Buying Life Insurance for Employees
Tax Rules Make This Practice More Complicated Than Many Think
By CATHERINE CURRY, CPA
There are many reasons why an employer might buy life insurance for their employees: employee benefits, succession planning, buy/sell agreements, and debt protection, to name a few.
There are just as many ways to arrange the life-insurance contract, regarding the policy owner, beneficiary, and payment of premiums. As an employer, purchasing a life-insurance policy for an employee may seem pretty straightforward at first glance.
However, there are a number of tax rules that should be considered when purchasing these policies, as tax laws vary depending on the specifics of the life-insurance policy.
One of the most common types of employer-purchased life insurance is a group-term life-insurance policy that covers all employees. This is often used as part of the employee benefits package. Generally, the employer pays the entire premium for the group, but the employee gets to specify their own beneficiary on the policy. The life-insurance benefit is usually a multiple of the employee’s salary (i.e. one, two, or three times their annual salary).
The company and the employee need to keep in mind that, based on IRS uniform premium cost tables, the employee must include in gross income the cost of any insurance benefit in excess of $50,000 provided by the employer. This income inclusion is usually achieved by an adjustment to the W-2s at year end or when an employee terminates employment.
Companies might also purchase a life insurance policy on a specific employee or group of employees. These specific policies may have the company as the owner and beneficiary.
There are several reasons why a company would choose to insure the life of an employee. The person may be a key individual within the organization, and the insurance proceeds could be used for recruiting and/or the salary of a replacement, if necessary.
Life-insurance policies may also be used to provide supplemental funding in a buy/sell agreement or business-succession plan. Life-insurance policies are even sometimes used as supplemental funding for outstanding debt guaranteed by an officer/employee.
Over the past several years, there has been a lot of buzz about employer-owned life-insurance policies because there have been some recent tax-law changes. The general tax rule is that premiums for life insurance, where the company is the beneficiary, are not deductible. Premiums on policies where the employee names a family member as beneficiary are a taxable fringe benefit.
This benefit is includable in their W-2 and deducted as an employee benefit on the company’s tax return. Generally, life-insurance proceeds are not considered taxable income if collected upon death. However, if the policy is surrendered early, then the proceeds are taxable to the extent they exceed the premiums paid. Corporations must also consider any AMT preferences regarding life insurance in their ACE calculation.
The IRS has instituted new rules on documentation and reporting of employer-owned life insurance policies issued after Aug. 17, 2006. Here are some of the specifics:
• Notice and consent requirements must be completed before the contract is issued.
• The employee must be notified in writing that the employer intends to insure the employee’s life. The notification must state the maximum face amount of the life-insurance contract to be issued.
• The employee must provide written consent to being insured and acknowledge that such coverage may continue if the employee were to terminate employment.
• The employee must be made aware that the employer will be a beneficiary of any proceeds paid under the terms of the contract. Usually this consent is prepared by the insurance agent, but it is important that a company retain a copy in its files.
The IRS has issued Form 8925, Report of Employer-owned Life Insurance Contracts, which is now required to be filed with the employer’s business tax return. Information required for Form 8925 (on policies issued after Aug. 17, 2007) includes:
• Total employees;
• The number of employees with employer-owned life insurance contracts (with ‘employees’ including common-law employees, officers, directors, and highly compensated employees);
• The total value of all employer-owned life insurance contracts; and
• The number of contracts that do not have employee consent.
It is imperative that companies make their tax preparer aware of the existence of any of these policies. Proper completion of the documentation and reporting process is required to ensure that any death proceeds of an employer-owned life-insurance contract are received income-tax free.
Failure to comply with the mandated documentation and reporting requirements could result in the proceeds from these contracts, in excess of premiums, being considered taxable income, and the increase in taxes could be severely detrimental to the company, negating the original intent of supplemental funding.
Your tax advisor should be able to help you ensure that you have adhered to all of the necessary requirements, and also assist with any prior filings which may be required if information had been inadvertently omitted from prior-year tax returns.
Companies may also enter into life-insurance contracts called split-dollar life-insurance arrangements. These contracts are usually for specific employees, particularly higher-level employees, where this arrangement becomes part of the overall compensation package. The employee is generally the policy owner, and the company will generally pay the premiums for such policies.
In this instance, the employee chooses their beneficiary. The tax rules around recognizing the expense and benefits of these policies changed for policies issued after Sept. 17, 2003.
There are two different calculations required for taxing split-dollar life-insurance arrangements: an economic-benefit approach and a loan approach. If the employer pays the premiums, the premium payments are treated as a loan, with interest accruing until repaid at death or surrender.
The economic benefit arises from the employee’s interest in the current life-insurance protection. The nuances of these approaches can get complex, but a trusted tax advisor or insurance agent can assist with the details of these arrangements.
If a company is considering the purchase of life insurance for its employees, for any of the varied reasons, they should take the time to consult with their insurance agent and tax preparer to ensure the contracts are structured for maximum tax effectiveness.
Catherine Curry, CPA is a tax manager with the Holyoke based public accounting firm, Meyers Brothers Kalicka; (413) 322-3544; [email protected]