Employer-owned life insurance: notice and consent rules under IRC 101(j)

If a business owns a life insurance policy on an employee and is the beneficiary, IRC 101(j) limits the tax-free death benefit to the premiums the business paid, unless the employee gave written consent before the policy was issued and an exception applies. The employer also reports its employer-owned policies each year on Form 8925. The rule applies to policies issued after August 17, 2006, and a missing consent cannot be fixed after the employee dies.

What counts as employer-owned life insurance

Under IRC 101(j)(3), an employer-owned life insurance (EOLI) contract is a life insurance contract that is owned by a person engaged in a trade or business, under which that person (or a related person) is directly or indirectly a beneficiary, and that covers an insured who was an employee of the applicable policyholder on the date the contract was issued. IRS Notice 2009-48, which interprets the statute, adds several points:

• "Employee" is not limited to common-law employees. It includes officers, directors and highly compensated employees under IRC 414(q).
• Partnerships and sole proprietorships can own EOLI. A policy a sole proprietor owns on his or her own life is not EOLI.
• A policy owned by an individual owner of a business, for example to fund the purchase of another owner's equity, is not EOLI, because the owner is not the business. Policies owned by a qualified plan or a VEBA are also outside the definition. This is why a cross-purchase buy-sell, where owners own policies on each other, generally falls outside 101(j), while an entity-redemption plan, where the company owns the policies, falls inside. See cross-purchase vs entity redemption buy-sell plans.
• A policy owned by a grantor trust, such as a rabbi trust, whose assets are treated as the employer's, can be EOLI.
• A policy subject to a split-dollar arrangement can be EOLI if owned by a trade or business. See split-dollar life insurance: economic benefit and loan regimes explained.

The general rule and the exceptions

Under 101(j)(1), the amount excluded under 101(a) is capped at the premiums and other amounts the policyholder paid. Any excess is income. The cap does not apply if both of the following are true: an exception in 101(j)(2) fits and the notice-and-consent requirements in 101(j)(4) were met.

The exceptions, from the statute and Notice 2009-48:

1. The insured was an employee at any time during the 12 months before death.
2. The insured was a director, a highly compensated employee (IRC 414(q)) or a highly compensated individual (IRC 105(h)(5), generally the top 35% by pay) when the contract was issued.
3. The death benefit is paid to a family member of the insured, a designated beneficiary, or a trust or estate, or is used to buy the insured's equity (capital or profits) interest from them. The Notice says the money must be paid or used by the due date, with extensions, of the employer's tax return for the year it is treated as receiving the benefit.

An employee who left more than 12 months before death, and who was not highly compensated or a director at issue, can fall outside the first two exceptions. This is why consent matters and why former employees are a trouble spot for broad-based COLI.

Notice and consent: what the statute requires

Before the policy is issued, the employee must:

1. Be notified in writing that the employer intends to insure the employee's life and of the maximum face amount for which the employee could be insured when the contract is issued.
2. Give written consent to being insured under the contract and to coverage continuing after employment ends.
3. Be informed in writing that the employer will be a beneficiary of any death proceeds.

Notice 2009-48 gives practical interpretations:

• Maximum amount means a number. Telling the employee that coverage may be "the maximum face amount" the employer could buy does not work. The notice must state a face amount, in dollars or as a multiple of salary, that the employer reasonably expects to buy during the employee's tenure. More coverage than the stated amount needs new notice and consent.
• Timing. The policy must be issued before the earlier of one year after the consent was signed or the end of the employee's employment. For this purpose a contract is treated as issued on the latest of the application date, the effective date of coverage or formal issuance, so consent can come while coverage is temporarily effective before the policy is issued.
• Owner-employees. A wholly owned corporation and its owner-employee must also comply. Actual knowledge is not a substitute for a written consent.
• One consent can cover several policies, if the total stays within the stated amount.
• Electronic consent is allowed if the system keeps the content intact, reasonably confirms who is signing, records a signature, and can print a hard copy for the IRS, along with a statement of the employer's knowledge.
• Existing policy transferred to the employer. The transfer itself serves as notice and consent, but a later face-amount increase needs a new notice and consent.

Inadvertent failures

Section 101(j) contains no correction procedure. Notice 2009-48 says the IRS will not challenge the exception for an inadvertent failure if the employer made a good faith effort (for example by keeping a formal system to give notice and secure consent from new employees), the failure was inadvertent, and it was discovered and corrected by the due date of the tax return for the year the contract was issued. Because consent must be in writing, it cannot be obtained after the employee dies.

Material changes and exchanges

Section 101(j) applies to contracts issued after August 17, 2006. A contract received in a Section 1035 exchange for a contract issued on or before that date is generally outside it. But a material increase in death benefit or other material change makes the contract new for this purpose, and a 1035 exchange that results in a material change other than a change of issuer is treated as a new issue. Increases required by IRC 7702, dividends buying paid-up additions, market performance in a variable contract, and administrative changes are not material. A new notice and consent is needed for a new contract unless a valid consent remains in force.

Where it matters most

Entity-redemption buy-sells, key person insurance: protecting the business from a loss of talent and executive benefit funding are the usual EOLI cases, and Funding a buy-sell agreement with life insurance after Connelly covers how entity-owned policies affect a buy-sell and business valuation. Ask counsel before an owner-employee signs a consent for an entity-owned policy, because the same document also becomes part of the company's records.

Form 8925

Every applicable policyholder owning one or more EOLI contracts issued after August 17, 2006 must file Form 8925 with its income tax return for each year it owns them (IRC 6039I). It reports the number of employees at year end, the number insured, the total insurance in force, the employer's name, address and identifying number and type of business, and whether valid consent exists for each insured employee or, if not, how many employees lack it. Only the owner files, not related persons.

Hypothetical example

Say a 60-employee distributor buys $750,000 of coverage on its two top salespeople, to be owned by the company. Before the application, each salesperson signs a form stating the company intends to insure their life for up to $750,000 and will be the beneficiary, and consenting to the coverage continuing after employment ends. One salesperson leaves for a competitor and dies three years later. The company collects the $750,000. Because the consent was valid and the insured was a highly compensated employee when the policy was issued, the exception applies, and the benefit is generally excluded. Had the consent form been missing, the company's exclusion would be capped at premiums paid. The facts are invented.

Compliance checklist

• Use a standing form that states a dollar amount or salary multiple, not "the maximum."
• Collect consent before application, and keep signed or electronic records permanently.
• Re-consent when coverage rises above the stated amount.
• Run a calendar check on the one-year consent limit.
• File Form 8925 every year with the return.
• Review state law on employee consent and insurable interest.
• Keep records for departed employees until the policy ends. See COLI and BOLI explained: corporate and bank-owned life insurance and nonqualified deferred compensation and corporate-owned life insurance for common uses.

Key takeaways

• IRC 101(j) caps the tax-free benefit on employer-owned policies at premiums paid unless an exception applies and notice and consent were completed before issue.
• The notice must state a face amount, and consent must be written, including consent to coverage after employment ends.
• Inadvertent failures can be corrected only until the return due date for the issue year, and never after the employee dies.
• Cross-purchase policies owned by individual owners generally fall outside the rule; entity-owned policies fall inside.
• Employers owning EOLI file Form 8925 each year.