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MP3: MP1059 CD: C1059
M
ore than three years ago changes were made to
the Internal Revenue Code that had a direct
impact on the taxation of life insurance death
benets paid to businesses upon the death of an em-
ployee. Unless employers follow specic steps prior to is-
sue of business-owned life insurance, policy death benets
will be subject to income tax when paid. In addition, the
language of the Code is so broad that it may be deemed
to cover situations involving the purchase of life insurance
by partners in a true partnership or members in an LLC.
Uninformed clients are unprepared to address the is-
sues and to meet the requirements imposed by the Code.
It is only through well-informed and positioned advisors
that business clients can be made aware of the issues and
the necessary steps to avoid the burden of additional and,
in most cases, avoidable income taxes.
Many lawyers and accountants are aware of the new
requirements of IRC 101(j). However, frequently they are
not part of the insurance planning process until after the
insurance is issued. It is the insurance professional who is
in the best position to make certain their business clients
are informed and protected.
During the next 45 minutes we will discuss the threat
and address the requirements of the Code for EOLI, em-
ployer-owned life insurance. For many of you, our time
together will conrm the proactive steps you are taking
with your own clients. For others, we will help you address
what steps are necessary for your practice to solidify your
best practices for business purchased life insurance. As a
result of our discussions, you may nd that what could be
seen as strictly a compliance issue can quickly turn into an
eective prospecting tool.
Review of Life Insurance Taxation
Te easiest place to start is with the basics.
Tere is a common misconception among most of us
that life insurance death benets are always income tax
free
1
. Actually, the reality is they are sometimes income
tax free.
2
Te two major attributes of life insurance that
are frequently discussed with potential purchasers are cash
Avoid the Pending Tax Disaster Facing
Employer-Owned Life Insurance
Richard L. Olewnik, J.D., CLU
Richard L. Olewnik, J.D., CLU, assistant vice
president of advanced sales at AXA Equitable,
joined the company in 2005, and provides broad
experience in the design and application of life
insurance and annuity products, frequently
consulting on complex technical product issues.
His wide-ranging expertise includes the use of life
insurance in a qualied plan, and in developing
marketing programs that support the advanced
sales department. In addition to technical expertise
developed during the years supporting home oce
marketing and sales activities, he has the added
advantage of having practical eld experience.
Olewnik is a former captain of the U.S. Army Judge
Advocate Generals Corps defense counsel.
AXA Equitable
80 Scott Swamp Road
Farmington, CT 06032
Phone: 860.409.1172
E-mail: rich.olewnik@axa-equitable.com
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Employer-Owned Life Insurance (continued)
values buildup sheltered from income taxes and life insur-
ance death benets that are received by the beneciaries
income tax free. Tese two attributes have been under at-
tack for years. In some cases, ground has been given up.
Regarding life insurance death benets, prior to August
2006 there were four situations in which life insurance
deathw benets might trigger income tax. Most of these
are common knowledge among insurance professionals
and they include the following:
Transfer for value
3
Meeting the denition of life insurance
4
Corporate AMT
Cash value of life insurance in qualied plan
Sadly, many professional counterparts (attorneys, ac-
countants, and trust ocers) are not always aware of these
exceptions. Since 2006 business-owned life insurance
death benets in excess of premiums paid are subject to
income tax unless (1) the planning arrangement meets
certain proles and (2) the purchaser obtains the insured
employees written consent prior to policy issue. It is im-
portant to reiterate that the ultimate process is not 1 or
2. It is 1 and 2. Te case ts a prole, and the written
employees written consent is provided.
Reality Versus Perception
Although many believe that EOLI applies only to cor-
porate-owned policies, that is not the case. Various entities
may fall under this section, including LLCs, partnerships,
sole proprietorships, C corporations, and S corporations.
IRC 101(j) further broadens the reach of what an employer
is by dening employer as any person engaged in a trade
or business. Ultimately, COLI cases certainly fall under
the EOLI blanket, but its important to recall that the
blanket covers much more.
IRC 101(j)(3) Employer-owned life insurance contract.
(A) In general. For purposes of this subsection, the
term employer-owned life insurance contract means
a life insurance contract which
(i) is owned BY A PERSON ENGAGED in a
trade or business and under which such person
(or a related person described in subparagraph
(B)(ii)) is directly or indirectly a beneciary un-
der the contract.
Motivation for EOLI Rules
Te EOLI rules developed as a reaction to developments
and perceptions regarding COLI (corporate-owned life
insurance) that occurred over a number of years.
Initially, corporations purchased life insurance on the
lives of executives and other key persons for very practi-
cal reasons to fulll specic needs of the company, such
as fullling the provisions of a stock redemption agree-
ment by purchasing stock of a deceased owner or to make
up for the nancial loss that would be experienced upon
the death of a key person and the risk of hiring a highly
trained replacement or training a replacement.
Te value of life insurance in the corporate setting de-
veloped additional traction in funding NQDC, deferred
compensation agreements for key executives. Frequently,
plans were and are death benet only plans, or life insur-
ance was used to reimburse employers for benets paid to
the insureds during their working years.
Tax Code
Under the IRC, life insurance death benets are nor-
mally excluded from taxable income of the beneciary.
Because of the tax-free nature of the death benet, the
Code prohibits the deduction of the premium paid for a
life insurance policy by an owner who is also a bene-
ciary. A policys inside buildup is taxed deferred, and loans
from insurers secured by a policys values are not treated
as income. In contrast, historically, interest incurred on
indebtedness has been deductible. On a personal basis, the
deductibility of interest on indebtedness was essentially
eliminated in 1986.
Leveraged Life Insurance
Beginning in the 1950s, insurance programs were mar-
keted that highlighted the tax advantage provided when
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Employer-Owned Life Insurance (continued)
tax was not triggered on the growth on life insurance
policy values, and you could borrow those values and take
an income tax deduction from interest paid. In addition,
the interest paid to the insurer was in eect credited to
the policys values as tax deferred earnings. Te ability
to deduct interest at one turn yet not include in income
the interest credited to the policys cash value was touted
as a tax arbitrage. After a series of court battles, the IRS
nally gave up the ghost with the implementation of the
four out of seven rules: Borrowing could not account for
more that three of the rst seven years premiums.
In 1986, another limitation was imposed on interest de-
ductions for businesses. Te maximum amount that could
be borrowed on any one policy was limited to $50,000. In
order to accomplish the same arbitrage previously avail-
able, corporations expanded the base of employees that
were to be covered by corporate-owned policies from se-
lect key executives to almost all employeesfrom large
policies on the few to small policies on the many. And in
most situations the sole beneciary of the insurance cover-
age was the company.
Janitor Insurance
It has been reported that it was not uncommon for an
employer to have coverage on the mass of lower-paid em-
ployees, and, in many cases, the insurance was procured
without the employees knowledge or the employees con-
sent. In many cases, a small portion of the death benet
might be paid to the insured employees family with the
greater portion remaining with the company. It was fairly
common that life insurance coverage remained with the
company even after the employee retired or left the busi-
ness to work elsewhere. It has been reported that many
companies insured thousands of the employees.
As the public at large became aware of this type of cov-
eragepolicies taken out on large numbers of the rank
and le, sometimes without their knowledge with the
business retaining all or most of the policy proceedsthe
coverage picked up the moniker of Janitor Insurance or
Peasant Insurance. Trough the 1980s and 1990s, these
types of transactions continued to receive scrutiny and pe-
riodic court time as survivors of insured sought to share in
policy death benets.
Te New Millennium
COLIs Impact
Te heat continued as more members of the media
began reporting on broad-based COLI plans, and ad-
ditional lawsuits brought out unsavory fact patterns to
congressional and public view. Many large companies had
COLI plans. In 2003 it was reported that between 1993
and 1996 Walmart had taken out 350,000 policies on its
employees; COLI premiums accounted for $8 billion in
life insurance premiums each year; and COLI policies
accounted for more than 20% of all life insurance sold.
Besides Walmart, some of the companies whose names
showed up on the court docket included Dow Chemical,
Proctor & Gamble, Walt Disney, and Winn Dixie.
An objective reader, in reviewing just a couple of the
reported COLI court cases from 2002 and 2003 reports,
you can gather a sense of how sentiment developed against
the rank-and-le COLI cases.
In a suit against Winn Dixie, an insured employee was
married and had two children. His wife was pregnant with
their third child when he died in an auto accident. His
wife contacted the company to check on benets available
for her and her children. She was told about a $17,500
policy for which she was the beneciary. What they did
not tell her was that there was another $102,000 policy for
which the company was the beneciary.
In a class action suit against Walmart, the widow of a
48-year-old assistant manager had discovered that Walmart
was the beneciary of a $300,000 policy on her husbands
life, but there wasnt any benet for her or her family.
Te pressure continued during 2002 and 2003. Tis
was the era of Enron. In September 2003, the Senate
Finance Committee approved legislation that would tax
payouts on life insurance death benets paid to companies
when the employee had quit or retired more than a year
prior to death. Te ACLI reported that sales of new COLI
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Employer-Owned Life Insurance (continued)
policies came to a standstill in September 2003, the im-
plication being that many policies were not being sold to
protect active employees.
Factors Carried Over
Many points have carried over from these early COLI
issues, concerns, and perceived abuses to the nal legisla-
tion in August 2006. Some of these include the following:
Dierence in treatment for insurance on key employees
and rank and le
Notice and consent from the insured employee
Notice and consent required before policy issue
Switch in treatment for insurance on rank-and-le em-
ployees after one year from termination in employment
Dierence in treatment for insurance on rank and le
paid to family
IRC 101(j) Requirements
What Denes EOLI?
What is EOLI (employer-owned life insurance)? It is
any life insurance policy on the life of an employee, owned
by a person engaged in a trade or business, in which the
business/employer is the beneciary of the policy death
benet, and the policy was issued or subject to a mate-
rial change after the date that the Act was signed into law
by the president on August 17, 2006. So it is eective for
cases issued starting August 18, 2006.
Te major point is, all cases you are working with today
that involve business-owned life insurance may be EOLI
and should be approached as such. Notice the use of the
term person, not entity. Tis is not an uncommon ap-
proach within the Internal Revenue Code. Te term is
intended to cover entities as well as individuals. All forms
of business are subject to the provisions. Tis includes C
corporations; S corporations; true partnerships, LLCs,
LLPs, and sole proprietors.
Te recent IRS Notice addressed two examples that
provide additional clarity on the IRS position. Te rst
involved a sole proprietorship. A policy purchased on the
sole proprietor is not EOLI, but a policy purchased on the
life of an employee of a sole proprietor is EOLI.
Te second situation involved a corporation that was
owned by one individual. In this case the Notice provided
that a life insurance policy purchased on the life of the
sole owner of a corporation would be EOLI, even though
there werent any owners and any other employees. A logi-
cal position might be, If I am the only party involved as
business owner and insured, cant we assume that I have
provided consent and that I am on notice that the policy
is being purchased? Te Notice went on to indicate that
even here the formal requirements of written Notice and
Consent is required to avoid income taxation of this busi-
ness-owned life insurance policy.
Te Impact of Failure to Comply
Lets consider a case with a very common and simple
fact pattern and see how noncompliance could impact
your business clients.
Bill and Mary are equal owners of Liquid Car Wash, a
C corporation. Tey have been in business for the past ve
years. Te business has grown rapidly and is valued today
at $2,000,000. Bill and Mary have been advised by their
attorney that they need to implement a business succession
plan. Te attorney recommends that they execute a stock
redemption agreement, a plan by which the corporation
will purchase the stock of a deceased owner upon his or
her death. Tey establish a buyout price for each owners
interest based on current business value, so $1,000,000
for each interest of their interests. In compliance with the
funding provision of their agreement, Bill and Mary com-
plete life insurance applications for insurance the business
will own and pay for. Te business will purchase and own
two $1,000,000 life insurance policies, one on each of
their lives. Annual premium on each policy is $10,000.
During the application process, neither the attor-
ney nor the accountant ever raised the EOLI rules as a
consideration.
Now lets focus on what Bills expectations are coming
out of this recent business succession plan.
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Employer-Owned Life Insurance (continued)
Bill is thankful that they have a funded buy-sell agree-
ment in place. He expects that the business will make an-
nual premium payments for many years as their business
grows. Its likely that there is also the expectation that
additional coverage will be needed as the business value
increases.
At this point the key expectation is that if either of
them were to die, the business would receive $1,000,000
and have to complete the obligations under the stock re-
demption agreement.
Fast forward one year. Mary is involved in a major auto
collision and dies instantly. Te whole point of entering
the buy-sell was to insure Marys life so that Bill would be
able to satisfy the contractual obligation and buy Marys
interest if and when the time came. Now that time has
come.
Lets think about how this might work from a practical
perspective.
Upon Marys death, her ownership interest is still in
her estate but will pass to her only surviving heir, her son
Bobby. Te executor of the estate spends a few weeks sort-
ing through Marys papers and nds a copy of the buy-sell
agreement. He discusses it with Bill, and Bill fully intends
to fulll his contractual obligations and pay the estate
$1,000,000 for Marys (now her estates) interest in the
business as soon as he receives the insurance proceeds. At
the moment, business cash ow death is an issue, and the
company doesnt have that kind of cash sitting in the bank.
Bill receives a call from their business accountant and
is asked whether anything was done at the time of policy
issue to comply with Internal Revenue Code 101(j), em-
ployer owned life insurance. After some brief research
into the company records, he responds in the negative.
Bill is advised that the insurance death benet is subject
to income tax. Noncompliance with employer-owned life
insurance (EOLI) rules resulted in the $1,000,000 death
benet being subject to a 34% corporate income tax.
Lets talk about expectations: Bill expects Marys
$1,000,000 death benet to be received income tax free so
that Marys business interest under the buy-sell agreement
may be purchased. Bobby (Marys son) expects to receive
the $1,000,000 for his moms business interest. All expec-
tations are now askew.
Bill may end up with Bobby as his new business part-
ner or be forced to liquidate assets or the business itself to
make up for the EOLI shortfall. To complicate matters,
business has been going down since Mary died, and a po-
tential liquidation will only hasten its decline. So whats
the next step for Bill? What will he expect from his busi-
ness advisors, including his life insurance agent? Whom
do you think Bill will call rst, his agent or his attorney?
Which advisors will he look to make up the cash shortfall?
For illustrative purposes in this case study, we assume
premiums paid for one year was $10,000 on Marys
policy.
(Death benet subject to income tax premiums
paid) = amount subject to income tax:
$1,000,000 $10,000 = $990,000
Income taxes payable on death benet times the mar-
ginal corporate income tax rate:
$990,000 x 34% = $336,600
Bill is short $336,600.
Enter the EOLI shortfall. In this case, non-com-
pliance with EOLI rules would result in the $1,000,000
death benet less premiums paid subject to a 34% corpo-
rate income tax. Assuming the $10,000 premium was paid
in year one, and Mary died at the one-year anniversary,
those premiums paid would be deducted from the death
benet prior to applying the income tax. In this example,
after one year, the dierence would be slight but still there.
When Bill receives the $1,000,000 death benet, there
are basically two ways the situation may evolve:
1. Bill immediately realizes there is an EOLI issue, but
he is still obligated to pay Bobby the $1,000,000.
He needs to liquidate business assets to meet the
$336,600 shortfall.
2. Bill does not realize there is an EOLI issue, automati-
cally pays Bobby the $1,000,000 death benet, but
has the IRS knocking on his door a year later tell-
ing him the business owes $336,600 (plus penalties
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Employer-Owned Life Insurance (continued)
and interest on the deciency, which well ignore for
simplicity purposes) since the death benet was in
fact taxable.
Te EOLI shortfall is the $336,600 dierence. Te
dierence under the two scenarios is the timing of Bill
realizing the liability, but the eect is the same.
Whether we like the EOLI rules or not, this tax cost
is what producers need to protect their clients from expe-
riencing. Tis is what producers need to know to protect
themselves.
What Situations Involve EOLI?
Business Forms EOLI includes more than just COLI
(corporate-owned life insurance). It is a fairly common
misconception that EOLI refers strictly to COLI. While
corporate-owned policies are certainly under the EOLI
blanket, its important for nancial professionals to realize
that, in actuality, the EOLI rules can cover a wide range of
business insurance purchases. And some areas of potential
application remain gray. Entities ranging from LLCs to
sole proprietorships to partnerships to S corporations all
may be subject to the EOLI rules.
Te IRS recently released Notice 2009-49, which clari-
ed and conrmed certain areas of EOLI, including cer-
tain applicable planning arrangements.
Sole proprietors Notice 2009-48 made it clear that
a policy purchased by a sole proprietor on the life of an
employee is EOLI, whereas a policy purchased on the life
of the proprietor is not EOLI.
Split Dollar Now lets look at the split dollar
arrangements:
1. Endorsement Method Split Dollar (Economic
Benet Tax Regime)
In a split-dollar arrangement in which the em-
ployer is the named owner of the underlying life
insurance policy and is a direct beneciary of the
policy, the arrangements seem to t within the
denition of EOLI.
2. Equity Collateral Assignment Method Split Dol-
lar (Loan Tax Regime)
In a split-dollar arrangement in which the em-
ployee is the named owner of the underlying life
insurance policy, and the employer is entitled to a
return of its premium advances from the policys
death benets, the policy should not be considered
EOLI, because the employer is not the named
owner of the policy in these arrangements.
3. Non-Equity Collateral Assignment Method Split
Dollar (Economic Benet Tax Regime)
In a non-equity collateral assignment split-dollar
arrangement, subject to the economic benet tax
regime, in which the employee is the named owner
of the underlying life insurance policy and is only
entitled to current life insurance protection under
the arrangement, the policy would not normally
be considered EOLI. Even though the employer is
not the named owner of the policy, the employer is
deemed to own the underlying life insurance policy
in such arrangements; this is due to the split-dollar
life insurance regulations under Code Section 61.
It may be safe to assume that the policy is EOLI
until the IRS provides additional guidance.
Bonus Plans As far as Section 162 Bonus Plans go, in a
typical Section 162 Bonus Plan, the employee is the named
owner of the policy, and his or her designated beneciary
receives the entire death benet. Such plans should not be
considered EOLI. However, if plans deviate from the tradi-
tional approach, attempts to maintain a string or owner-
ship interest in the policy may create an EOLI fact pattern.
Buy-Sell Arrangements Moving on to some other ar-
rangements, lets start with buy-sell situations.
1. Redemption/Entity Purchase
Because the employer is the named owner and direct
beneciary of the underlying life insurance policy,
life insurance purchased to fund a redemption
buy-sell arrangement should be considered EOLI.
Note: Notice and Consent is required even when a
corporation purchases a policy on the sole owner.
2. Cross-Purchase (All Business Forms Except
Partnership)
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Employer-Owned Life Insurance (continued)
In corporate situations, it appears that a life insur-
ance policy underlying a cross-purchase buy-sell
arrangement will not be considered EOLI because
the corporation is not the named owner of the
policy. It is also unlikely that the shareholder who
purchases the policy will be considered engaged in
the trade or business of the corporation.
3. Cross-PurchasePartnerships
Partnerships fall into that gray area. It is not clearly
dened whether the partner who owns the policy
will be considered engaged in the trade or busi-
ness of the partnership. Because it is unclear, it
may be safe to assume that the policy is EOLI until
the IRS provides further guidance.
Qualied Pension Plans Any life insurance policies
held within a qualied retirement plan should not be con-
sidered EOLI. Te policy will be owned by the pension
trust, not the employer.
VEBA-Welfare Benet Plans Any life insurance poli-
cies held in voluntary employee benet association or
other welfare benet plan should not be considered em-
ployer owned. Similar to qualied pension plans, life
insurance purchased to provide benets under these ar-
rangements is owned by the plan trustee.
Charitable Life Insurance One of the confusing
factors involving charities as employers is that their ac-
tivities are normally exempt from income taxes except
income earned as a result of unrelated business activi-
ties. It is unclear whether a charity will be considered
to be engaged in a trade or business for purposes of the
EOLI rules. It may be prudent at this time to assume
that policies purchased by charities on the lives of their
employees in which the charities are beneciaries will be
considered EOLI, whereas insurance purchased on the
lives of donors will not be EOLI. One of my businesses
associates is a member of a committee of the American
Bar Association that deals with legal issues facing chari-
table organizations and arrangements. Feedback from her
committee says that most attorneys practicing in this area
are requiring that their charitable clients obtain EOLI
notice and consent when they purchase life insurance
on the lives of employees. However, a policy on a nonem-
ployee donor that is owned by the charity should not be
considered EOLI.
Rabbi Trusts Because an employer who establishes a
rabbi trust is generally considered to own any assets held
by the trust for income tax purposes, life insurance poli-
cies held by a rabbi trust will likely be considered EOLI.
Nonqualied Deferred Compensation Plans (Policy
Used as Informal Funding Vehicle) Because the life in-
surance purchased to fund these plans is owned by the
employer, the policy will be considered EOLI. Tis is the
classic EOLI situation and one of the reasons EOLI legis-
lation was rst formulated.
Key Person As would be expected, key person policies
do fall under EOLI.
You can see how EOLI has black and white areas, but
there are certainly a number of gray areas as well. In your
planning, it is necessary to plan for those gray areas, as
well consider those cases as EOLI. It is better to be safe
than sorry.
Exceptions and Notice and Consent
We have addressed EOLI (policy owned by an employer
on the life of an employee with benets to be received by
the employer), considered the EOLI shortfall, and started
to address the potential liability. Now we will look at the
best practices to avoid the tax.
I will illustrate the sales opportunities with a case study
and also provide you with the tools for compliance and
the advantages you can bring to your clients and centers
of inuence.
Status Exceptions Lets go over Issue #1, the excep-
tions. EOLI contracts may be exempted from income
taxation based on status.
Te insured was an employee of the applicable policy-
holder at any time during the 12-month period before
death. (Tis applies to rank-and-le employees.)
Te insured is a director or highly compensated em-
ployee. Highly compensated means anyone who is a
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Employer-Owned Life Insurance (continued)
5% owner, has received compensation for the preced-
ing year over the dollar limit in IRC section 414(q),
which is $110,000 for 2009, or is among the highest
paid 35% of the employees.
Te death benet is directly or ultimately paid to bene-
ciaries other than the business/employer, including (1)
paid to a family member of the insured, an individual
who is a beneciary designated by the insured (other
than the employer or a related entity); (2) paid to a trust
for the benet of any such family member or designat-
ed beneciary; (3) paid to the estate of the insured; or
(4) used to purchase an equity (or partnership capital or
prots) interest in the applicable business/policy owner
from a family member, beneciary, trust, or estate.
What about time restrictions that may apply to these
status exceptions? What do we mean by time restric-
tions? I stated that for the death benet to be income tax
free, the case must meet one of three status exceptions.
Each of those exceptions holds only under certain cir-
cumstances. For starters, if an amount under the death
benet is paid to the heirs, as in a deferred comp plan,
there are no time restrictions for the death benet to
qualify as long as the Notice and Consent rules were fol-
lowed prior to policy issue. If the employee is a director
or highly compensated employee, there are also no time
restrictions.
However, if the life insurance coverage is on the life
of a rank-and-le employee, in which no portion of the
death benet is being paid to the heirs and the employee
is not a director or highly compensated, then the only way
the death benet could still qualify under the IRS excep-
tions and be income tax free is if the insured employee dies
within 12 months of being employed by the policyholder/
employer or the insured individual gets red after working
for the company for a few years. If the employer continues
to own the policy and the insured does not die within 12
months of being red, regardless of whether the Notice
and Consent provisions were complied with, the death
benet would be subject to income tax.
Notice and Consent Issue #2 is Notice and Consent.
In any situation involving employer-owned life insurance
prior to issue of the life insurance contract, the employee
must be notied in writing, and the employee must con-
sent in writing to the following:
Employers intention to insure the employee
Te maximum amount of applied-for coverage (specic
amount)
Employer as the owner and beneciary of the policy
Employer with the right to continue the contract after
employment is terminated
If a policy is issued and consent has not been received
prior to issue, there are only limited means of addressing
a failure to comply.
Correcting Failure to Comply Is there a way to correct
for noncompliance with the initial requirements? Te IRS
has provided comment on only one method to correct a
failure to obtain Notice and Consent prior to policy issue.
If the failure to comply was inadvertent:
IRS Notice 2009-48
a. Notice and Consent cannot be assumed from facts
b. Inadvertent failure to comply
Good faith eort made
Correction made by tax return due date
Other practical solutions might be:
a. Transfer to EE and then back again
b. Surrender policies and buy new ones
Not 1035 Exchange
In summary, it is becoming clear that there is a pro-
cedure to protect an EOLI client from income tax and
get Notice and Consent, but it is best addressed up front
before policy issue.
If you believe your client is an EOLI client and he or his
advisors elect not to comply, you then need to consider
how to protect yourself from later claims. More on that
later. You can imagine how disappointed a client would
be to nd out after the fact that not only has he failed to
comply, but there is no clear and easy way to correct the
situation.
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Employer-Owned Life Insurance (continued)
Other EOLI Issues
Among the other issues to consider is an annual l-
ing requirement for all business/employers who own life
insurance that is subject to the EOLI rules.
Eective for tax years ending after November 13, 2007,
an employer must annually le with the IRS a summary
of all EOLI policies. Information to be provided must in-
clude the following:
Number of total employees versus insured employees
with policies issued after August 17, 2006
Total in-force insurance on employees
Policyholder details, including type of business
Represented policyholder with valid consent for each
insured employee, otherwise, with a note of the names
of those for whom consent was not obtained
Te IRS even created a special reporting form that ap-
propriate parties should attach to their annual tax return.
Here again it demonstrates that Congress and the IRS
have their eyes on employer-owned life insurance. Failure
to le the annual EOLI return triggers an administrative
penalty. It might be possible to correct a failure to le the
annual EOLI return by re-ling an annual tax return and
including the completed form.
State Issues Involving Employer-Owned Life
Insurance
Aside from subjecting the death benet to federal in-
come tax, there are state issues involved with employer-
owned life insurance. Te most basic is insurable interest.
Te classic common law rule (incorporated by statute
in most states) on insurable interest requires that a person
purchasing a life policy have some interest, nancial or
otherwise, in the continued life of the insured. In all states
this would generally include an employer purchasing a
policy on the life of a key employee (one on whose contin-
ued life the nancial success of the business is dependent,
however that is determined), but not a more replaceable
employee. A number of states have expanded the common
law denition of insurable interest to include additional
classes of persons.
Te classic common law rule (incorporated by statute
in most states) on insurable interest requires that a per-
son purchasing a life policy have some interest, nan-
cial or otherwise, in the continued life of the insured.
All life insurance contracts must have valid insurable
interest at the time of issue.
Additional requirements exist in certain states for an
employer-owned contract to properly establish insur-
able interest.
A contract with valid insurable interest under state law
may still be subject to income tax if the IRC 101(j)
EOLI rules are not complied with.
Likewise, a contract that complies with IRC101(j) in
order to preserve the income taxfree death benet
may be a voidable insurance contract if it does not com-
ply with state insurable interest laws.
Its important to note that certain states do have dif-
ferent forms to complete to comply with state laws, and
they may have a set procedure to follow for the contract
to qualify as an EOLI compliant policy. In the past three
years, there were changes in the laws of Florida (July 1,
2008), Georgia (July 1, 2009), New York (July 21, 2008),
North Carolina (January 1, 2006), Utah (April 30, 2007),
and Washington (July 24, 2005, and January 17, 2008).
Tis list is not exhaustive, but it includes a few states with
recent changes. Tere are numerous states that address
EOLI contracts, and nancial professionals should be
aware that they exist and need to be complied with.
One of the best examples is provided by Washington
State. Washington State regulations impose responsibili-
ties on the employer in cases involving the purchase of
life insurance by businesses on their employees. Tere are
specic requirements for Notice and Consent. Tere must
be evidence that the employee was a key person (under
Washington statutes) at the time of issue.
For the purpose of Washington regulations, the term
key person means a person who, during the year the
contract was made, was (1) a director; (2) a shareholder
who owns more than 5% in value of the stock of the
employer; or (3) a highly compensated individual or
P R O C E E D I N G S
366
Avoid the Pending Tax Disaster Facing
Employer-Owned Life Insurance (continued)
highly compensated employee within the meaning of
Internal Revenue Code sections 414(q), 105(h), or 101(j),
as applicable. Tis amount is $105,000 for 2008 and
$110,000 for 2009.
Tere is also a requirement that the employer maintain
evidence that the employee applied for, or consented to,
the purchase of life insurance on his or her life. Te insurer
can require that the employer maintain proof of consent
in their les.
You should take note that in Washington State an em-
ployer is not deemed to have an insurable interest in the
life of a rank-and-employee.
Establishing EOLI Best Practices
Now lets discuss EOLI best practices.
A key area that can separate you from others involved
in business planning is the level of support you oer and
provide for your clients in cases involving employer-owned
life insurance. With business clients, institute a best prac-
tices approach.
Tere is also a great opportunity for producers to target
centers of inuence and build credibility by identifying
and acknowledging the EOLI issue. Trough eective cli-
ent communication, you can protect your client against
the risk of a shortfall due to noncompliance with EOLI
rules. Here are some basic steps to consider.
Collect materials to notify and educate clients/employ-
ers.
Establish a process to address your EOLI cases.
Build EOLI into your policy audit approach.
Use EOLI to (1) reinforce client relationships, (2) iden-
tify prospects, and (3) develop centers of inuence.
With business clients, institute a best practices
approach.
Discuss EOLI with clients and their advisors during
planning.
Have activity checklist for EOLI compliance for all
participants.
Action
Item
Responsible
Party
Date
Completed
1) Verify that, at the time of
policy issue, (1) the em-
ployee/insured is a director
or highly compensated em-
ployee or (2) amounts under
the contract are to be paid to
heirs of the employee.
2) Notify the employee in writ-
ing of the employer/poli-
cyholders intent to insure
the employees life and the
maximum face amount for
which the employee could
be insured at the time the
contract is issued.
3) Obtain the employees writ-
ten consent to being insured
under the contract, to such
coverage continuing after
termination of employment,
and conrmation that the
employee has been informed
in writing that the employ-
er/policyholder will be the
beneciary of any proceeds
payable upon the death of
the employee.
4) Review employer/policy-
holders existing policies
for any material changes,
including an increase in face
amount.
5) Prepare for the ling of an
annual reporting form (IRS
Form 8925) with your tax
return.
Developing Relationship Opportunities
Tere is a great opportunity for producers to target
centers of inuence and build credibility by raising the
EOLI issue. Trough eective client communication,
you can protect your client against the risk of a shortfall
due to noncompliance with EOLI rules.
P R O C E E D I N G S
367
Avoid the Pending Tax Disaster Facing
Employer-Owned Life Insurance
Checklist
o Discuss EOLI with clients and their advisors during
planning.
o Have activity checklist for all participants.
o Have sample N & C for clients.
o Where EOLI is certain, get signed N & C or waiver.
o Where EOLI uncertain, err on side of EOLI.
o Watch for future material changes.
o Watch for EOLI on policy audits.
o Send letters to clients, prospects, and centers of
inuence.
Become the Expert Tere is a real opportunity for pro-
ducers to establish credibility with employers and other
advisors through communication of valuable information.
Producers can stand apart from other advisors and provide
clients with the opportunity to make informed decisions
regarding the risk of a shortfall due to noncompliance
with EOLI rules.
Reach Out EOLI rules present a meaningful opportu-
nity to raise the issue with centers of inuence, including
CPA and law rms.
Closing Comments
Failure can result in income taxation of life insurance
death benet. (Dont let the failure to comply be yours.)
A portion of the death benet is payable to the employ-
er, less premiums paid, subject to income tax. (If there
is a tax, make certain the beneciaries are not knocking
on your door to cover the shortfall.)
Protect your client up front rather than try to correct
later.
We encourage you to prepare prospecting letters for
your current business clients. Separately, you should reach
out to centers of inuence and request time to explain the
EOLI rules. Te information is sure to be welcomed and
appreciated.
Endnotes
1
IRC 101(a)
2
IRC 101(a) Proceeds of life insurance contracts payable by
reason of death.
1) General rule.
Except as otherwise provided in paragraph (2) , subsection
(d), subsection (f ) , and subsection (j) , gross income does not
include amounts received (whether in a single sum or otherwise)
under a life insurance contract, if such amounts are paid by
reason of the death of the insured.
3
IRC 101(a)(2)
Transfer for valuable consideration. In the case of a transfer for
a valuable consideration, by assignment or otherwise, of a life
insurance contract or any interest therein, the amount excluded
from gross income by paragraph (1) shall not exceed an amount
equal to the sum of the actual value of such consideration and
the premiums and other amounts subsequently paid by the
transferee. Te preceding sentence shall not apply in the case of
such a transfer.
4
IRC 101(f ); IRC 7702