Retirement Benefits Planning UpdateRetirement Benefits Planning Update Editor: Harvey B. Wallace II, Berry Moorman PC, The Buhl Building, 535 Griswold, Suite 1900, Detroit, MI 48226-3679, hwallace@berrymoorman.com.

Probate & Property Magazine, September/October 2009, Volume 23, Number 5

Retirement Benefits Planning Update

Retirement Benefits Planning Update provides information on developments in the field of retirement benefits law. The editors of Probate & Property welcome information and suggestions from readers.

Employer-owned Life Insurance Defined

Under Code § 101(j)(1), added to the Internal Revenue Code by section 863 of the Pension Protection Act of 2006 (PPA), Pub. L. No. 109-280, 120 Stat. 780, the death benefit proceeds received from certain employer-owned life insurance policies issued after August 17, 2006, are not eligible for the full exclusion from income tax that would otherwise apply under Code § 101(a). Instead, only the sum of the premiums and other amounts paid by the policyholder for the life insurance (the employer's investment in the contract) is free of income tax. The balance of the proceeds (the "at risk" portion) will be subject to income tax unless one of the two exceptions to this treatment applies, the notice and consent requirements are met, and continuing reporting and recordkeeping obligations are observed as described below. "Employer-owned life insurance" for this purpose is defined as a life insurance contract that (1) 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 under the contract and (2) covers the life of an insured who is an employee of the trade or business of the applicable policyholder on the date the contract is issued. Code § 101(j)(3)(A). The term "applicable policyholder" not only refers to the person described in (1) above who owns the policy but also includes a person related to the employer in any of the 13 manners provided in Code § 267(b) (the Code section that defines related parties for purposes of denying the recognition of a loss on a sale or exchange between them), in the two manners specified in Code § 707(b)(1) (the Code section that prohibits the recognition of losses for transactions between partners and partnerships), or who is engaged with the employer in trades or businesses that are under common control within the meaning of subsections (a) or (b) of Code § 52. Code § 101(j)(3)(B). In general, these sections refer to relationships among family members, shareholders and corporations, corporations that are members of a controlled group, trust grantors and fiduciaries, tax-exempt organizations and the persons who control them, estates and beneficiaries, commonly controlled S corporations, partnerships, and C corporations, commonly controlled partnerships, and partners and partnerships. An "insured" for this purpose must be a U.S. citizen or resident and, in the case of an insurance contract covering joint lives, references to the insured include both individuals. Code § 101(j)(5). For purposes of the employer-owned life insurance rules, if coverage for each insured under a master contract is treated as a separate contract for purposes of Code § 817(h) ("Treatment of Certain Nondiversified Contracts"), Code § 7702 ("Life Insurance Contract Defined"), and Code § 7702A ("Modified Endowment Contract Defined"), coverage for each insured shall be treated as a separate contract. Code § 101(j)(3)(A).

The exceptions to the inclusion in income of the at-risk portion of life insurance proceeds received by the applicable policyholder for an employer-owned life insurance policy make it clear that the primary purposes that employer-owned life insurance have served traditionally—to provide a source for funding employee compensation and benefits, to fund the purchase of a deceased shareholder's or partner's interest in the business, and to indemnify the employer for the loss of the services of a key employee—are not targeted by the employer-owned life insurance provision. If the notice and consent requirements are met, the full amount of the proceeds from an employer-owned life insurance policy are excluded from income tax if either of two exceptions (one based on the status of the insured employee and one based on amounts paid to the insured employee's heirs) are met. The breadth of the exceptions and a number of technical clarifications to the employer-owned life insurance rules are set forth in Notice 2009-48, 2009-24 I.R.B. 1085, issued on May 22, 2009. Code § 6039I, added by § 863(b) of PPA, requires information reporting for employer-owned life insurance contracts, and final Treasury Regulations promulgated on October 16, 2008, provide the final rules for such reporting using Form 8925, "Report of Employer-Owned Life Insurance Contracts." Treas. Reg. § 1.6039I-1. Although the purpose of the statutory rule is to discourage those insurance arrangements that do not meet the exceptions (such as the practice of obtaining life insurance on rank and file employees as an employer investment), practitioners must understand the employer-owned life insurance rules to avoid the inadvertent imposition of tax for failure to comply with the threshold notice and consent requirements and the ongoing information reporting without which the exceptions are unavailable.

Refining the Definition

Notwithstanding the literal application of the related party rules that apply to define the applicable policyholder of an employer-owned life insurance contract, a life insurance contract can be an employer-owned life insurance contract only if it is owned by a person engaged in a trade or business. Thus, a contract owned by the owner of an entity engaged in a trade or business (for example, for the purpose of funding the purchase of an equity interest of another owner) is not an employer-owned life insurance contract. Similarly, an insurance contract owned by a qualified plan or VEBA that is sponsored by a trade or business entity is not an employer-owned life insurance contract. By contrast, a life insurance contract that is owned by a grantor trust of a business entity (such as a rabbi trust used to fund nonqualified deferred compensation) is an employer-owned life insurance contract because the trust assets are considered to be the employer's assets under the grantor trust rules. Notice 2009-48, A-1.

A life insurance contract subject to a split-dollar arrangement is an employer-owned life insurance contract if it is otherwise described in Code § 101(j)(3) although amounts paid to a family member of the insured, an individual who is a designated beneficiary, or a trust established for the benefit of a family member or designated beneficiary are not subject to the general inclusion rule of Code § 101(j)(1) under the exception in Code § 101(j)(2)(B) described below. Notice 2009-48, A-2. If the applicable policyholder's interest in the policy is limited to the investment in the contract, no part of the proceeds would be taxable and the notice and consent requirements would apparently not need to be satisfied. Collateral assignment "loan regime" split-dollar arrangements should similarly not need to comply because the employer has no ownership interest in the policy. Although partnerships and sole proprietorships can own employer-owned life insurance, a life insurance contract that is owned by a sole proprietor on his or her own life is not an employer-owned life insurance contract (presumably because the insured sole proprietor or the proprietor's heirs must be the designated beneficiary of the contract such that the exception for amounts paid to the insured's heirs is always met). Notice 2008-48, A-3.

For the purpose of applying the exception based on the employee's status described below and for the purposes of determining the timeliness of the notice and consent that must be given and obtained to qualify an employer-owned life insurance policy for either of the exceptions described below, the time at which the life insurance contract is issued is critical. For these purposes, an employer-owned life insurance contract is treated as issued on the later of (1) the date of application for coverage, (2) the effective date of coverage, or (3) the formal issuance of the contract. Thus, if the contract is effective before its formal issuance, the notice and consent may be given and obtained in the interim. Notice 2009-48, A-4. Code § 101(j) does not provide for a method to correct an inadvertent failure to satisfy the notice and consent requirements. The IRS, however, will not challenge the applicability of the exceptions described below because of such a failure if (1) the applicable policyholder made a good faith effort to satisfy the notice and consent requirements (such as by maintaining a formal system for providing notice and securing consents from new employees), (2) the failure to satisfy the requirement was inadvertent, or (3) the failure was discovered and corrected no later than the due date of the tax return for the taxable year of the applicable policyholder in which the employer-owned life insurance contract was issued. Note that the failure to obtain the employee's consent cannot be corrected after the insured has died. Notice 2009-48, A-16. The treatment of a contract as a new contract (and, therefore, newly issued) by reason of a material increase in death benefit or other material change is discussed below.

Exception for Employee Status

If the notice and consent requirements are met, the proceeds of an employer-owned life insurance contract are fully income tax free if the insured, either (1) was an employee of the applicable policyholder at any time during the 12-month period before the insured's death or (2) was, with respect to the applicable policyholder, at the time the contract is issued, a director, a highly compensated employee within the meaning of Code § 414(q) (relating to the nondiscrimination rules for qualified retirement plans), or a highly compensated individual under Code § 105(h)(5) (relating to self-insured medical reimbursement plans). For this purpose, Code § 414(q) applies without reference to any election by an employer to limit highly paid employees to the highest paid 20% in the top paid group of employees for the prior year. Therefore, the highly compensated employees for this purpose are (1) any 5% owner at any time during the current or preceding year and (2) any employee whose compensation for the preceding year exceeded $80,000 (adjusted for cost of living increases to $105,000 for 2008). Code § 101(j)(2)(A). In addition to encompassing a former employee who was an employee in the year preceding the issuance of a life insurance contract, Code § 414(q) provides that a former employee is treated as a highly compensated employee if the individual was a highly compensated employee when he separated from service or was a highly compensated employee at any time after attaining age 55. Code § 414(q)(6). Moreover, the term "employee" is not limited to common law employees and includes a self-employed individual who is treated as an employee under Code § 401(c)(1). Notice 2009-48, A-5. An "employee" also includes a director who is an independent contractor. Notice 2009-8, preface to Q&A 4.

Under Code § 105(h)(5) as modified by Code § 101(j)(2), a highly compensated individual means an individual who is one of the five highest paid officers, a shareholder who owns (with application of Code § 318) more than 10% of the value of the stock of the employer, or an individual who is among the highest paid 35% of all employees (excluding, for this purpose, employees who have not completed three years of service, employees under age 25, part-time or seasonal employees, employees covered by a collective bargaining agreement, and nonresident aliens who receive no U.S. sourced income from the employer). Code § 101(j)(2)(A)(ii)(III).

Exception for Payment to Insured's Beneficiaries

Code § 101(j)(2)(B)(i) provides an exception to the Code § 101(j)(1) income taxation of the at-risk component of the proceeds of an employer-owned life insurance contract to the extent that any amount received is paid to (1) a member of the family of the insured within the meaning of Code § 267(c)(4) (which includes the employee's brothers and sisters, whether by the whole or half blood, spouse, ancestors, and lineal descendants), (2) any individual who is the designated beneficiary of the insured under the contract (other than the applicable policyholder), (3) a trust established for the benefit of any such member of the family or designated beneficiary, or (4) the estate of the insured. Code § 101(j)(2)(B)(ii) similarly excepts any amount that is used to purchase an equity (or capital or profits) interest in the applicable policyholder from any person related to the insured described above. To be eligible for this purchase payment exception, an amount must be paid or used by the due date, including extensions of the tax return for the taxable year in which the applicable policyholder is treated as receiving the death benefit under the contract. Notice 2009-48, A-6.

Notice and Consent Requirements

The notice and consent requirements are met if, before the issuance of the employer-owned life insurance contract, the employee (1) is notified in writing that the applicable policyholder intends to insure the employee's life and of the maximum face amount for which the employee could be insured at the time the contract was issued, (2) provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment, and (3) is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable on the death of the employee. Code § 101(j)(4). To satisfy the requirement that the employee be notified of the maximum face amount for which the employee would be insured, the written notice must state the maximum, either as a dollar amount or as a multiple of the employee's salary, that the applicable policyholder reasonably expects to purchase for the employee during the course of the employee's tenure. Notice 2009-48, A-12.

Once an employee's consent is provided, the consent remains valid (that is, an insurance contract covered by the consent may be issued) until the earlier of (1) the expiration of the one-year period beginning on the date the consent was executed or (2) the employee's termination of employment with the policyholder. Unless the total face amount of insurance maintained by the employer exceeds the maximum amount stated in a notice for an existing policy, there is no need to provide further notice or renew an employee's consent for an existing policy. Notice 2009-48, A-9. A notice and consent may apply to multiple insurance contracts as long as the notice requirements are met. Notice 2009-48, A-10. Notice and consent are required of an owner-employee of a wholly owned corporation that purchases an employer-owned life insurance contract, Notice 2009-48, A-7, but no notice and consent are required for an existing life insurance contract that an employee irrevocably transfers to an employer (although a notice is required if the employer subsequently increases the contract's face amount). Notice 2009-48, A-8. The notice and consent requirements can be satisfied electronically provided that the system for electronic notification and consent ensures that the information received by the employee is the same as the information sent by the employer, makes it reasonably certain that the person accessing the system is the employee for whom notice and consent is required, includes a process for electronic signature or other means of formally recording the employee's consent to being insured, and permits the publication of a hard copy of the electronic notice and consent. Notice 2009-48, A-11.

Policy Exchanges and Modifications

PPA § 863(d) states that the employer-owned insurance provisions shall apply to all life insurance contracts issued after the date of the PPA's enactment (Aug. 17, 2006) except to a new contract issued after that effective date under a Code § 1035 like-kind exchange for a contract issued before that effective date. PPA § 863(d) also provides that, for purposes of determining when a life insurance contract is issued, a material increase in the death benefit or other material change generally causes an existing contract to be treated as a new contract. Accordingly, a life insurance contract issued after August 17, 2006, under a Code § 1035 exchange that results in a material increase in the death benefit or other material change (other than a change in issuer) is treated as a new contract for purposes of Code § 101(j). Notice 2009-48, A-15.

Several changes to an employer-owned life insurance contract have been identified as not being material, including (1) increases in the death benefit that occur as a result of either the operation of Code § 7702 or the terms of the existing contract (provided the insurer's consent to the increase is not required), (2) administrative changes, (3) changes from a general account to a separate account, or (4) changes as the result of the exercise of an option or right granted under the contract as originally issued (for example, the application of dividends to purchase paid up additions or increases as a result of market performance in a variable contract). Notice and consent are required to be given/obtained if a contract is treated as a new contract by reason of a material increase in death benefit or other material changes unless a valid consent remains in effect for the insured (that is, the one-year period has not run and the maximum amount is not exceeded). Notice 2009-48, A-14. Similarly, if an existing employer-owned life insurance policy for which a notice has been given and consent provided is exchanged for a new policy in a Code § 1035 exchange, no further notice and consent are required if the existing consent remains valid and there is no material change in the death benefit or the contract. Notice 2009-48, A-14. In the case of a master contract within the meaning of Code § 264(f)(4)(E), the addition of covered lives is treated as a new contract only for the additional covered lives. Notice 2009-48, preface to Q&A 14.

Information Reporting

Code § 6039I, as supplemented by Treas. Reg. § 1.6039I-1, requires every taxpayer that is an applicable policyholder owning one or more employer-owned life insurance contracts issued after August 17, 2006, to attach Form 8925 to the policyholder's income tax return by the due date of that return for each year the contracts are owned. The information to be provided includes (1) the number of employees of the applicable policyholder at the end of the year, (2) the number of such employees insured under employer-owned contracts at the end of the year, (3) the total amount of insurance in force at the end of the year under such contracts, (4) the name, address, and taxpayer identification number of the applicable policyholder (if the name of the applicable policyholder differs from the name of the reporting taxpayer) and its type of business, and (5) whether the applicable policyholder has a valid consent for each insured employee (or, if not, the number of insured employees for whom no consent was obtained). Each applicable policyholder owning one or more employer-owned life insurance contracts during each year shall keep such records as may be necessary for purposes of determining whether the requirements of Code §§ 6039I and 101(j) are met. Code § 6039I(b). Those persons who are included in the definition of "applicable policyholder" under Code § 101(j)(3)(B)(ii) because they are related to the applicable policyholder that owns the life insurance contract are not required to file Form 8925. Notice 2009-48, A-17.

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