EOLI Tax Trap – Why Your Client’s Death Benefit May be Taxable
Picture this. You recommend that your client’s S-Corp purchase a $1,000,000 life insurance policy to cover a key employee. The S-Corp is the owner and beneficiary of this policy. This $1,000,000 of tax-free funds was determined to meet the clients needs by his advisors. Now, how happy would this client be if, in the event of his key employee’s death, his corporation received $1,000,000 of taxable money? Suddenly, his $1,000,000 need is only covered by $600,000. Ouch.
Wait one second, life insurance Death Benefits are supposed to tax-free. Why would this case be any different? In 2006 congress created an exception to the general rule that life insurance proceeds are a tax-free benefit with IRC section 101(j). This section of the code was created to stave off abuses such as the so called “Janitor’s Insurance” (ahem, Walmart). With one broad swoop the IRS succeeded in preventing such abuses, while putting the legitimate uses of employer owned life insurance in a pickle.
101(j) deals with employer owned life insurance contracts (EOLI). It states that proceeds from EOLI will be taxed as income on the amounts received in excess of the premiums paid into the contract unless certain consent requirements are met. With the numerous uses of EOLI such as split dollar arrangements, key employee insurance, buy-sell agreements, creditor insurance, deferred compensation, etc.. - How many of your clients are compliant?
If certain notice and consent requirements are met prior to the issuance of the policy, your client’s EOLI policy will retain it’s tax favored death benefit. These requirements are met if:
- The policyowner provides written notice that they intend to purchase insurance on the employee’s life and disclose the maximum amount which can be purchased.
- The employee provides written consent to be insured and that coverage will continue even after the employment agreement terminates.
- The employee is informed that the policyowner will be the beneficiary of insurance proceeds upon the death of the employee.
Clearly, section 101(j) created many questions (and caused dismay for many advisors) when it was created. Just recently, the IRS provided some answers. In May of 2009 the IRS released IRS Notice 2009-48. This notice provides guidance for the treatment of EOLI under section 101(j) in a question and answer format. While it answers many questions, it leaves some unanswered, and still creates more. I’ll dive into Notice 2009-48 in my next post.
-Jamison Hibbard
