Taxability of employer-owned life insurance contracts.

• Author: Jarmusch, Keith

In general, proceeds from life insurance policies are tax free under the general exception rules in Sec. 101(a). This general rule changed when Sec. 101(j)(1) was added with the enactment of the Pension Protection Act of 2006, P.L. 109-280. The new section limits the amount of tax-free treatment a person (which can be any type of entity) can receive from the proceeds on an employer-owned life insurance (EOLI) contract. The amount that is considered tax free is limited to the total amount of premiums paid and other amounts paid by the life insurance policyholders, leaving the remaining proceeds taxable. This eliminates the tax-flee treatment for EOLI on the total amount of the proceeds afforded under the general exclusion rules in Sec. 101(a).

EOLI Contracts

Sec. 101(j)(3)(A) defines an EOLI contract as a contract that is owned by a person (this includes business entities) engaged in a trade or business under which that person is directly or indirectly a beneficiary under the contract, and that covers the life of an insured employed in the trade or business at the time the contract is issued. It also includes split-dollar arrangements, defined under Regs. Sec. 1.61-22(c)(1) as an insurance policy where two or more persons are named as policy owners of a life insurance contract.

Despite being defined as EOLI under Sec. 101(j)(1), an insurance arrangement can still qualify for the general exclusion under Sec. 101(a) if the EOLI conforms with the notice and consent procedures prescribed under Sec. 101(j)(4). Failure to obtain timely notice and consent will result in the insurance proceeds becoming taxable (proceeds less total premiums paid or other related expenses) and not subject to the general exclusion. Therefore, it is very important that all new policies meet the notice and consent requirements before the policy is issued. To meet those requirements, the employee must:

* Be notified in writing that the policyholder intends to insure the employee's life and the maximum amount of such policy.

* Provide written consent to being insured under the contract and that the coverage may continue after the insured's employment is terminated.

* Be informed in writing that the policyholder will be the beneficiary of any proceeds upon the death of the insured.

If a company and the employee meet these notice and consent requirements, Sec. 101(j)(1) will not apply to any amounts received by reason of the death of an insured if he or she was an employee...