Business Owners: Don’t Get Caught Off Guard by a Taxable Death Benefit

Situation: Many businesses own life insurance to cover losses that will be incurred at the untimely death of their owners and employees. In general, proceeds from life insurance are income tax-free under the IRC Section 101(a). However, this general rule changed when Section 101(j) was enacted as part of the Pension Protection Act of 2006.

In general, IRC Section 101(j) provides that for employer-owned life insurance (EOLI) contracts issued after August 17, 2006, death benefits will be taxed as ordinary income to the extent the amounts paid under the contract exceed premiums and other amounts paid by the employer. Congress wrote the rules into the tax code in order to prevent perceived abuses where a few businesses were insuring rank-and-file employees.

At first glance, the Section 101(j) rules seem to negatively impact many common business uses of life insurance such as key person coverage, non-qualified deferred compensation, entity buy-sell arrangements, and endorsement split dollar agreements. Fortunately, the rules provide an exception which when followed preserves the income tax-free character of the death proceeds. In this Counselor’s Corner we describe when the EOLI rules apply and how to qualify for the exception.

Solution: Let’s start by looking at when the rules apply.

Definition of an Employer-Owned Life Insurance Contract. An employer-owned contract is a life insurance contract:

• That is owned by a person engaged in a trade or business (applicable policyholder, as defined by law)
• Under which, the applicable policyholder, or related person (as defined by the law), is directly or indirectly a beneficiary, and
• That covers an insured who is an employee of the trade or business of the applicable policyholder on the date the contract is
  issued.

It’s clear that this definition includes policies where a business is the owner and beneficiary, such as key person coverage, entity purchase buy-sell arrangements, and endorsement split dollar arrangements. What’s not so obvious is that under the applicable policyholder and related party definitions, the legislation expands its reach to a broad group of individuals and entities, such as family members, trusts, and estates.