Bar News - February 18, 2011
Tax Law: Adverse Consequences of Corporate-Owned Life Insurance Policies
By: Harry A. Shepler & Daniel W. Sklar
On August 17, 2006, President Bush signed into law the Pension Protection Act of 2006. Among the important provisions of the Act was Section 863(a) which added IRC Section 101(j) to the code. This new section requires an employer to give notification to an employee/ director/shareholder of the proposed purchase of life insurance on them by their employer, and that the employee/director/shareholder must give written consent to the employer before the issuance of any policy. Failure to comply with these requirements, along with new IRS annual reporting requirements for employer-owned policies, will result in dire tax consequences. This addition to the law became effective for all employer-owned policies issued on or after August 17, 2006. IRS Notice 2009-48, effective June 15, 2009 clarified the Act, and added certain annual reporting requirements for corporate owned policies issued after the effective date.
For example, in typical corporate financing, lenders may require life insurance on the life of the business owner/borrower to partially secure the loan. Assume the owner’s business borrows $2,000,000 from his bank, and is required, as part of the financing arrangement, to purchase a $1,000,000 policy on the owner’s life, assigned to the bank. Assume that our borrower’s business takes out a policy for $1,000,000 on the business owner in January 2007, and pays $2000 in annual premiums for three years, and the owner dies in March of 2010. Without having complied with the new tax rules, the “gain” over the cost basis of the policy (1,000,000-6,000) of $994,000 becomes taxable income. If the business structure is a pass-through entity, the taxable income would be added to the ordinary income of each business owner pro rata for 2010. If it is not a pass-through entity, the taxable income would be charged as ordinary income to the entity. Moreover, since the bank is entitled to the entire death benefit, the borrower will be required to pay the resulting tax liability out of its own working capital. Had the borrower complied with §101(j), the death benefit would have been received and paid to the bank without any income tax consequences whatsoever.
In another example, a corporation has purchased three $1,000,000 life insurance policies in 2010 to secure a deferred compensation arrangement on each of three key executives. Later that year, one of the key employees dies in a skiing accident. The entire proceeds of the life insurance policy, less the premium paid, becomes taxable income to the business, assuming that it has not complied with the new law and regulations.
In our last example, owners of a business enter into a formal stockholders or cross- purchase agreement secured by the entity with life insurance on the owners, purchased on or after August 16, 2006. They fail to execute the proper disclosure and consent paperwork, and likewise fail to file the appropriate IRS information returns regarding the purchase. At the death of any owner, the proceeds of the life insurance, less the cost basis thereof, will be taxable income to the entity (or owners, pro rata if the entity is pass-through for income tax purposes) reducing the net funds available to redeem the stock of the decedent.
The new requirements impact every life insurance policy used in connection with stock redemption buy/sell agreements, entity purchase buy/sell agreements, key person agreements, non-qualified and deferred compensation agreements, and any other employer-owned life insurance arrangement. Despite the adverse consequences of this law and its regulations, many professional advisors are unaware of the requirements.
Fortunately, the Act’s compliance rules only apply to new policies issued on or after August 16, 2006. Unfortunately, the Act provides no relief or remediation for non-compliance. For most situations where the new rules have not been appropriately followed, acquiring new, substitute policies which comply with the Act may be the only rational solution.
Harry A. Shepler is a principal of the Shepler Financial Group, located in Bedford, NH. Daniel W. Sklar is a partner with the international law firm of Nixon Peabody. He has been a member of the NH Bar since 1978.