If you are like many owners of closely held businesses, you likely own life insurance policies to fund cross-purchase provisions in a buy-sell agreement. Or, perhaps you have obtained key-man life insurance to provide funds in the event of the death of a key employee.
The general rule is that proceeds received from a life insurance policy are generally excluded from income and the premiums are generally nondeductible. However, a recently-enacted law changed the rules significantly.
The new legislation was a reaction to Congress’ concern about the practice of certain large corporations purchasing life insurance on the lives of rank-and-file employees, naming themselves as beneficiaries (not to be confused with life insurance as an employee fringe benefit). Frequently, these employees were not even aware of the insurance coverage. Unfortunately, the language of the new provision reaches many more situations than the large corporation scenario.
The impact of this law is to subject the gross proceeds from life insurance policies issued after August 17, 2006 (adjusted for premiums paid), to income tax. Certainly, this is a situation you do not want to be in!
Fortunately, the law does have extensive exceptions which allow you to claim a full exemption of the death benefit from gross income. However, to use these exceptions certain notices and consents must be issued and obtained BEFORE the policy is issued. The requirement to comply with the notice and consent provisions before the policy is issued is a big trap for the unwary.
The notice and consent requirements are met if, before the issuance of the contract, the employee:
- is notified in writing that you intend to insure the life of the employee and the maximum face amount of the policy for which the employee can be insured;
- provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment; and
- is informed in writing that you will be a beneficiary of any proceeds payable upon the death of the employee.
In addition, you are required to report to the IRS annually on IRS Form 8925:
- the number of employees at the end of the year;
- the number of employees insured under an employer-owned life insurance contract at the end of the year;
- the total amount of insurance in force at the end of the year under such contracts;
- your name, address, and taxpayer identification number and the type of business you are engaged in; and
- a statement that you have a valid consent from each insured employee.
The use of life insurance can be a great part of a cross-purchase strategy and can avert financial hardship in the event of the death of a key-employee. To maximize the benefits of this planning and avoid paying income tax on death benefits, it’s important that you meet the applicable requirements. Be sure to discuss these matters with your CPA or other trusted business and financial advisor.
