Employers own life insurance policies on the lives of their employees for various reasons. Often it is to informally fund a non-qualified benefit plan for key employees. Other times it is used to facilitate the transfer of the business at the unexpected death of a key person, another owner, or a shareholder.
Although new rules for employer-owned life insurance policies (EOLI) went into affect over a decade ago, many financial professionals are unfamiliar with them. The rules have been included as part of the provisions of IRC §101(j) and apply to all policies issued after August 17, 2006. If they are not complied with, the life insurance proceeds at death will be subject to income taxes.
7 Things You Should Know About EOLI
EOLI is defined as a life insurance contract that is owned by a person or entity engaged in a trade or business under which the contract owner is directly or indirectly a beneficiary. The definition also includes any policy that covers the life of an insured who is an employee with respect to the trade or business of the policy owner on the date that the policy is issued.
Notice & Consent Rule.
The ‘notice’ provisions of §101(j) require that the insured-employee receive written notice that the policy is being taken out and that the employer will be the beneficiary of the policy’s death benefit. The employee then must provide written ‘consent’ that he/she agrees to be the insured even after he/she leaves employment. The notice and consent must be given prior to the issuance of the policy. The policy is considered “issued” on the later of 1) application, 2) the effective date of coverage, or 3) the formal issuance of the policy.
Taxation of Proceeds.
The proceeds of an employer owned life insurance policy (EOLI) will be included in the employer’s income if the notice and consent rules under §101(j) have not been met before the policy was issued.
Exceptions Category 1.
If the notice and consent has been given prior to the issuance of the policy, and the insured fits into one of the following groups, then the life insurance proceeds will not be taxable:
- The insured is an employee at any time during the 12 months preceding the insured’s death;
- The insured is a Director of among the highest paid 35% of all employees and defined as a highly compensated employee under the rules of IRC Section 105(h)(5)); or
- The insured is a highly compensated employee as specified under §414(q).
Exceptions Category 2.
If the notice and consent has been given prior to the issuance of the policy, and the death benefit is:
- Paid to a member of the insured’s family, to the insured’s designated beneficiary under the policy, to a trust for the benefit of a family member or designated beneficiary, or to the estate of the insured; or
- Used to purchase an equity interest in the policyholder (employer) from a family member, beneficiary, trust or estate.
Policies issued prior to August 17, 2006 are not subject to the provisions of §101(j) unless there has been a material change made to the policy. Policies that originated prior to August 17, 2006 and that are 1035 exchanged are also not subject to the rules.
Types of Plans Affected.
Non-qualified plans, collateral assignment split dollar, endorsement split dollar, 457(f) plans and restricted endorsement bonus arrangements must follow the rules. Interestingly, the 101(j) rules apply to a collateral assignment split dollar plan because the collateral assignment, which is the repayment to the employer for premiums paid in the arrangement’, is ‘deemed the owner’ of the contract under the split dollar rules of IRC §61.
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