By John P. Crolle, Ward and Smith, P.A.
Editor’s Note: John Crolle is a member of the Business Practice Group of Ward and Smith, P.A.
Protecting Your Business
It is common for businesses to purchase life insurance on key management personnel and/or owners of the business. These policies are referred to as employer-owned life insurance ("EOLI") policies. EOLI polices are used most commonly as a risk management tool to mitigate the impact of a sudden, unexpected loss of an integral member of the management team and/or to fund a buy-out of a deceased owner’s interest. Historically, the death benefits received by a business from an EOLI policy escaped taxation in most circumstances. The Pension Protection Act of 2006 ("PPA"), however, changed the tax treatment of proceeds received under such policies.
The Tax Man Cometh
Before enactment of the PPA, the proceeds received by the owner of an EOLI policy ("Policyholder") were not taxable to the Policyholder except in limited situations. Under the new PPA rules, however, the proceeds of an EOLI policy are taxable to the Policyholder to the extent they exceed the amount of the premiums paid by the Policyholder for the policy, unless an exception applies. The new treatment of EOLI policy benefits is intended, at least in part, to curb abuses such as an employer taking out a life insurance policy on rank and file employees, often without the insured’s knowledge (commonly referred to disparagingly as a "janitor policy"), in order to provide a tax-free cash windfall to the employer upon the death of the employee, possibly years after the employee has left the employer, even though the employee’s death does not have a significant, or perhaps any, impact on the operation of the Policyholder’s business.
The PPA implicitly acknowledges the utility and legitimate purposes of EOLI policies through the provision of specific exceptions to the new general rule that the excess proceeds of such a policy are taxable to the Policyholder. To qualify for these exceptions, the person whose life is insured ("Covered Person") must:
• Receive written notice, prior to the issuance of the policy, of the fact that a policy will be taken out on his or her life, of the maximum face amount for which such employee may be insured at the time of issuance of the policy, and the Policyholder’s status as the intended beneficiary of the policy;
• Provide written consent to the Policyholder for such coverage prior to the issuance of the policy; and,
• Fall within one or more specified categories of persons.
There currently are no provisions for curing a defect in the notice and consent requirements after an EOLI policy has been issued. Accordingly, it is extremely important that these requirements be satisfied prior to the issuance of such an EOLI policy in order to avoid income taxation on the proceeds. If the notice and consent requirements are met, benefits under an EOLI policy generally will be excluded from the Policyholder’s gross income if the Covered Person was an employee (defined for purposes of the PPA rules as an officer, director, or "highly-compensated individual") of the Policyholder at any time during the 12-month period prior to the Covered Person’s death.
A "highly compensated individual" is an employee who, at the time the policy was issued, is:
• One of the five highest paid officers of the employer,
• A shareholder or member of the company owning more than 10 percent of the equity of the company, or,
• Among the highest paid 35 percent of all employees.
Even if the Covered Person does not fall into one of the above categories that qualify the policy proceeds as non-taxable, the Policyholder still may avoid tax liability if the proceeds of the policy are paid to the Covered Person’s family or designated beneficiary or are used by the Policyholder to purchase the Covered Person’s ownership interest in the Policyholder from the Covered Person’s estate or beneficiaries.
However, if the person or entity receiving those proceeds has a relationship with the Policyholder that falls within the definition of a "Related Person" under the PPA, those proceeds still will be subject to taxation unless another exception applies. For purposes of the PPA, the most common categories of "Related Persons" to a Policyholder include:
• Family members of the Policyholder including brothers and sisters (whether by the whole or half blood), spouses, ancestors, and lineal descendants;
• A person or entity owning, directly or indirectly, more than 50 percent of a Policyholder entity’s stock, capital, or profits interest;
• An entity in which a Policyholder owns, directly or indirectly, more than 50 percent of the stock, capital, or profits interest;
• The trustee of a trust created by the Policyholder ;
• Any beneficiary of a trust of which the Policyholder is the trustee; and,
• A trustee of a trust and a Policyholder corporation if more than 50 percent of the value of the corporation’s outstanding stock is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust.
Uncle Sam Wants to Know
In addition to changes to the rules for taxation of the proceeds of an EOLI policy, the PPA also added annual reporting and record-keeping requirements for Policyholders. For any EOLI policies issued after August 17, 2006, the Policyholders are required to file a Form 8925 with the IRS on or before the due date of the Policyholder’s tax return. The information required to be reported on the Form 8925 includes:
• The number of employees the Policyholder had at the end of the tax year;
• The number of employees covered under an EOLI policy issued after August 17, 2006;
• The total face amount of the EOLI policies held by the Policyholder at the end of the tax year; and,
• An acknowledgement of whether the Policyholder has a valid consent from each employee covered by an EOLI policy.
Penalties for failure to comply with these reporting and record-keeping requirements are not clear at this time, but likely include administrative penalties and interest.
Although the rules have been changed, it is still possible, with appropriate planning and implementation, to protect your business from the effects of the loss of a key employee or to fund a buy-out of a deceased owner’s interest through the use of an EOLI policy or policies. However, failure to follow the PPA’s rules likely will result in unexpected tax liability. The consequence of failure to comply may be a significant reduction in the assistance provided by an EOLI policy during the transition period following the death of a key member of the management or ownership team, or a shortfall in the capital needed to fund a buy-out of a deceased owner’s interest.
© 2010, Ward and Smith, P.A.
Ward and Smith, P.A. provides a multi-specialty approach to the representation of technology companies and their officers, directors, employees, and investors. John Crolle is a member of the Business Practice Group, where he concentrates his practice on business start-ups, acquisitions, and transactional matters. Comments or questions may be sent to firstname.lastname@example.org.
This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.