for a period of time, and then irrevocably transfers it back to XYZ.
The transfer for value rules do not apply because Kevin is a shareholder of the corporation when the policy is transferred back to the business. More to the point, the notice and consent requirements of IRC ? 101(j) are considered to be satisfied pursuant to Question #8 of Notice 2009-48. If Form 8925 is filed on or before the due date of XYZ’s next tax return, the company will be in compliance and the death benefit will be received income tax free.
Approach #1 is not without its disadvantages. For instance, if Kevin were to die during the period in which he holds the policy, the policy proceeds will be included in his personal estate and his employer will be deprived of the proceeds. The IRS may attempt to apply the “step transaction doctrine,” which it uses to invalidate transactions when tax avoidance is the sole motivation. However, the fact that Kevin, Harry and XYZ are in different economic positions before, during and after the transaction would be a strong defense against the step transaction doctrine.
Approach #1 is equally effective for S Corporations, LLCs and partnerships.
Kevin and Harry (and/or XYZ) could consider purchasing interests in the same publicly traded partnership (“PTP”). A PTP is any partnership with an interest that is regularly traded on an established securities market.
First, XYZ distributes the policy to Kevin for its FMV and provides a bonus to cover any additional income taxes owed. Second, Kevin and XYZ both purchase interests in the same PTP. Finally, Kevin irrevocably transfers the policy back to XYZ while he and XYZ are both holding PTP interests.
Transfer for value rules will not apply because XYZ is a partner of the insured when Kevin transfers the policy back to the business.
This approach may also be attacked under the step transaction doctrine. As such, Kevin and XYZ should not purchase their PTP interests simultaneously. Instead they should purchase differing amounts on different dates, hold them for more than one year, and not dispose of them simultaneously. Taxpayers considering employing this approach should consult their tax advisors prior to engaging in this transaction.
IRC ? 101(j) affects many employer-owned life insurance contracts. If you have sold life insurance after August 17, 2006 for any of the following purposes, then IRC ? 101(j) may apply to:
? Key-person policies;
? Stock redemption buy-sell agreements for employee-owners;
? Certain split-dollar arrangements;
? Family limited partnerships and LLCs where the insured also acts as an employee;
? Deferred compensation;
? SERPs; and
? 457 plans.
If you have sold employer-owned life insurance that is not in compliance with IRC ? 101(j), then you may want to give consideration to the two solutions described above.
Jack F. Elder, J.D., LL.M. (taxation) and William R. Buslee, MS, CLU, ChFC, are directors of advanced sales at Crump Life Insurance, Bethesda, Md. You can e-mail them at [email protected] and [email protected].