Non-compliance has devastating tax consequences.
New Reporting Requirements
As part of the Pension Protection Act of 2006, Congress mandated under new § 6039I of the Internal Revenue Code of 1986, as amended (“IRC”), the annual reporting of information regarding employer-owned life insurance contracts. This annual reporting is required on new IRS Form 8925, Report of Employer-Owned Life Insurance Contracts. This form must be filed by every employer that owns a life insurance contract on the life of one or more of its employees that was issued after August 17, 2006. Additionally, any life insurance contract for which there is a material increase in death benefit or other material change is treated as a new contract. Hence, pre-August 17, 2006 contracts can become subject to this rule if they are materially modified.
Form 8925 must be attached to the employer’s annual income tax return. This form requires disclosure of the following information:
- The number of employees at the end of the year.
- The number of employees who are insured at the end of the year under employer-owned life insurance contracts.
- The total amount of life insurance in force at the end of the year under these contracts.
- The name, address, and taxpayer identification number of the employer and the type of business in which the employer is engaged.
- Whether the employer has a valid consent for each insured employee, and if not, the number of insured employees for whom a consent was not obtained
Failure to Comply with the New Notice and Consent Requirements
Results in Taxable Life Insurance Proceeds
As a general rule, life insurance proceeds, whether the insurance contract is individually or corporate owned, are income tax free per IRC §101(a)(1). One longstanding exception is IRC §101(a)(2), which taxes insurance proceeds where the life insurance contract has been transferred for valuable consideration and none of transfer-for-value exceptions apply.
Now, with the passage of the Pension Protection Act of 2006 and the addition of new IRC §101(j), life insurance proceeds derived from employer-owned life insurance contracts are likewise taxed, subject to four important exceptions. Provided statutorily prescribed notice and consent requirements are satisfied, life insurance proceeds from employer-owned life insurance contracts can be received tax-free if (a) the insured was an employee of the employer at any time during the 12-month period preceding his or her death; (b) the insured was at the time the contract was issued (i) a director, (ii) a highly compensated employee (a defined term) or (iii) a highly compensated individual (likewise a defined term) of the employer; (c) (i) a member of the insured’s family, (ii) a designated beneficiary of the insured under the subject life insurance contract, (iii) a trust established for either the family member or the designated beneficiary, or (iv) the insured’s estate; or (d) the insurance proceeds are utilized to purchase an equity interest in the employer from any of the persons described in (c) above.
Three prerequisites must be fulfilled before the notice and consent requirements can be satisfied. First, the employee must be notified in writing that the employer intends to insure the employee’s life and the maximum amount of death benefit for which the employee will be insured. Second, the employee must provide the employer with written consent to being insured and that such coverage may continue after the employee terminates employment. Third, the employee is informed in writing that the employer will be the designated beneficiary upon the insured’s death.
The History Behind the New Rule
So, why did Congress include this life insurance provision in pension legislation? These new rules find their origin in tax shelter cases involving a strategy known as “broad based leveraged COLI.” In this strategy, employers would purchase permanent life insurance policies on employees without their knowledge. Premiums were often leveraged providing income tax deductions for interest expense, while the insurance policy’s cash surrender values would grow tax free. Eventually employees would die and the employers would benefit from tax-free policy death benefits, while dependants received nothing. The self-serving and draconian nature of these tax shelters eventually caught national attention when the Wall Street Journal renamed them “dead peasant insurance” and “janitor insurance.” (WSJ obtained those names from internal planning memos used by employers to describe their creative tax planning strategies.) After several IRS court battles, IRC §101(j) was enacted. Now armed with the new reporting requirements embodied in IRC § 6039I, the IRS has the means to begin to quantify how many of these types of transactions and polices may be out there.
Congress’s attempt to curb this tax shelter abuse has far reaching and unintended consequences. Employers are now obligated to annually disclose the details of all employer-owned life insurance contracts, including term insurance contracts, regardless of the motivation behind their acquisition. As a result, this new reporting requirement applies to many common business insurance needs that could initially be overlooked, such as:
- Key-man life insurance.
- Buy-sell arrangements structured as stock redemptions funded with life insurance.
- Employer-owned life insurance contracts required by a bank loan covenant.
- Certain split-dollar life insurance arrangements.
- Non-qualified deferred compensation plans where employer liabilities are financed with life insurance, whether owned by the employer or a Rabbi trust.
More importantly, employers have to satisfy the notice and consent requirements to have any hope of receiving tax-free life insurance proceeds on the death of an insured employee.
What Should Employers Do Now?
Employers should document and track all employer-owned life insurance contracts issued after August 17, 2006. The information should include the number of insured employees and amounts of coverage.
Employers should document and retain employee notices of and consents to life insurance coverage. This is typically a one page form obtained in the underwriting process. Because there are no regulations yet, there has been significant discussion as to how long an employee consent is valid for purchasing new policies. As such, pending further guidance, it is advisable to obtain employee consents on an annual basis.
Employers should also use this new compliance requirement as an opportunity to review existing life insurance contracts and the associated planning, keeping in mind: (a) the cost of life insurance continues to decline; (b) the appropriateness of existing levels of coverage; (c) the continued relevance of the initial planning; and (d) any changes to those plans over time.