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Friday, August 11, 2006

EMPLOYER-OWNED LIFE INSURANCE TRAP

Generally, the recipient of life insurance proceeds at the death of an insured is not subject to income tax on those proceeds. Under Code Section 101(j) of the Pension Protection Act of 2006, an exception is created for certain employer-owned life insurance. While the new provision does have extensive exceptions, to use these exceptions certain notices and consents must be issued and obtained BEFORE the policy is issued. The requirement to comply with the notice and consent provisions before the policy is issued is a big trap for the unwary.

The following summarizes the new provision:

THE TAX. If applicable, Code Section 101(j) will tax the beneficiary on receipt of life insurance proceeds to the extent the proceeds exceed the total premiums and other amounts paid for the policy.

POLICIES SUBJECT TO THE PROVISION. The provision applies to employer-owned life insurance, which is insurance owned by a person engaged in a business, if such person (or a related person) is the beneficiary, and covers the life of someone who is an employee on the date the contract is issued.

EXCEPTIONS. If the notice and consent provisions are satisfied, the following policy proceeds will not be subject to income tax:

INSURED IS EMPLOYEE. The insured was an employee during the preceding 12 months; or

INSURED IS DIRECTOR/HIGHLY COMPENSATED. The insured, at the time the policy is issued, was a director or highly compensated individual (as defined in the new provision); or

NON-BUSINESS BENEFICIARY. The beneficiary is a member of the family of the insured, an individual who is the designated beneficiary of the insured under the contract (other than the applicable policyholder), a trust established for the benefit of any such member of the family or designated beneficiary, or the estate of the insured; or

FUNDS USED TO REDEEM INTEREST. If the recipient will use the proceeds to purchase an equity interest of a person described above as a non-business beneficiary, to the extent such proceeds are so used.

NOTICE AND CONSENT REQUIREMENTS. The notice and consent requirements that must be met before the policy is issued are that the employee:

(A) is notified in writing that the applicable policyholder intends to insure the employee's life and the maximum face amount for which the employee could be insured at the time the contract was issued,

(B) provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment, and

(C) is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee.

ANNUAL REPORTING REQUIREMENTS. Any business owning any policies subject to the new provisions are required to file an annual return with the IRS detailing information regarding such policies. This reporting arises under new Code Section 6039I.
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