Life insurance proceeds are generally received by the beneficiary free of income tax. However, as part of the Pension Protection Act of 2006 ["PPA 2006"] , proceeds from employer-owned life insurance ["EOLI"] contracts issued after August 17, 2006, are taxable to the beneficiary as ordinary income to the extent that such proceeds exceed the sum of the premiums and other amounts paid by the policyholder (cost basis). This PPA 2006 legislation affects all businesses, regardless of size or type, where the employer is the owner and beneficiary of the contract and the employee is the insured. Specifically, it includes key-man coverage, buy-sell agreements and nonqualified deferred compensation plans.
Fortunately, there are certain exceptions to the general rule of tax inclusion. The first test which must be met in order for EOLI death benefits to remain tax-exempt is that, prior to issuance of the policy, the employer must provide written notice to the insured-employee stating that a policy is to be issued on the employee's life which will be owned by and payable to the employer. Further, the employer must obtain the employee's written consent to such policy's being issued, and the notice and consent form must satisfy the requirements set forth in Section 101(j)(4) of the Internal Revenue Code ["IRC"].
The second test to be met is that one or more of the following "safe harbors" must apply: (1) the insured is an employee of the employer at any time during the 12-month period preceding death; (2) at the time of policy issuance the insured is a director of the employer-corporation or a highly compensated employee thereof, as defined in IRC §414(q); or (3) the death benefit is either (i) payable to the insured's family members, estate or designated beneficiaries, or (ii) used to purchase an equity or capital interest in the employer from any of the persons described in clause (i), above.
If both the notice & consent and one or more of the safe harbor requirements are met, the EOLI death benefit will be received income-tax free, provided the policy's death benefit is otherwise eligible for favorable income tax treatment under IRC §101(a).
As a result of the PPA 2006 legislation, many of the EOLI policies issued after August 17, 2006, will be subject to income taxation when the employee dies, unless corrective measures are taken. IRS requires reporting of all EOLI policies by the "applicable policyholder" (i.e., the employer), on Form 8925. That form is used to report whether the notice and consent requirements have been met for each and every employee whose life is insured under an EOLI contract held by that employer.
In order to bring a post-August 17, 2006 EOLI policy into compliance and thereby avoid income taxation on the portion of the proceeds in excess of cost basis, a new policy must be issued or an existing policy must be reissued with a "material change" to the death benefit (in either case, after the proper notice and consent form has been obtained from the insured-employee). New guidance issued by IRS, in Notice 2009-48, states that if a Section 1035 exchange is made which includes a material modification of the policy, the notice and consent requirements will apply to the new policy. Thus it may be possible to bring a noncompliant policy into compliance by making a 1035 exchange to a policy with an increased death benefit or other change which constitutes a material modification. However, a death benefit increase made merely to meet the requirements of Section 7702, dealing with modified endowment contracts ["MECS"], will not be considered a material modification by IRS.