C—Employer Owned Life Insurance (EOLI)

Life insurance can serve many business purposes. Life insurance death benefits can be used to offset the loss of a key employee. The death benefit and/or tax-advantaged cash value can provide a source for the indirect funding of employee benefits – such as a salary continuation or salary deferral plan, like a deferred compensation plan. Life insurance is also an important means of funding a buy-sell arrangement. And, with C corporation tax rates reduced to 21 percent by the 2017 Tax Act, the purchase of life insurance by businesses has gotten even more common. However, to avoid taxation on the death benefit, one of the key advantages to life insurance over other financial assets, it is important that the purchase be done in accordance with rules set forth in the Pension Protection Act of 2006. Ordinarily, life insurance death benefits are received income tax-free. However, because of the Pension Protection Act of 2006, death benefits paid to employers are generally taxable to the extent they exceed the employer’s premium payments unless certain requirements and exceptions are met for policies that were bought (or substantially changed) after August 17, 2006.

To qualify for an exception that will allow the death proceeds to be received income tax free (under IRC Section 101(a)), all employers must meet certain notice and consent requirements. Moreover, for all but a limited number of employees the life insurance cannot continue beyond 12 months following a separation of service, and still hope to receive the income tax free death benefit even if the notice and consent requirements are met. However, for certain employees, an employer may continue to own the life insurance policy and can receive the death proceeds income tax free, again, provided specific notice and consent requirements are met. Note that there are certain state specific requirements for Massachusetts, New York, and Washington State.

Notice and Consent Requirements. To qualify for an exception, it is essential to first meet strict notice and consent requirements. Under these requirements, the employee must: (1) be notified in writing that the employer intends to insure the employee’s life and the maximum face amount to be issued; (2) be informed that the employer will be the policy beneficiary; and (3) give written consent, before the policy is issued, to being insured and consent to the coverage continuing after the insured employee terminates employment. This must be obtained before the life insurance policy is issued. It is strongly recommended that notice be given, and consent be obtained, at the time an application is taken for virtually any life insurance contract that might conceivably fall within the scope of this law. The statute provides no means of obtaining relief from these requirements. The potential cost of noncompliance is income taxation of the death proceeds in excess of premiums paid.