Employer-owned Life Insurance After the Pension Protection Act of 2006
Many employers purchase insurance policies insuring the lives of their employees. These policies, generally referred to as “corporate-owned life insurance” (COLI) or “employer-owned life insurance” (EOLI), are used to fund employee benefit plans and buy-sell agreements, and to protect employers against the financial consequences of the death of a key employee. Under the general rule of §101(a) of the Internal Revenue Code (I.R.C.),1 the death benefit received by an employer under an EOLI policy is excluded from the employer’s gross income. Highly publicized reports of abuses of EOLI policies by employers, however, have caused Congress to impose disclosure, consent, and reporting requirements on employers that must be satisfied in order for employers to exclude EOLI death benefits from gross income.
This article discusses I.R.C. §101(j) of the code, which was added to the I.R.C. by the Pension Protection Act of 2006 to combat perceived abuses of EOLI policies. While the abuses of EOLI policies by employers received national attention, the additional requirements imposed on employers under I.R.C. §101(j) have received relatively little fanfare. As a result, I.R.C. §101(j) has become a trap for the unwary that may result in the taxation of EOLI death benefits in routine transactions.
Abuses of EOLI Policies — Dead Peasants Insurance
Prior to the 1980s, state laws generally required a purchaser of a life insurance policy to have “a significant financial or emotional stake in the [insured’s] survival.” In the 1980s and 1990s, several states modified their “insurable interest” laws to permit employers to insure all employees, including rank-and-file employees. Many employers responded to the change in state law by purchasing insurance policies on the lives of a broad range of employees, including clerical and janitorial workers, which became known as “janitor’s insurance” or “dead peasant’s insurance.”2 Employers initially benefited from EOLI policies through the receipt of tax-free insurance proceeds upon the death of an insured employee, and from the deduction of interest on debt incurred to finance the premiums payable under the EOLI policies, thereby effectively creating a tax shelter. In 1986, however, Congress generally barred the deduction of interest paid or accrued on any indebtedness with respect to EOLI policies, except in the case of certain “key person” policies.3 Congress strengthened the rules barring the deduction of interest paid on EOLI policy loans in 1996 and 1997.4 Nonetheless, employers continued to purchase EOLI policies on a broad base of employees.
The abuse of EOLI policies first gained national public attention in a case involving the Winn-Dixie supermarket chain.5 Winn-Dixie purchased EOLI policies on approximately 36,000 employees and systematically borrowed against the cash value of the policies to fund the premiums. The income tax savings to Winn-Dixie from deducting the interest payments and related fees were projected to be substantially in excess of potential benefit to Winn-Dixie from maintaining the EOLI program. The Internal Revenue Service disallowed the deduction of the interest and fees under the sham transaction doctrine, arguing that Winn-Dixie’s purchase of the EOLI policies lacked economic substance and a valid nontax business purpose, and the Tax Court and the U.S. Court of Appeals for the 11th Circuit agreed.
Winn-Dixie was not alone in maintaining EOLI policies on a broad base of employees.6 While Congress and the I.R.S. continued to challenge the deductibility of interest and fees incurred in connection with EOLI policies, the public was becoming increasingly concerned with the ghoulish nature of employers profiting from the death of their employees. On October 23, 2003, Spencer Tillman, a former NFL football player who became a sports analyst for CBS, testified before the U.S. Senate Committee on Finance regarding the insurance policy that Camelot Music maintained on the life of his brother, Felipe. Felipe was a low-level employee of Camelot Music who had not worked for Camelot Music for many years prior to his death. Unbeknownst to Felipe or his family, Camelot Music maintained an insurance policy on Felipe’s life that paid Camelot Music approximately $340,000 upon Felipe’s death. Felipe’s family did not receive any portion of the insurance proceeds.7 Congress responded to the public’s growing discomfort with EOLI policies by enacting I.R.C. §101(j).
Notice and Consent Requirements Under I.R.C. §101(j)
I.R.C. §101(j), which is generally effective for life insurance policies issued after August 17, 2006, is an exception to the general rule of I.R.C. §101(a). Specifically, I.R.C. §101(j) provides that the death benefits received under an EOLI policy in excess of the premiums paid for the policy (excess death benefits) are included in the employer’s gross income, except in the case of certain EOLI policies for which the notice and consent requirements of I.R.C. §101(j)(4) are satisfied.
• The Exceptions —I.R.C. §101(j)(2) provides two classes of exceptions to the general rule that excess death benefits received under an EOLI policy are taxable, which exceptions apply only if the notice and consent requirements are satisfied. The first class of exception is based on the insured’s status, and applies to excess death benefits received with respect to an insured who 1) was an officer, director, or highly compensated employee8 of the policyholder at any time during the 12-month period beginning before the insured’s death; or 2) was a director, highly compensated employee,9 or highly compensated individual10 of the policyholder at the time the insurance policy was issued.
The second class of exception is for certain amounts paid to the insured’s heirs, and applies to 1) amounts paid to a member of the family of the insured,11 an individual who is the designated beneficiary of the insured under the EOLI policy (other than the employer), a trust established for the benefit of any such member of the family or designated beneficiary, or the estate of the insured; or 2) amounts used to purchase an equity (or capital or profits) interest in the policy holder from a person described in clause one (e.g., amounts payable to the insured’s heirs under an insurance-funded buy-sell agreement). Congress intended that the insurance proceeds be paid to the decedent’s heirs, or used to purchase an equity interest from the decedent’s heirs, on or before the due date of the employer’s tax return for the year in which the employer received the proceeds.12
• The Notice and Consent Requirements —I.R.C. §101(j)(4) requires that each of the following three notice and consent requirements must be satisfied before the EOLI policy is issued:
1) The employee must be notified in writing that the employer intends to insure the employee’s life and the maximum face amount for which the employee could be insured at the time the EOLI policy was issued.
2) The employee must consent in writing to 1) being insured under the EOLI policy, and 2) the continuation of coverage under the EOLI policy following the termination of the employee’s employment with the employer.
3) The employee must be notified in writing that the employer will be a beneficiary of the proceeds payable upon the death of the employee.
• Effective Date —The provisions of I.R.C. §101(j) are effective for EOLI policies issued after August 17, 2006, except for EOLI policies issued after that date pursuant to an exchange described in I.R.C. §1035 for a policy issued on or before that date.13 For purposes of the effective date rules, any material increase in the death benefit payable under an EOLI policy, or other material change to the policy, causes the policy to be treated as a new policy issued on the date of the material increase or other material change.14 The legislative history to I.R.C. §101(j) provides examples of certain situations in which death benefit increases under an EOLI policy will not cause the policy to be treated as a new policy (e.g., death benefit increases due to the use of policyholder dividends to purchase paid-up additions in accordance with the terms of the EOLI policy).15 Pursuant to Notice 2008-42, a change in the terms of a split-dollar life insurance arrangement will not be treated as a material change for purposes of I.R.C. §101(j) provided that the parties do not modify the terms of the underlying life insurance policy.16
• Reporting and Recordkeeping Requirements Under I.R.C. §6039I—I.R.C. §6039I requires every employer that owns one or more EOLI policies that are subject to I.R.C. §101(j) to report the following information on I.R.S. Form 8925 for each year that it owns such policies.
1) The number of employees of the employer at the end of the year.
2) The number of such employees insured under EOLI policies subject to I.R.C. §101(j) at the end of the year.
3) The total amount of insurance in force at the end of the year under such policies.
4) The name, address, and taxpayer identification number of the employer and the type of business in which the employer is engaged.
5) A valid consent form for each employee insured under an EOLI policy (or the number of employees for whom such consent was not obtained).17
In addition, employers are required to maintain such records as may be necessary to demonstrate their compliance with the notice and consent requirements of I.R.C. §101(j) and the reporting and recordkeeping requirements of I.R.C. §6039I.18
Issues Arising Under I.R.C §101(j)
• Complying with the Notice and Consent Requirements — The notice and consent requirements added by I.R.C. §101(j) were a direct response to situations, such as the situation described by Spencer Tillman, in which rank-and-file employees were not aware that their employers had purchased insurance policies on their lives, and had not consented to such policies. Note, however, that the class of employees that is eligible for the exception to the rule of I.R.C. §101(j) is generally limited to officers, directors, and highly compensated employees (e.g., excess death benefits received by an employer upon the death of a rank and file employee will generally be taxed under I.R.C. §101(j), regardless of whether the notice and consent requirements are satisfied). So the notice and consent requirements are generally applicable only to key employees who are likely to be aware of, and to have consented to, the insurance coverage. Indeed, key employees are likely to have completed and signed an insurance application, and undergone a medical examination, clearly indicating their awareness of, and consent to, the insurance policy.
As more employers become aware of the notice and consent requirements, employers will routinely obtain the consents required by I.R.C. §101(j). Insurance companies are now including sample acknowledgment and consent forms in their insurance document packages. It is likely, however, that many employers who purchased EOLI policies after August 17, 2006, were not aware of the notice and consent requirements and, therefore, did not comply with them.19 Because employers are required to comply with the notice and consent requirements before the policy is issued, the only way for those employers to comply with them is to terminate the existing insurance policies, give the required written notices, obtain the required written consents, and then obtain new insurance policies. Alternatively, the employer can transfer the ownership of the policy so that it no longer constitutes an EOLI.
• Application to Buy-Sell Agreements — The Related Party Rules — One of the most common uses of EOLI policies is to fund obligations arising under a buy-sell agreement. In the case of a buy-sell agreement structured as a redemption agreement, whereby the employer is obligated to redeem the equity interest of a deceased employee, any EOLI policy purchased by the employer to fund its purchase obligation will be subject to I.R.C. §101(j) (and should be eligible for the exception for excess death benefits paid to the decedent’s heirs in order to purchase an equity interest, provided the notice and consent requirements are satisfied).20 In the case of a buy-sell agreement structured as a cross-purchase agreement, whereby the surviving equity owners are obligated to purchase the equity interest of the deceased equity owner, the application of I.R.C. §101(j) is less clear. On its face, I.R.C. §101(j) would not appear to apply to an insurance policy purchased by an equity owner to fund his or her obligations under a cross-purchase agreement (because the policy is not owned by the employer). The definition of an “applicable policy holder” under I.R.C. §101(j)(3), however, includes certain related persons21 with respect to the employer. As a result, an insurance policy owned by an employee who is a related person with respect to an employer (e.g., an employee who owns 50 percent or more of the employer) could be subject to I.R.C. §101(j).22
Another potential issue with respect to insurance-funded buy-sell agreements arises from the requirement that, in order to satisfy the notice and consent requirements, the employee must be notified in writing of the maximum face amount for which the employee could be insured at the time the EOLI policy was issued. Most buy-sell agreements provide that the purchase price for the purchased equity interests will be based on the fair market value of the equity interests on the date of the decedent’s death. As the fair market value of the equity interests increases over time, the employer may wish to increase the death benefit payable under the EOLI policy. As a result, employers will want to overstate the maximum face amount for which the employee could be insured in order to allow for future increases in the death benefit payable under the EOLI policy to be excluded from the employer’s income.
Conclusion
I.R.C. §101(j) is another example of tax legislation intended to prevent abusive behavior that also adversely impacts legitimate transactions. For most legitimate uses of EOLI policies by employers (such as key man insurance and funding buy-sell agreements), I.R.C. §101(j) will not result in taxation of the excess death benefits received by the employers, provided they comply with the notice and consent requirements, which are not burdensome. The challenge for tax practitioners is to make clients aware of the notice and consent requirements, including clients who have insurance funded cross-purchase agreements that may be impacted by I.R.C. §101(j), and to assist clients who have purchased EOLI policies after August 17, 2006, without complying with the requirements.
1 All references to the I.R.C. are to the Internal Revenue Code of 1986, as amended.
2 Ellen E. Schultz & Theo Francis, Valued Employees: Worker Dies, Firm Profits Why? — Many Companies Insure Staff, Yielding Benefits on Taxes, Bottom Line — Where to Put Dead Peasants, Wall St. J., April 19, 2002, at A1.
3 I.R.C. §264(a)(4); I.R.C. §264(e)(1).
4 See §501(a)(1)-(2) of the Health Insurance Portability and Accountability Act of 1996 (P.L. 104-191) and §1084(a)(2) of the Taxpayer Relief Act of 1997 (P.L. 105-34).
5 Winn-Dixie Stores Inc., et al. v. Commissioner, 11 T.C. 254 (1993), aff’d, 254 F.3d 1313 (11th Cir. 2001).
6 Schultz & Francis, Valued Employees: Worker Dies, Firm Profits Why? — Many Companies Insure Staff, Yielding Benefits on Taxes, Bottom Line — Where to Put Dead Peasants, Wall St. J., April 19, 2002, at A1. American Electric Power, AT&T, Ball, Basset Furniture, Dow Chemical, Eaton, Nestle USA, Olin, Pitney Bowes, PPG Industries, Proctor & Gamble, Trans World Entertainment, and Walt Disney were among some of the other companies that maintained broad-based EOLI policies.
7 Company Owned Life Insurance: Hearing Before the Comm. on Finance, United States Senate, 108th Cong. 19-20 (2003) (statement of Spencer Tillman).
8 Within the meaning of I.R.C. §414(q). See I.R.C. §101(j)(5)(A).
9 Within the meaning of I.R.C. §414(q) (determined without regard to paragraph (1)(B)(ii) thereof).
10 Within the meaning of I.R.C. §105(h)(5) (determined by substituting “35 percent” for “25 percent” in subparagraph (C) thereof).
11 Within the meaning of I.R.C. §267(c)(4).
12 Report of the Joint Committee on Taxation (J.C.T. Rep. No. JCX-38-06).
13 §863(a) of the Pension Protection Act of 2006 (P.L. 109-280).
14 Id. In the case of a master contract (within the meaning of I.R.C. §264(f)(4)(E)), the addition of covered lives is treated as a new policy only with respect to such additional covered lives.
15 Report of the Joint Committee on Taxation (J.C.T. Rep. No. JCX-38-06).
16 2008-15 I.R.B. 747. This is the case even if the modification to the terms of the split-dollar arrangement would be treated as material modification of the split dollar arrangement for purposes of Treas. Reg. §1.61-22(j).
17 See Treas. Reg. §1.6039I-1.
18 I.R.C. §6039I(b).
19 I.R.C. §101(j) has received attention in the tax press, see, e.g., James Magner & Stephan R. Leimberg, Pension Protection Act Adopts Far-Reaching New Rules for COLI, 33 Est. Plan. 3 (October 2006); and David Weinstock, Life Insurance Now Taxable?, The CPA Journal (September 2008). In the authors’ experience, however, many tax and insurance professionals are not familiar with the requirements of I.R.C. §101(j).
20 See Sebastian V. Grassi, Jr., New Rules Concerning Employer-owned Life Insurance Affect Buy-Sell Arrangements (with Sample Drafting Language), 21 Practical Tax Lawyer 7 (Winter 2007).
21 Within the meaning of I.R.C. §267(b) or I.R.C. §707(b)(1).
22 See Sebastian V. Grassi, Jr., Transfer for Value Rules and Life Insurance Proceeds, ACTEC Journal 314, fn. 2 (2007).
Craig E. Behrenfeldis a partner in the tax department of Barnett, Bolt, Kirkwood, Long & McBride in Tampa and an adjunct professor of law at Stetson University College of Law. He received his J.D. and LL.M. (taxation) from New York University School of Law.
Erica Good Pless is a J.D. candidate at Stetson University College of Law.
This column is submitted on behalf of the Tax Section, David Pratt, chair, and Michael D. Miller and Benjamin A. Jablow, editors.
