Employer Owned Life Insurance: File a tax form and save $400,000

Business entities use insurance to provide protection against various risks ranging from natural disasters to cyber threats. As our economy has evolved the risks that can be insured against have grown more complex. An introduction to business insurance was the topic of our August, 2015 Emerging Business Group seminar. One traditional use of insurance is to provide funds to compensate a business in the event of the death of a founder or other key employee. For founders and other stockholders, the life insurance proceeds received by the entity can be used to fund the purchase of the founder’s ownership interest in that entity. In the case of key employees, life insurance proceeds can help to offset potential revenue losses or increased costs incurred while the entity determines how to deal with the knowledge and resources lost due to their employee’s death.

The arrangements described above are commonly called “Employer Owned Life Insurance” (EOLI) or “Company Owned Life Insurance” (COLI). The business entity is the owner and beneficiary of a policy insuring the life of an employee. The business pays non tax deductible premiums and as beneficiary receives the policy proceeds. Prior to 2006, the life insurance proceeds received by the business entity were tax free income. Due to perceived abuses the law was changed by the Pension Protection Act of 2006 for policies issued or modified after August 17, 2006. The Act required that:

  1. Employees be notified and grant consent before an employer purchases insurance on their lives and
  2. Requires businesses to annually notify the Internal Revenue Service if any COLI policies issued after 2006 are in force.

If these two requirements are met (in additional to several other compliance requirements not discussed in this blog) the life insurance proceeds would continue to be tax free.

Meeting the first requirement may pose a problem for employers with existing policies. If the written notice and employee consent requirements were not met before the policy was initially issued they cannot be met now after the policy has been issued. A grace period for late notice and consent is allowed up to the due date of the employer’s tax return for the year the policy was issued. A potential remedy, if the grace period is missed, is to have the existing policy reissued and obtain the required consent before this new policy is in force.

The Internal Revenue Service created Form 8925 to meet the second disclosure requirement.

The form only asks five questions. Failure to include this form with the entity’s annual income tax returns can result in the life insurance proceeds being fully taxable. Proceeds of $1 million would result in a $400,000 federal and California tax bill…….simply for not including one form in a tax return!     

If your company has COLI you need to comply with the employee disclosure and consent rules and annually file Form 8925 to ensure that the life insurance policy proceeds can be treated as tax free income.