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Wednesday, October 6, 2010

Think your life insurance proceeds are income tax free? Maybe not, under new rules


One of the key income tax benefits of life insurance policies is that, in general, proceeds received by the beneficiary on the death of the insured are excluded from income for tax purposes. This is true whether proceeds are received from a policy payable to the estate of the insured, to a family member or trust, or to an employer.

The Pension Protection Act of 2006 created a new rule to protect employees against certain life-insurance-related abuses by their employers. If notice isn’t given to the employee and consent received, the employer’s ability to exclude life insurance proceeds from income may be limited to only the premiums and other expenses paid.

Now IRS guidance on how to comply with these rules has been issued in IRS Notice 2009-48, published and effective on June 15, 2009. Employers won’t want to lose this potential exclusion from income, so it’s important to make sure to comply with these rules.

When the Rules Do and Don’t Apply

  • The rules generally apply if the insured was an employee, director, officer or independent contractor of the policy owner or a related business at the time the policy was issued. The rules don’t, however, apply to:
  • Policies owned by qualified retirement plans,
  • Policies owned by one business owner on the life of another owner (typically used for buy-sell agreements), or
  • Policies owned by and payable to a business if the policies are used to buy out an equity interest from a family member of the insured, or a related trust or estate.

The rules also don’t apply if the insured was still an employee at any time during the twelve months before death.

The New Guidelines

Notice 2009-48 spells out guidelines regarding the notice and consent requirements, such as that:

  • The notice be in writing,
  • The notice be prior to the issuance of the policy — but not more than one year prior to it,
  • The notice indicate the maximum face value of the policy at the time of issuance,
  • The employee provide written consent, and
  • The consent includes acknowledgment that the coverage could continue after employment has terminated.

The notice covers additional technicalities as well. For example, one consent for multiple policies is acceptable; notice and consent can be done electronically; and even an owner-employee must receive notice. The rules also can apply to split-dollar arrangements with respect to policies owned by the employer.

A material increase in the death benefit at a subsequent time, or other material changes, will require new notice and consent as if it were a new policy. But the tax-free exchange of a policy for a substantially similar one won’t be considered a new policy.

Annual Reporting Required

Finally, the employer must report to the IRS annually on Form 8925. This reporting consists of disclosing:

  • The number of total employees,
  • The number who are insured,
  • The total amount of insurance in force, and
  • The type of business.

The business also must certify that consent has been obtained from each insured employee.

Failure to Comply can be Costly

In most cases, compliance with these rules isn’t terribly burdensome. But failure to comply could be very costly. Now that the IRS has issued guidance, be sure you are carefully following the rules.

 

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