For organizations with employer-owned life insurance, which is a policy owned by an entity that acts as the beneficiary, there is the potential for major tax savings. But employers must be sure they are following all of the regulations in order to see that tax advantage, says Russell Hall, senior regulatory adviser at Towers Watson, a global professional services firm in New York City.
Under the notice and consent requirements in the Pension Protection Act of 2006, an employer must notify the employee in writing that it intends to take out a life insurance policy on his or her life, and the maximum amount of the death benefit that could be insured at the time the contract is issued must be listed, says Terry Headley, president of Headley Financial Group, a financial services group in Omaha, Neb.
The employer is also responsible for informing the employee in writing that the employer is the sole or partial beneficiary of any death benefits, and the employee must consent to the EOLI policy in writing. Each of these requirements must happen before the policy is issued.
Additionally, only specific types of employees may be insured by EOLI policies to qualify for the tax-free status, Headley says.
To qualify for the tax-free status, an employee insured under an EOLI policy must be either a director within the company or a highly compensated employee. The IRS defines a highly compensated employee as someone who owns 5 percent or greater of the business, ranks among the top 35 percent of company earners or makes $115,000 per year, though that figure is adjusted annually.
Family members related to those who are 5 percent or more business owners are also included in the highly compensated group, even if their salaries are not as high or they themselves do not have stock ownership, Headley says.
EOLI policies are restricted to certain types of employees because before the Pension Protection Act of 2006 was enacted, some employers tried to take advantage of the tax-free status by insuring everyone in the company, which is known as janitors insurance, Hall says. Usually when this was done, the employees were not even aware that policies were being taken out on their behalf.
“It would really be used as an investment by an employer,” Hall says. “EOLI is especially attractive because of the investment returns. If you wait until the insured dies, you’ll receive the tax-free status, and you can get bigger investment returns by having a bigger policy. That means if you insure more employees, you get a bigger policy. You would have some companies insuring literally every employee in their organizations.”
However, with the restrictions regarding the types of employees who are eligible to be covered by EOLI, it prevents employers from practicing janitors insurance, Hall says. Now that those employees aren’t covered by the tax-free statute, there’s no incentive to insure everyone in the company.
“If I cover people outside of the allowable groups, I’m not getting these favorable tax results,” Hall says. “If I’m not getting those favorable tax results, chances are it doesn’t look like a particularly good investment opportunity for me compared to other alternatives because the death proceeds will not be tax free.”
If an employer with an EOLI policy fails to comply with the notice and consent regulations or covers the wrong types of employees, it would lose that tax-free status upon receipt of the death benefits for the portion that exceeds the premiums already paid, and that comes with major financial implications, says Ken Kies, managing director of the Federal Policy Group, a consulting firm in Washington, D.C.
“Let’s say you had a $1 million face-amount policy, which means that’s the amount paid upon the death of the insured, and you paid in $300,000 in premiums,” Kies says. “If you fail to satisfy the notice and consent requirements, then under those circumstances, you’d get a check for $1 million from the insurance company and be taxable on $700,000 of it because it’s reduced by the amount of premiums you already paid into it.”
Hall adds that the financial implications can be especially strong because, as in Kies’ example, employers have typically paid much less in premiums than the full policy amount, which is why EOLI is so attractive in the first place. Therefore, there’s more to lose if an employer fails to comply with the notice and consent requirements.
“Usually, you’re pooling risks and such so often that the amount being paid is substantially more than the premiums that have been paid for the policy, so that’s quite an attractive income tax outcome for the recipient,” Hall says. “When it’s exposed to even more taxation, that’s the hook to encourage employers to comply with these notice and consent requirements.
”Often these highly compensated employees are also so indispensable that an employer might purchase EOLI on their lives to protect what they bring to the business, Headley says. In these cases, an employer would be directly impacted if those employees were no longer around.
“We’re characterizing this as a key-person insurance to indemnify the business because this person’s skills sets are as such that they’re so valuable to the company, and if something were to happen, it would be detrimental to the employer,” Headley says. “This person could also control major accounts or have an impact on the lines of credit that the business has access to from lenders.”
Some employers also choose to purchase EOLI to fund buy-sell agreements, Kies adds. This is done to protect ownership rights when one partner in the business passes away. Even families entities, such as a family limited partnership or a limited liability corporation, are covered under this.