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.
“What is very commonly done is companies will buy insurance so that upon the death of one of the major owners, there are proceeds available to buy out that person’s ownership interests, so they don’t end up being partners with someone they don’t want as partners,” Kies says.
Covering replacement costs
Other reasons to purchase EOLI are redeeming the stock of a deceased employee or shareholder and funding executive benefits, which include preretirement salary continuation benefits and deferred compensation benefits, Headley says. EOLI also helps fund employee stock ownership plans as well as group life, disability, medical and other basic insurance coverage. These benefits are typically underfunded, but purchasing an EOLI policy helps cover the cost of providing those benefits.
“There’s a cost to replacement, and these are good business-planning tools,” Headley says. “Insurance happens to be the vehicle to fund in many cases additional benefits above and beyond the traditional employee benefits that a business would offer to its employees.”
Small employers, in particular, can be more susceptible to compliance mistakes than large employers, Hall says. While large employers typically have multiple resources, such as advisers, lawyers and consultants, small businesses don’t always have that luxury and are sometimes more likely to be unaware of the requirements. Determining which employees are in the highly compensated category can also cause some problems because that can change annually, and it takes time and resources to stay current on where everyone’s salaries rank each year.
“Because of the lack of resources, a small business might either make an ill-informed choice or insure someone who doesn’t fit within those categories,” Hall says. “That’s when the small business might find itself breaking the regulations.”
Even if a small business does have a lawyer on its side, that lawyer typically does not specialize in life insurance but instead focuses on a wide variety of small-business issues, Kies says. Thus, it’s important that life insurance agents and brokers make sure they communicate these requirements with the employer.
Communication is key
Employers must be especially careful that they comply with the notice and consent requirements before the policy is issued, Hall says. While an employer can take the time to follow all of the steps in the notice and consent requirements and insure the proper employees, it would still be subjected to taxation if the policy is issued before these processes are completed.
“It’s a very harsh timing requirement, so employers need to make sure they follow the notice and consent requirements before the policy is issued,” Hall says. “If you don’t take care of that in time and several years go by or you wait until the person dies, you’re just out of luck, and you have to pay taxes.”
However, the IRS does offer an extension for any employer that makes a mistake in good faith and fails to comply with the notice and consent requirements, Kies says. As long as the employer provides the notice and consent forms on the due date of the tax return for the year the policy was issued, the taxable status can be waived. In many cases, employers take extensions on filing their tax returns each year, which gives them even more time to ensure compliance.
“The IRS didn’t have to offer the extension because the statute didn’t provide for it, but just to be lenient, it provided that relief,” Kies says “Employers with questions about how this provision works should turn to IRS notice 2009-48, which was issued in 2009 and answers quite a few questions about this provision. It has all kinds of helpful guidance in it for employers.”
While the rules for the notice and consent requirements are not difficult to follow, it does take some administrative diligence from the employer to make certain that they are in compliance, Hall says. The IRS requires employers to file IRS Form 8925, which is attached to tax return documents. On the IRS Form 8925, employers must outline the number of workers employed, the total amount of workers who were insured at the end of the year under EOLI and the full dollar amount of EOLI at the end of the year.
“The main thing is to just be aware that you have this notice and consent requirement and understand what it is,” Hall says. “It’s not that elaborate, but you need to touch on those key points – I am insuring you, and I am the beneficiary – and you have to keep the records necessary to report that employee information to the IRS.”
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