8777 / For employer-owned life insurance contracts issued after August 17, 2006, are there any special requirements that must be met in order for the proceeds to be exempt from income tax?

An employer-owned life insurance contract is defined as a life insurance contract owned by a person or entity engaged in a trade or business under which that person or entity, or certain related persons, is a beneficiary under the contract, if 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.

First, before an employer-owned life insurance contract is issued, the employer must meet the following notice and consent requirements:

(1)  The employer must notify the insured employee in writing that the employer intends to insure the employee’s life;

(2)  The employer must provide notice of the maximum face amount the employee’s life could be insured for at the time the contract is issued;

(3)  The employer must state that the policy owner will be the beneficiary of the death proceeds of the policy; and

(4)  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

Another set of requirements relates to an insured’s status with an employer. The insured must have been (i) an employee at any time during the 12 month period before his or her death, or (ii) a director or highly compensated employee at the time the contract was issued. A “highly compensated employee” is one who is classified as highly compensated under the qualified plan rules of IRC Section 414(q) (except for the election regarding the top paid group), or under rules regarding self-insured medical expense reimbursement plans of IRC Section 105(h), except that the highest paid 35 percent instead of 25 percent will be considered highly
compensated.³

In the alternative, 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 proceeds are paid to any of the following:

(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.

Additionally, the proceeds will not be included in an employer’s income if death proceeds are used to purchase an equity interest from a family member, beneficiary, trust, or estate.⁴ The Pension Protection Act of 2006 (“PPA 2006”) also imposes new reporting requirements on all employers owning one or more employer-owned life insurance contracts. Final reporting regulations were issued in November 2008.⁵

Further, Notice 2009-48 provides guidance on certain issues that may arise when dealing with employer-owned life insurance contracts with respect to IRC Section 101(j)’s notice and consent requirements and IRC Section 6039I’s information reporting requirements. The guidance, which is presented in a question-and-answer format, is effective June 15, 2009, but the IRS has announced that it will not challenge a taxpayer who made a good faith effort to comply with IRC Section 101(j) based on a reasonable “interpretation of the provision before that
date.”

Reporting Requirements

All employers who own one or more life insurance contracts on the life of any employee that are considered employer-owned contracts under IRC 101(j) must file with the IRS an informational return, which includes the following information:

(1)  The number of employees of the “applicable policy holder” (e.g. the employer) at the end of the year;

(2)  The number of employees insured by employer-owned contracts at the end of the year;

(3)  The total amount of insurance in force at the end of the year under such
contracts,

(4)  The name, address, and taxpayer ID number for the applicable policyholder and the type of business in which the policyholder is engaged; and

(5)  That the applicable policyholder has a valid consent for each insured employee
(or, if all such consents are not obtained, the number of insured employees for whom such consent was not obtained).⁶

These reporting requirements became effective for tax years ending after November 6, 2008. To comply with the reporting requirements, the applicable policyholder must provide the requested information by attaching Form 8925 to the policyholder’s income tax return by the due date of that return.⁷