Many businesses maintain life insurance policies on their owners or employees for estate planning, buyouts and various other business purposes. To receive the maximum tax benefits from business-owned life insurance, though, you need to understand the IRS rules and requirements.
Business-owned life insurance generally refers to a life insurance policy that 1) is owned by a business that’s directly or indirectly a beneficiary under the policy, and 2) covers the life of an individual who’s an employee of the business on the date the policy is issued. Under the tax code, the issue date is the latest of the following:
- The date of application for coverage,
- The effective date of coverage, and
- The date the policy is formally issued.
A business might purchase life insurance for several reasons. For example, it might plan to use the death benefits from a policy on the owner to fund post-death tax liabilities and equalize distributions to the owner’s family members when much of his or her estate is shares in the closely held family business.
Life insurance proceeds also can play a critical role after the death of a “key person.” Death benefits may be needed to finance a buyout of the key person’s shares from his or her family, whether under the terms of an existing buy-sell agreement or otherwise. Death benefits can help a company bridge the gap while it recruits and trains a replacement after a key person’s death, too. In fact, to help mitigate risk, a lender might require a business borrower to purchase life insurance on a key person.
Additionally, some companies use business-owned life insurance to fund nonqualified plans. For example, they might purchase a split-dollar life insurance policy on an employee so they can recover the amount spent on premiums from the death benefit, with the remainder going to other beneficiaries designated by the employee.
Exclusions from Income
Generally, the premiums a company pays on employee life insurance aren’t deductible if the company retains rights or has a beneficiary interest in the policy, as with business-owned life insurance. But the death benefits the company receives may be excluded from its gross income if the policy insures the life of any of the following individuals:
- A director, highly compensated employee or highly compensated individual at the time the policy was issued, or
- An employee at any time during the 12 months preceding his or her death.
To qualify for this exclusion, the business also must satisfy three notice-and-consent requirements before the policy is issued. First, the business must notify the employee in writing that it intends to insure the employee’s life. The notification should specify the maximum face amount for which the employee could be insured at the time the policy was issued. The written notification also must include a disclosure of the face amount of life insurance, either in dollars or as a multiple of salary, that the business reasonably expects to purchase on the employee during the employee’s tenure with the company.
Second, the employee must provide written consent to being insured under the policy and that such coverage may continue after the insured terminates employment. Additional notices and consents are required if the aggregate face amount of business-owned life insurance policies on an employee exceeds the amount to which the employee consents.
Third, the employee must be informed in writing that the business will be a beneficiary of any proceeds payable upon the employee’s death.
Additionally, time limits apply on purchasing the policy. It must be issued within a year after the consent is provided or before the employee terminates employment with the business, whichever comes first.
The tax code also allows an exception for death benefits used to fund a buyout. Specifically, it treats the business’s portion of death benefits as tax-exempt if that portion is paid to, or used to purchase, an equity, capital or profits interest belonging to a family member of the insured. It also is tax-exempt if it’s paid to a designated beneficiary, a trust established for the benefit of the insured’s family member or designated beneficiary, or the insured’s estate. Again, the business must satisfy the notice-and-consent requirements.
If no exception applies, the tax benefits are significantly curtailed. Any death benefits that exceed the business’s tax basis in the policy (generally, the premiums paid) will be taxable income.
Companies that purchase business-owned life insurance must report it to the IRS. The report includes the number of employees covered by the policies issued after August 17, 2006, and the total amount of these policies in force on such employees at the end of the applicable tax year. The business also must indicate whether it’s obtained a valid consent from each covered employee, as well as the number of covered employees who haven’t provided a valid consent.
Important: The reporting obligation is ongoing. Companies must file the appropriate tax forms with their annual income tax returns for every year that business-owned life insurance policies remain in effect.
For More Information
Purchasing business-owned life insurance on eligible employees can provide a range of benefits that help ensure the continuing success of your company. To make the most of those benefits, though, you need to understand and comply with the strict tax rules. Contact your tax and financial advisors regarding any questions you may have about determining the appropriate level of coverage and understanding the relevant tax rules.