Prior to 2006, the death benefits from corporate or business-owned life insurance policies were generally tax-free. After August 17th, 2006, laws were changed to allow for income taxation of death benefits on these policies issued after this date.
The legislation affected business of all sizes and types where life insurance policies were purchased by a company on the lives of its employees where the employer was the owner and beneficiary of the policy. The legislation included (but were not limited to) key-person coverage, buy-sell arrangements and non-qualified deferred compensation plans.
The law was enacted to address Congress’ concerns about large corporations purchasing life insurance policies on the lives of rank-and-file employees who were not aware of these life insurance policies whose benefits were payable to the corporation.
In essence, this law reversed the rule that Corporate or Business-owned life insurance death benefits are generally received income tax free. However, there are exceptions to this rule if certain criteria are met:
A Notice and Consent form must be signed and submitted to the insurance carrier for an employer-owned life insurance policy before the policy is issued. Failure to comply will mean that part of the death benefit may be taxed as ordinary income.
One of the four safe harbors as specified in the law must be in place to keep the death benefit income tax free:
- The insured is a key person at policy issue.
- The insured was an employee any time in the 12-month period before death.
- The death benefit is paid to the Insured’s heirs.
- Buy-Sell funds. The death benefits remain income tax free if they’re used to buy the Insured’s interest in the employer from someone listed in Safe Harbor 3.
Unfortunately, you cannot know if Safe Harbors 2-4 are available until the employee dies. Until then, the employer won’t know for sure if the death benefit is taxable or not taxable.
This is a synopsis of the law and in no way should this information be construed as tax advice. You should always consult with your CPA before entering into one of these agreements.