How to help clients avoid a tax trap

In the Pension Protection Act of 2006, Congress created a strict set of rules for employer-owned life insurance (EOLI). If your business clients own policies written on the lives of employees and issued after August 17, 2006, they must “dot every i” of the new rules, or else the policy will be treated as EOLI and lose the favorable federal treatment of an income-tax-free death benefit. In that case, only the original cost basis in the policy will be returned tax-free, and the rest of the death benefit will be taxable as ordinary income.

The unexpected tax impact is a costly potential trap, and it can leave business clients far short of amounts they expect to have available. You can help by conducting an EOLI policy audit, to make sure life insurance death benefits won’t be taxable. Four questions are key:

1. Do EOLI rules apply to the policy?
2. Is the insured person eligible for tax-advantaged EOLI?
3. Have notice and consent requirements been met?
4. Have IRS filing requirements been met?

Do EOLI rules apply to the policy?

A life insurance contract is subject to EOLI rules when three conditions are met:

1. The policy was issued after August 17, 2006;
2. The contract’s owner is engaged in a trade or business that employs the insured person, at the time the contract is written; and
3. The employer is the direct or indirect beneficiary of the contract. A policy owned by a sole proprietorship, in which the proprietor is the only insured, is not subject to EOLI rules.

Is the insured person subject to EOLI?

For a contract to be EOLI, the insured person must be:

1. A U.S. citizen or resident; and
2. An employee of the contract holder when the contract was issued. The term “employee” is broadly defined and generally includes anyone who receives W-2 income. It also includes officers, directors and highly compensated employees, whether or not they are currently employed or receive W-2 income.

Example: ABC Co. buys new life insurance in which the insured is a retired employee who has not worked for the company for several years. If the employee was not highly compensated when employed, it is not EOLI. If the employee was highly compensated, it is EOLI.

Have notice and consent requirements been met?

Notice and consent requirements must be met for all EOLI policies before the policy is issued, or else the tax-advantaged death benefit will be permanently lost. The policy must be issued within one year, at most, after a notice and consent form is signed by the insured employee. 

The form discloses that the employee:

1. Consents to the coverage;
2. Understand that the employer is a beneficiary of the death proceeds;
3. Knows the maximum face amount of the coverage ( in one or more policies) expressed in dollars or as a multiple of salary. The IRS says that if notice and consent forms are not obtained, properly and on a timely basis, the oversight can’t be fixed. The only exception is for inadvertent mistakes corrected on a timely basis.

Have IRS filing requirements been met?

For each year in which employers have even one policy written on an employee, they must file Form 8925 along with the federal income tax return. The form summarizes:

1. The number of employees insured under EOLI-eligible contracts;
2. The total amount of such insurance in force; and
3. An attestation that valid consent has been obtained from each insured. Failure to meet filing requirements can subject EOLI policies to loss of the tax-advantaged death benefit.

Why an EOLI audit is valuable

Of the four questions listed above, the first two determine whether or not a policy is EOLI. The last two – notice/consent and IRS filing – determine whether an EOLI contract is eligible for tax-advantaged death benefit treatment. An audit can help you remind clients of the need to:

1. Obtain the insured’s notice and consent on all EOLI contracts, including 1035 policy exchanges in which there are material changes to the coverage; and
2. File Form 8925 for every tax year in which an EOLI contract is in force.

When requirements have not been met on EOLI contracts, clients should reduce their expectations for the amount of death benefit (after income tax) policies will provide. For example, if a policy has a $1,000,000 death benefit and a cost basis (premiums paid) of $100,000, the federal income tax on the death benefit will be $306,000 – the $900,000 taxable portion x 34% corporate tax rate. That’s $306,000 less the company will have available to fulfill the objectives of the insurance purchase.