Income Taxes and Employer-Owned Life Insurance

January 27, 2011

It’s almost February, which means everyone should be receiving their w-2s and 1099s if they haven’t already. While we don’t cover tax issues as a general rule, we think it’s worth mentioning the way death benefits from corporate- or business-owned life insurance are handled.

Before 2006, death benefits from the types of life insurance mentioned above were usually tax-free. After August 17th of that year, however, tax law changed to allow income taxation of death benefits on policies issued from that day forward.

The legislation affected businesses of all types and sizes where life insurance policies were purchased by the company on the lives of its employees, and where the employer was the owner and beneficiary of the policy. The law included – but wasn’t limited to – buy-sell arrangements, key-person coverage, and non-qualified deferred compensation plans. It was enacted to address the concerns of members of Congress with regard to large corporations purchasing life insurance coverage on the lives of their “rank and file” employees who were generally unaware of these policies, and which benefits were paid to the corporation.

Basically, this law reversed the rule that corporate or business-owned life insurance death benefits are generally received without being subject to taxation, but there are exceptions to the newer law, if certain criteria are met:

* A Notice and Consent form must be signed and submitted to the insurance carrier for an employer-owned life insurance policy before the policy is issued. Failure to comply will mean that part of the death benefit may be taxed as ordinary income.
* One of the four safe harbors as specified in the law must be in place to keep the death benefit income tax free:
1. The insured is a key person at policy issue.
2. The insured was an employee any time in the 12-month period before death.
3. The death benefit is paid to the Insured’s heirs.
4. Buy-Sell funds. The death benefits remain income tax free if they’re used to buy the Insured’s interest in the employer from someone listed in Safe Harbor 3.

Unfortunately, until the covered employee actually dies, there’s no way to know if Safe Harbors 2-4 are applicable, and until that is determined, the employer won’t know if the death benefit is taxable or not.

Note: This post is meant as a synopsis of the law, and is not meant as tax advice. Please consult with your CPA before entering into any of the arrangements mentioned here.