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How to avoid tax traps in life insurance

Steve Gorin January 10, 2017

Beware that an employer-owned life insurance contract might not qualify for the usual exclusion from regular income tax. An “employer-owned life insurance contract” (a term that applied to much more than one would think) does not receive the exclusion unless certain notice and consent requirements are met.

An “employer-owned life insurance contract” is a life insurance contract that:

    1. Is owned by a person engaged in a trade or business and under which such person (or certain related party) is directly or indirectly a beneficiary under the contract, and

    2. Covers the life of an insured who is an employee with respect to the trade or business of the applicable policyholder on the date the contract is issued. An “applicable policyholder” means, with respect to any employer-owned life insurance contract, the person described in the preceding sentence who owns the contract at the time it is issued.

“Employee” includes a “highly compensated employee” under Code § 414(q), and Code § 414(q)(1)(A) pulls in people who own at least 5% of the company. Thus, an owner who is not an employee is an “employee” for purposes of this rule by being a 5% owner.

The notice and consent requirements are met if, before the issuance of the contract, the employee:

  • Is notified in writing that the applicable policyholder intends to insure the employee's life and the maximum face amount for which the employee could be insured at the time the contract was issued,

  • Provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment, and

  • Is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee. The only way that this requirement makes any sense is if the policy was issued to the person treated as the insured’s employer under these rules — this requirement would be impossible to satisfy if it was issued to the insured or someone else because the person treated as an employer might not even know about the policy. Thus, “applicable policyholder” should mean the person to whom the policy is issued when the insured is an “employee” of that person.

A life insurance-funded buy-sell agreement might be structured to comply with these rules, in case the parties forget to do the required notice and consent. It also would guard against error in my suggestion that “applicable policyholder” is limited to being the person to whom the policy is issued when the insured is an “employee” of that person.

These rules impose various notice and other requirements that in most cases will not be a practical obstacle to implementing buy-sell agreements if signed before the application is signed. The employer might be able to cure a failure before the due date of its return for the year in which the policy was issued if the insured has not died yet.

Clients should obtain the insured’s written consent before the life insurance application is signed.

Consider having the maximum face amount in that consent provide a cushion in excess of the largest amount that the parties can conceive of that death benefit being (including increased death benefits due to investing the cash value very successfully).

An insurance agent might provide such a consent form, which counsel should consider reviewing, or counsel could provide his/her own consent form to the client. Although some agents understand these issues, many agents do not know (or think they know but actually misunderstand) these rules. Accordingly, tax advisors should consider warning their clients that the tax advisors need to be involved before any policy is issued.

Every applicable policyholder owning one or more employer-owned life insurance contracts issued after August 17, 2006, is required to file IRS Form 8925 each year. “Applicable policyholder” and “employer-owned life insurance contract” are defined for purposes of this reporting rule the same way they are for determining whether a policy is subject to the notice and consent rules.

These are rules for life insurance contracts issued or materially changed after August 17, 2006. Notice 2009-48 elaborates on the rules described above, as well as providing rules for what constitutes a material modification, including guidance on tax-free exchanges. As to buy-sell agreements, Notice 2009-48 provides that a contract that is owned by the owner of an entity engaged in a trade or business (such as for purposes of financing the purchase of an equity interest of another owner — in other words, a cross-purchase) is not subject to these rules.

I insist on notice and consent — even for redemption arrangements that might qualify for an exception under the statute and Notice 2009-48 — because the purchase might not be completed within that deadline, the parties might later all agree that the money would be better used in the business, or the death benefit might exceed the purchase price.

If an employee owns a policy at issuance and then transfers it to the employer, then the notice and consent are not required; however, if the employer later increases the face amount of the contract, written notice and consent must be secured to establish the requisite notice to the employee and consent to the new face amount.

For more information on life insurance and buy-sell agreements, including not only supporting materials from my partner Georgia Loukas Demeros and me but also some ACTEC work product on buy-sell agreements, please view the recording and materials from our Thursday, September 29, 2016, webinar, "Life Insurance to Fund Buyouts or Loss of Key Person: Practical Ways to Avoid Tax Traps and Other Pitfalls."

Steve Gorin is a practitioner in the areas of estate planning and the structuring of privately held businesses. CPAs, lawyers, trust officers, family office professionals, and financial advisors are encouraged to sign up for Steve’s popular quarterly newsletter, “Gorin’s Business Succession Solutions.”