Business-Owned Life Insurance: A Trap for the Unwary
It is very common for small insurance agencies to engage in perpetuation/succession planning that may culminate in a number of agreements between various parties. For example, multiple owners of an agency may enter into a stock redemption agreement whereby, in the event of death, the agency acquires the stock from the deceased stockholder. In addition, there may be instances where agencies procure “key man insurance” upon the lives of certain owners because it simply makes good business sense to do so. In the foregoing instances, the agency is acquiring life insurance upon an individual who also is generally an employee of the agency.
For many years, life insurance was one of the very few assets that received preferential treatment for federal income tax purposes. In other words, proceeds were not taxed as ordinary income. However, that changed as a result of amendments to the IRS Code in 2006.
At that time, Congress added a new subsection IRC 101(j), which provides that death benefits of employer-owned life insurance contracts issued after August 17, 2006, will be subject to income tax to the extent the death benefit exceeds the sum of premiums and other amounts paid by the policyholder for the insurance contract. That is the general rule. However, death benefit taxation of such policies can be avoided if:
- The notice and consent requirements of the Code are satisfied; and
- A safe harbor exemption exists relative to the transaction.
Both of these items require explanation.
In order to avoid death benefit taxation on business-owned life insurance, the Code requires that certain notice and consent provisions be satisfied prior to issuance of the policy. Specifically, the business (i.e., the agency) must give written notice to the employee indicating:
- An intention to insure the employee’s life;
- The maximum face amount of the intended coverage at the time of policy issuance; and
- A disclosure that the applicable policyholder (i.e., the employer) will be the beneficiary of any death benefits paid.
The employee must then give his/her written consent, permitting the employer to purchase the policy. The employee’s consent must indicate an awareness of the coverage amount and the fact that the coverage may extend beyond termination of his/her employment with the employer. Please note that the death benefit may escape income taxation provided:
- The notice and consent are satisfied before the policy issuance;
- The policy is in fact issued within the shorter of one year beginning on the date the consent was executed or before the termination of the employee’s employment with the employer; and
- One of two safe harbors exists.
The focus now is on the safe harbor exemptions. The Code provides for two safe harbor exemptions. The first is whether or not the insured is a highly-compensated employee at the time the policy was issued. In situations involving “key man” insurance, the individual invariably satisfies this particular requirement. The second safe harbor applies when the death benefit on the policy is received by a family member or the estate of the insured, as a result of the purchase of the equity interest (i.e., stock) of the deceased in the employer (i.e., the agency). Specifically, the life insurance death benefit must be used to purchase the equity interest no later than the due date, including any extensions, of the income tax return for the taxable year in which the death benefit is paid. Provided the notice and consent requirements are met and one or more of the safe harbor exemptions apply, the death benefit can remain tax-free.
As I noted at the beginning of this article, it is routine for agencies to procure life insurance upon owners for purposes of funding buy-sells/redemptions, as well as for key man purposes. For those agencies that are doing so, it is essential they be aware of the potential taxability of those proceeds for income tax purposes; and take the necessary steps to fit within the exemptions. Otherwise, proceeds will be taxable; and the amount of the tax thereon could very well limit the implementation of the plan of succession/perpetuation.
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