Tax Pitfall of Employer-Owned Life Insurance

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What happens when a company loses its top salesperson to a tragic accident? Imagine that the salesperson drove 40 percent of the company’s million-dollar-a-month revenue. Can the remaining, less experienced sales staff compensate for the loss? Do the employees stick around if they have to take a temporary (but indefinite) cut in pay? Can the owners find someone to replace their star salesperson?

Consider what might become of a valuable, two-owner company when one owner dies? The remaining owner probably wants to purchase the shares from her former partner’s family, but does not have sufficient funds set aside. If the business value is not too high, the owner might be able to acquire a loan to acquire the shares. What if the business is relatively new and is not yet creditworthy? What if the operation fizzles out without the shareholder’s leadership and the surviving owner is left with a personal guarantee on a loan that she cannot pay?

Often, businesses purchase life insurance on the life of such key employees. There are countless scenarios in every industry that prompt businesses and their leaders to purchase coverage for valuable employees. While this coverage may be a wise financial decision, there is an important pitfall business owners must know about.

The Pension Protection Act of 2006 gave birth to Section 101(j) of the Internal Revenue Code (“IRC"), which taxes death benefits paid to owners of Employer-Owned Life Insurance (“EOLI") contracts if certain legal requirements are not met. Tax can be avoided in most situations if certain notice and consent (“N&C") requirements are met before the contract is issued. EOLI contracts are common in estate and business planning arrangements, and many purchasing this insurance are unaware of this requirement. Unfortunately, corrective measures are limited and may require cancelation of an existing policy and satisfaction of the N&C requirements before a new policy is issued.

IRC§101(j) defines an EOLI contract as a life insurance contract policy issued after April 17, 2006 that: (1) is owned by a person engaged in a trade or business and under which such person (or a related person) is a direct or indirect beneficiary under the contract, and (2) insures an employee of the trade or business of the policy owner or a related person on the date of contract issuance.

Absent an exception, a policyholder will be forced to report death benefits received under an EOLI contract on a federal income tax return to the extent the benefit exceeds the premiums paid by the policyholder. Exceptions to EOLI taxation include: (1) employee status of the insured during the year before death or a highly compensated status at the time the policy was written and (2) payment of the death benefits to the insured’s estate or trust or used to purchase an interest in the policyholder. Important: these exceptions apply only if the N&C requirements are met before the issuance of the EOLI contract.

To learn more about structuring a new EOLI policy or correcting an existing policy to avoid potential taxation, contact The Coleman Law Firm, PLLC. Our attorneys have the estate planning, business planning, and asset protection knowledge to help your company avoid this and other planning pitfalls.

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