277 / What special requirements must be satisfied by employer-owned life insurance contracts issued after August 17, 2006, in order for death proceeds to be received income tax-free?

An employer-owned life insurance contract is defined as a life insurance contract (1) owned by a person or entity engaged in a trade or business where (2) that person or entity, or certain related persons, is a beneficiary under the contract, and (3) the contract covers the life of an insured who is an employee when the contract is issued.¹

For life insurance contracts entered into after August 17, 2006, certain requirements must be met for death proceeds of an employer-owned life insurance contract to be received income tax-free.

One set of requirements is that before an employer-owned life insurance contract is issued, an employer must meet certain notice and consent requirements. An 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 also must state that the policy owner will be the beneficiary of the death proceeds of the policy. The insured also must give written consent to be the insured under the contract and consent to coverage continuing after the insured terminates employment.² Note that there is no cure provision under IRC Section 101(j) if the notice requirements are not satisfied before the policy is issued. However, in very fact-specific circumstances, the IRS has recognized that the documentation secured by an employer in the course of applying for a life insurance policy on the life of an employee has inadvertently constituted “notice and consent” under the statute.³

Another set of requirements relates to an insured’s status with an employer. The insured must have been an employee at any time during the 12-month period before death or a director or highly compensated employee at the time the contract was issued. A highly compensated employee is an employee classified as highly compensated under the qualified plan rules of IRC Section 414(q), except for the election regarding the top paid group ( Q 3927), or under rules regarding self-insured medical expense reimbursement plans of IRC Section 105(h) ( Q 341), except that the highest paid 35 percent instead of 25 percent will be considered highly compensated.⁴

Alternatively, death proceeds of employer-owned life insurance will not be included in an employer’s income, assuming the notice and consent requirements are met, if the amount is paid to:

(1)     a member of an insured’s family, defined as a sibling, spouse, ancestor, or lineal descendent;

(2)     any individual who is the designated beneficiary of the insured under the contract (other than the policy owner);

(3)     a trust that benefits a member of the family or designated beneficiary; or

(4)     the estate of the insured.

If death proceeds are used to purchase an equity interest from a family member, beneficiary, trust, or estate, the proceeds will not be included in an employer’s income.⁵