3638 / If an employer is under contract to pay a death benefit to an employee’s surviving spouse, is the benefit taxable income to the surviving spouse?

Frequently, death benefits are funded by insurance on the life of the employee, with the insurance owned by and payable to the employer (traditional key associate life insurance). The fact that the death payments originate from life insurance proceeds received tax-free by the employer does not cause them to be tax-exempt to the employee’s surviving spouse. The surviving spouse receives them as compensation payments from the employer and not as life insurance proceeds.³ (For tax effects of insurance funding, see Q 262, Q 263, and Q 276.) Employee death benefits rarely qualify as life insurance benefits wholly excludable under IRC Section 101(a) ( Q 63, Q 65, and Q 260).⁴ Death benefits payable to an employee’s surviving spouse under a split dollar life insurance arrangement, however, may be received free of income tax obligations ( Q 4022, Q 4023).

Contractual death benefits are “income in respect of a decedent.”⁵ Consequently, where an estate tax has been paid, the recipient of the death payments is entitled to an income tax deduction for that portion of the estate tax attributable to the value of the payments, which may not prove very valuable.

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Planning Point: For the reasons mentioned above -income taxation of the death benefit to the beneficiary and only a potential deduction to the estate – it is often more attractive to create an endorsement split dollar life insurance plan for an employee so that the death benefits will be treated as the proceeds of life insurance to the beneficiary. The trade-off is some annual current economic benefit to the employee.

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