1. The first depends on the insured’s status as an employee.
The exception will apply if the insured under the contract was:
- An employee at any time during the 12 months prior to his or her death, or
- A director or a highly compensated employee or individual at the time the contract was issued.2
2. The second exception occurs when the death benefits are either:
- Paid to the insured’s estate, family members or other designated beneficiaries (other than the policyholder), or
- Paid to a trust for the benefit of any such individuals, or
- Used to purchase an equity (or capital or profits) interest in the applicable policyholder from any person described above.
These exceptions apply only if the notice and consent requirements are met before the issuance of an EOLI contract.
As a general rule, whenever a business entity owns a life insurance policy (including wholly owned corporations and sole proprietorships), specifically in these business succession strategies:
- Entity redemption buy-sell The business owns the policy insuring the business owner and receives the death benefits to fund the owner’s buyout.
- Lifecycle buy-sell A separate partnership or LLC holds life insurance on the owners of an operating business to fund the buy-sell of the operating business.
- Key person life insurance A business owns the policy to protect it against the loss of a key employee, owner, director, etc.
- Changes or exchanges of grandfathered policies Any change to a grandfathered policy or an IRC §1035 exchange of a grandfathered policy for a new policy if there is:
- A material increase in the death benefit, or
- Another material change in the policy.
The IRS stated that life insurance policies issued in cross purchase arrangements generally will not qualify as EOLI contracts for purposes of IRC §101(j).3
To fit within any exception to EOLI taxation, policyholders must satisfy certain notice and consent requirements prior to issuance of the EOLI contract. The IRS issued the following guidance regarding compliance with the notice and consent requirements:1
The employee must receive written notification that the applicable policyholder intends to insure the employee’s life; reasonably expects to purchase a specified maximum amount of life insurance (stated either in dollars or as a multiple of salary) on the employee during the employee’s tenure; and will be a beneficiary of any proceeds payable upon the death of the employee.
The employee must provide written consent to being the insured and to the continuation of coverage after termination of the insured’s employment. The contract must be issued:
- Within one year after the employee’s consent, or
- Before the termination of the employee’s employment — whichever is earlier.
EOLI compliance is the policyholder’s responsibility. In any potential EOLI situation involving a Minnesota Life Insurance Company or Securian Life Insurance Company policy, there are two steps:
- The employer must sign a copy of Minnesota Life Insurance Company’s form F66015 or Securian Life Insurance Company’s form FSL-66015, “Employer Notification Regarding the Potential Taxation of Death Benefits,” before the policy is issued, and return it to the financial representative. This form simply notifies the employer of its potential obligations under these rules. It does not relieve the employer of its obligation to obtain a signed notice and consent from the prospective insured.
- The client should discuss the EOLI rules with an attorney and, if the EOLI rules apply, obtain a signed notice and consent from the insured before the policy is issued. A sample “Insured’s Acknowledgement of Notice and Consent — Employer Owned Life Insurance Policy” is located at the end of the buy-sell foreword to counsel.
- The employer must obtain a signed form from each prospective insured before the policy is issued.
- The employer should retain these signed forms and file them along with their life insurance policies.
- The employer must also report these policies to the IRS annually by attaching completed Form 8925 to the employer’s annual income tax return.
While the IRS presumes that an employee will receive a separate form for notice and consent, a recent private letter ruling by the IRS held that a separate document was not required where the totality of the applicable policyholder’s documentation in connection with the EOLI contract evidenced that all the notice and consent requirements were met prior to contract issuance (specifically a buy-sell agreement and a life insurance application, both executed by the insured employee prior to issuance of the contract, which together contained all the required notice and consent information).4
For existing EOLI contracts
An employer may be able to show evidence of notice and consent without separate documentation if it can demonstrate that all required notice and consent information was included in one or more documents that were provided to and/or executed by the insured employee prior to the contract’s issuance.
For newly issued contracts
Obtaining a separately executed notice and consent form from the insured employee will more easily and clearly document compliance.
In addition, EOLI policyholders must file Form 8925 with their annual federal tax returns for each year that an EOLI contract is owned to report certain information regarding EOLI contracts, including the number of employees insured, the total insurance held under EOLI contracts and the number of non-consenting insured employees (if any). The policyholder must also keep whatever records may be necessary to evidence compliance.
The only situations in which the IRS will not challenge inadvertent failures to satisfy the Notice and Consent requirements are when:5
- The applicable policyholder made a good faith effort to satisfy the notice and consent requirements (e.g., maintains a formal system for notice and consent for new employees);
- The failure to satisfy the requirements was inadvertent; and
- The failure to obtain the notice and consent was discovered and corrected by the due date of the tax return for the taxable year in which the EOLI contract was issued (failure to obtain consent cannot be corrected if the insured employee has died).
Otherwise, removing the “taint” of an improperly issued EOLI contract often involves 1) canceling the existing policy and issuing a new one, or 2) affecting a material increase in the policy death benefit or other material change in the contract. The notice and consent requirements must be satisfied prior to the issuance of a new policy or a material change in an existing policy.