Most corporate clients assume that proceeds of a life insurance policy insuring the life of an employee are tax free. Revisions to the Internal Revenue Code in 2006 provide, however, that life insurance proceeds are included as taxable income of the corporate owner of a life insurance policy unless certain IRS requirements are met.
Corporations often purchase life insurance policies on their important employees who are officers, directors and shareholders. Key man policies are commonly purchased to provide ready cash during the difficult times following the death of a critical or founding corporate employee. More and more corporations purchase policies to fund succession plans involving redemption of the shares of a deceased shareholder. Executive compensation plans also commonly include life insurance components. Our attorneys have seen life insurance agents recommend corporate ownership of policies intended to fund shareholders’ agreements, as a means to assure that policy premiums are paid timely.
Section 101(j) of the Internal Revenue Code provides that proceeds of these corporate-owned life insurance policies are includable in income for tax purposes, but there is a simple yet critical documentation and return requirement which makes the proceeds non-taxable. IRS Form 8925 must be filed at the end of the year of policy issuance. Form 8925 is a fairly simple informational return, filed with the corporation’s income tax return. Further, the corporation must give notice of the policy and coverage amount to the insured employee, and obtain his or her consent to the insurance arrangement, as well as to the fact that the corporation is to be named as beneficiary. The notice and consent documentation must be obtained before the life insurance policy is issued.
Failure to comply with section 101(j) results in policy proceeds paid on the death of the insured employee being taxable to the extent that proceeds exceed premiums paid and other costs incurred in obtaining the insurance. Late filing is not a solution. In order to avoid income tax on proceeds, corporate policyholders may be forced to consider reissuance of the policy or an IRS private letter ruling as to the section 101(j) requirements if Form 8925 was not properly filed and/or the pre-policy notice and consent were not documented.
Insurance advisors, corporate accountants, corporate officers and financial planners should be alert to the pitfalls of section 101(j). The cost of missing the filing requirement can be a loss of 30 to 50% of the policy proceeds in taxes, which can undermine the insurance plan, and frustrate clients. For more information on the filing requirements or the solutions for corporations which failed to meet these reporting requirements, consult a member of the Kaufman & Canoles Private Client Services Group. —Gregory R. Davis