Advisor Guide to IRC 101(j) Compliance AVOIDING POTENTIAL TAXATION OF EMPLOYER-OWNED LIFE INSURANCE

Transcription

1 Advisor Guide to IRC 101(j) Compliace AVOIDING POTENTIAL TAXATION OF EMPLOYER-OWNED LIFE INSURANCE

2 Employer Owed Life Isurace Compliace with IRC Sectios 101(j) ad 6039I IRC Sec. 101(j) applies to policies issued after August 17, 2006 (or issued pursuat to a 1035 exchage with material icreases to the death beefit or material chages to the policy) i which a busiess is the ower of the policy, the busiess is directly or idirectly the beeficiary, ad a employee is the isured. The geeral rule is that death beefits paid from a life isurace policy subject to IRC Sec. 101(j) are taxable whe received. I order to avoid taxatio of the death beefits you must qualify for oe of the followig exceptios. The isured is a director or highly compesated employee 1 The employee/isured was employed by the busiess o later tha 12 moths prior to death The death beefits are payable to the employee s heirs (family members, trust, estate) The death beefits are used to purchase a iterest i the busiess I additio to qualifyig for a exceptio, the employer must provide the isured employee with writte otice statig That the busiess iteds to isure the life of the employee ad that coverage may cotiue after the employee termiates employmet, That the busiess will be the beeficiary of the life isurace policy, ad The maximum amout of life isurace coverage the busiess will obtai o the employee. The isured employee eeds to coset i writig to beig isured ad to havig coverage cotiue after they termiate their employmet PRIOR TO ISSUANCE OF THE POLICY. I order to avoid taxatio of the death beefits the busiess also must report to the IRS (o IRS Form 8925): The umber of employees of the applicable policyholder at the ed of the year, The umber of such employees isured uder such cotracts at the ed of the year, The total amout of isurace i force at the ed of the year uder such cotracts, The ame, address, ad taxpayer idetificatio umber of the applicable policyholder ad the type of busiess i which the policyholder is egaged, ad That the applicable policyholder has a valid coset for each isured employee (or, if all such cosets are ot obtaied, the umber of isured employees for whom such coset was ot obtaied). 1 The highly compesated requiremet ca be met by ay of the followig: Isured employee has compesatio i excess of the 414(q) limit ($105,000 i 2008) Isured employee is amog the top 35% i pay IRC Sec. 105(h) Isured employee ows 5% or more of the busiess

3 IRS Notice I Jue of 2009 the IRS published additioal guidace o IRC 101(j) i the form of IRS Notice The Notice provides guidace i five differet areas: 1 The defiitio of employer owed life isurace 2 Exceptios to the applicatio of 101(j)(1) timig of the otice ad coset requiremet 3 Satisfactio of the otice ad coset requiremet 4 Trasitio rules ad 1035 exchages 5 Iformatio Reportig uder 6039I ad Form 8925 Oe of the most frequetly asked questios has bee whether or ot ay relief is available for iadvertetly failig to comply with the otice ad coset requiremets. With regards to that questio the Notice stated the followig: Q-13. How ca a iadvertet failure to satisfy the otice ad coset requiremets of 101(j)(4) be corrected? A-13. Sectio 101(j) does ot cotai a provisio for correctig a iadvertet failure to satisfy the otice ad coset requiremets of 101(j)(4). The Service will ot, however, challege the applicability of a exceptio uder 101(j)(2) based o a iadvertet failure to satisfy the otice ad coset requiremets if the followig coditios are met: (1) the applicable policyholder made a good faith effort to satisfy those requiremets, such as by maitaiig a formal system for providig otice ad securig cosets from ew employees; (2) the failure to satisfy the requiremets was iadvertet; AND (3) the failure to obtai the requisite otice ad coset was discovered ad corrected o later tha the due date of the tax retur for the taxable year of the applicable policyholder i which the employer-owed life isurace cotract was issued. Because 101(j)(4)(B) requires that the employee s coset be writte, failure to obtai such coset caot be corrected after the isured employee has died. While Notice is effective Jue 15, 2009, the IRS will ot challege a taxpayer who made a good faith effort to comply with IRC 101(j) based o a reasoable iterpretatio of the statutory provisio prior to the effective date. The iformatio cotaied herei is ot iteded as legal, tax or accoutig advice. All plaig ad desig alteratives should be discussed with your legal, tax ad accoutig advisors/professioals.

4 PLR I Private Letter Rulig the taxpayer requested a rulig from the IRS that the taxpayer did ot violate the otice ad coset requiremet of IRC 101(j) because they had made a good faith effort to comply pursuat to Notice The taxpayer (a employer) purchased isurace policies o shareholders of the busiess i order to fud a buy-sell agreemet. The facts state that the taxpayer did NOT provide each isured with a separate documet that cotaied all of the ecessary otice ad coset iformatio. However, the IRS looked at the applicatio for isurace alog with the buy-sell agreemet ad determied that: 1 Through the Buy-Sell agreemet ad the life isurace applicatio, each shareholder was otified i writig that the taxpayer (employer) iteded to isure their lives; 2 Through the applicatio, each shareholder was otified i writig of the maximum face amout for which the shareholder could be isured at the time the cotract was issued, i dollars; 3 By sigig both the buy-sell agreemet ad the life isurace applicatio, each shareholder coseted to beig isured uder the cotract; 4 By sigig the agreemet, each shareholder coseted that such coverage may cotiue after the shareholder termiates employmet; ad, 5 Through the agreemet ad the applicatio, each shareholder was iformed i writig that the taxpayer will be a beeficiary of ay proceeds payable upo the death of the shareholder. Due to these fidigs of fact the IRS ruled that the taxpayer had satisfied the otice ad coset requiremets of 101(j) before the policies were issued. It is importat to cosider a umber of importat facts regardig this guidace from the IRS 1 There were specific provisios i the buy-sell agreemet that lead the IRS to determie that the shareholders coseted that the coverage could be cotiued by the employer after they termiated employmet [which is a requiremet uder 101(j)]. May buy-sell agreemets do ot cotai the laguage used i this buy-sell agreemet ad would therefore fail to meet this particular requiremet. 2 While the employer did ot obtai separate documetatio from each shareholder that expressly complied with the otice ad coset requiremets PRIOR to the issuace of the policies, they did i fact obtai separate documetatio after the policies were issued (but ot before the due date of the taxpayer s federal icome tax retur). The fact that they did obtai the separate documetatio most certaily helped the taxpayer i this case argue that they had acted i good faith. 3 Private letter ruligs are directed oly to the taxpayer requestig them ad caot be used or cited as precedet for other taxpayers. Based o these facts, i order to avoid havig the death beefits o employer owed policies subjected to icome taxes, it is still highly recommeded that employers comply with all of the otice ad coset requiremets of 101(j) prior to havig life isurace policies coverig the lives of employees issued.

5 Exhibit 1 IRS Form 8925 Form 8925 (Rev. Jauary 2010) Departmet of the Treasury Iteral Reveue Service (99) Name(s) show o retur Report of Employer-Owed Life Isurace Cotracts Attach to the policyholder s tax retur See istructios. Idetifyig umber OMB No Attachmet Sequece No. 160 Sca to access IRS Form 8925 olie or visit the website below Name of policyholder, if differet from above Type of busiess Idetifyig umber, if differet from above apps3.irs.gov/pub//irs-pdf/f8925.pdf 1 Eter the umber of employees the policyholder had at the ed of the tax year Eter the umber of employees icluded o lie 1 who were isured at the ed of the tax year uder the policyholder s employer-owed life isurace cotract(s) issued after August 17, See Sectio 1035 exchages o page 2 for a exceptio Eter the total amout of employer-owed life isurace i force at the ed of the tax year for employees who were isured uder the cotract(s) specified o lie a Does the policyholder have a valid coset (see istructios) for each employee icluded o lie 2? Yes No b If No, eter the umber of employees icluded o lie 2 for whom the policyholder does ot have a valid coset b Geeral Istructios Sectio refereces are to the Iteral Reveue Code uless otherwise oted. Purpose of Form Use Form 8925 to report the umber of employees covered by employer-owed life isurace cotracts issued after August 17, 2006, ad the total amout of employer-owed life isurace i force o those employees at the ed of the tax year. Policyholders must also idicate whether a valid coset has bee received from each covered employee, ad the umber of covered employees for which a valid coset has ot bee received. See sectios 101(j) ad 6039I, ad Notice , I.R.B. 1085, for more iformatio. Defiitios Employer-owed life isurace cotract. For purposes of Form 8925, a isurace cotract is a employerowed life isurace cotract if it is owed by a policyholder as defied below, ad covers the life of the policyholder s employee(s) o the date the life isurace cotract is issued. If you have master cotracts, see sectio 101(j)(3) for additioal iformatio. Policyholder. For purposes of Form 8925 ad these istructios, a policyholder is a "applicable policyholder" as defied i sectio 101(j)(3)(B). Geerally, a policyholder is the perso who ows the employerowed life isurace cotract, ad who is (a) egaged i a trade or busiess that employs the perso isured uder reasoably expects to purchase with the employer-owed life isurace regard to the employee durig the cotract ad (b) the direct or idirect course of the employee's teure. beeficiary of the employer-owed life Additioal otice ad coset are isurace cotract. required if the aggregate face amout of Related perso. A related perso is the employer-owed life isurace cosidered a policyholder if that perso cotracts with regard to a employee is (a) related to the policyholder (defied exceeds the amout of which the earlier) uder sectios 267(b) or 707(b) employee was give otice ad to which (1), or (b) egaged i a trade or busiess the employee coseted. See Q&A-9 uder commo cotrol with the ad Q&A-12 i Notice policyholder. See sectios 52(a) ad (b). 2. Provide writte otificatio to the Employee. Employee icludes a employee that the policyholder will be a officer, director, or highly compesated beeficiary of ay proceeds payable employee uder sectio 414(q). upo the death of the employee. Isured. A idividual must be a U.S. 3. Receive writte coset from the citize or residet to be cosidered employee. See Valid coset uder the isured uder a employer-owed life istructios for lie 4a. isurace cotract. Both idividuals Electroic otificatio ad coset. covered by a cotract coverig the joit The writte otificatio ad coset lives of two idividuals are cosidered NAME AND requiremet ADDRESS OF ca CARRIER: be met electroically isured. oly if the system for electroic Notice ad coset requiremets. To otificatio ad coset meets qualify as a employer-owed life requiremets 1 through 3, above. See isurace cotract, the policyholder Q&A-11 i Notice for more must meet the otice ad coset iformatio. requiremets listed below before the 1. EMPLOYEE Issue (PROPOSED date of INSURED) cotract. INFORMATION Geerally, the issuace of the cotract. issue date of a life isurace cotract is 1. Provide writte otificatio to the the date o the policy assiged by the employee statig the policyholder isurace compay o or after the date iteds to isure the employee s life ad of applicatio. For purposes of meetig the maximum face amout for which the the otice ad coset requiremets, the employee could be isured at the time issue date of the employer-owed life the cotract was issued. Occupatio isurace cotract is the later of (1) the date of applicatio of coverage, (2) the The writte otificatio must iclude effective date of coverage, or (3) the a disclosure of the face amout of life 2. EMPLOYER formal (OWNER) issuace INFORMATION of the cotract. See isurace, either i dollars or as a Q&A-4 i Notice for more multiple of salary, that the policyholder Full Legal Name iformatio. For Paperwork Reductio Act Notice, see page 2. Cat. No A Form 8925 (Rev ) Sca to access Notice ad Coset form olie or visit the website below Employer_Coset_Notice.pdf Exhibit 2 Sample Notice ad Coset Form NOTICE AND CONSENT TO EMPLOYERS APPLICATION FOR LIFE INSURANCE Full Name (First, Middle, Last. Iclude maide ame i paretheses.) Geder Date of Birth Social Security Number F M MM/DD/CCYY Street Address City State Zip Code Street Address City State Zip Code 3. NOTICE BY EMPLOYER (OWNER) a. Employer iteds to apply for isurace o the life of the Employee (Proposed Isured). b. The maximum face amout the Employee (Proposed Isured) could be isured for at the time the cotract is issued is $ c. The Employer will be the Ower of ay policy issued ad a beeficiary of ay proceeds payable upo the Employee s (Proposed Isured s) death. 4. CONSENT OF EMPLOYEE (PROPOSED INSURED) a. I coset to beig a isured uder the life isurace policy for which my Employer iteds to apply. b. I coset to my Employer cotiuig coverage, after my employmet eds, uder ay policy issued. c. I uderstad that my Employer will ow the policy. Uless provided i a separate agreemet, my Employer will receive all of the death proceeds, ad my persoal represetative, ext of ki, ad heirs at law will have o beeficial iterest i the policy or its death proceeds. AGREEMENT AND AUTHORIZATION This form is provided as a coveiece to the Employer ad to obtai iformatio that may be eeded for iformatio reportig services. By providig this form, the carrier makes o represetatio that completig it will costitute compliace with ay law or regulatio, tax or otherwise. Federal tax law specifies that the death beefits of certai employer-owed life isurace cotracts will ot be completely excluded from federal gross icome of the Employer uless otice-ad-coset requiremets ad other requiremets specified i the law are fulfilled. The carrier ad its represetatives ad distributors do ot provide tax or legal advice. The carrier did ot accept this form for use by ay taxpayer to avoid ay Iteral Reveue Service pealty. You should ask your idepedet tax ad legal advisors for advice based o your particular situatio. A photocopy of this form shall be as valid as the origial. Sigature of Employee (Proposed Isured) Date Sigature of Employer (Ower) Date Title

6 IRC Sectios 101(j) ad 6039I Worksheet The Pesio Protectio Act of 2006 cotaied a umber of provisios dealig with the taxatio of employerowed life isurace. The Act added Iteral Reveue Code (IRC) Sectios 101(j) ad 6039I to the IRC i a attempt to curtail what they perceived to be abuses by busiesses of the favorable tax treatmet afforded life isurace death beefits. I November of 2007, the Iteral Reveue Service (IRS) issued temporary regulatios regardig employer-owed life isurace (effective November 13th, 2007). The Service released fial regulatios November 6, 2008, specifyig reportig requiremets uder Code 6039I. The fial regulatios provide guidace as to how the requiremets of 6039I should be applied. If you are ucertai whether or ot IRC Sectios 101(j) ad 6039I apply to a particular life isurace policy, or if you are ucertai what must be doe to assure the death beefits are received tax-free, please follow the steps below. Step 1: Do IRC Sectios 101(j) ad 6039I apply to your case? Was the policy issued after August 17, 2006? OR Was the policy issued pursuat to a 1035 exchage with material icreases to the death beefit or material chages to the policy? 1 q Yes q No Is the busiess (or a related party ) 2 the ower of the policy? q Yes q No Is the busiess (or a related party ) directly or idirectly the beeficiary? q Yes q No Is the isured a employee of the busiess (o the date the policy is issued)? q Yes q No If you aswered YES to EACH questio above, the IRC sectios 101(j) ad 6039I do apply to your life isurace case Move o to Step 2. If you aswered NO to ANY questio above, the IRC sectios 101(j) ad 6039I do ot apply to your life isurace case. Step 2: Icome tax treatmet of employer-owed life isurace death proceeds. Geeral Rule: Death beefits (i excess of the cumulative premiums paid) are icluded as icome for icome tax purposes uless you qualify for oe of the exceptios. Is the isured a director or highly compesated employee? 3 q Yes q No Was the employee employed by the busiess o later tha 12 moths prior to death? Are the policy death beefits payable to the employee s heirs (family members, trust, their estate)? Will the policy death beefits be used to purchase a iterest i the busiess from the isured s family, estate or trust? q Yes q Yes q Yes q No q No q No If you aswered YES to ANY of the questios above, you have met oe of the exceptios to the geeral rule of taxig employer-owed life isurace death beefits. You must comply with otice ad coset requiremets as well as reportig ad recordkeepig requiremets Move o to Step 3. If you aswered NO to EACH questio above, the the isured employee does ot qualify for a exceptio from the geeral rule of taxig employer-owed life isurace death beefits: The death proceeds may be subject to icome tax whe paid.

7 Step 3: Notice ad Coset Requiremets I order to avoid taxatio of employer owed life isurace death beefits, you are required to meet the followig otice ad coset requiremets prior to the issuace of the policy: Notice required: The busiess must provide the isured employee with writte otice statig That the busiess iteds to isure the life of the employee ad that coverage may cotiue after the employee termiates employmet, That the busiess will be the beeficiary of the life isurace policy, ad The maximum amout of life isurace coverage the busiess will obtai o the employee. Coset required: The isured employee eeds to coset i writig to be isured ad to havig coverage cotiue after they termiate their employmet. Move o to Step 4. Step 4: Reportig ad Recordkeepig Requiremets I order to avoid taxatio of employer-owed life isurace death beefits, you are required to meet the followig reportig ad recordkeepig requiremets: Reportig Requiremets: Aually, the applicable policyholder (the employer) shall report to the IRS (via IRS Form 8925) The umber of employees of the applicable policyholder at the ed of the year The umber of such employees isured uder such cotracts at the ed of the year The total amout of isurace i force at the ed of the year uder such cotracts The ame, address, ad taxpayer idetificatio umber of the applicable policyholder ad the type of busiess i which the policyholder is egaged That the applicable policyholder has a valid coset for each isured employee (or, if all such cosets are ot obtaied, the umber of isured employees for whom such coset was ot obtaied) Recordkeepig: Each applicable policyholder owig oe or more employer-owed life isurace cotracts durig ay year shall keep such records as may be ecessary for purposes of determiig whether the requiremets of Sectios 101(j) ad 6039I are met. 1 Techical Explaatio of H.R. 4, August 3, Material icrease i death beefit/material chages i the cotract: Icreases i the death beefit that occur as a result of the operatio of sectio 7702 of the Code or the terms of the existig cotract, provided that the isurer s coset to the icrease is ot required, will ot cause a cotract to be treated as a ew cotract. I additio, certai chages to a cotract will ot be cosidered material chages so as to cause a cotract to be treated as a ew cotract. These chages iclude admiistrative chages, chages from geeral to separate accout, or chages as a result of the exercise of a optio or right grated uder the cotract as origially issued. 2 A related perso is either a perso who is egaged i busiess havig a commo cotrol (withi the meaig of IRC Secs. 52(a) or (b)) or a perso havig a relatioship defied i IRC Secs. 267(b) or 707(b)(1). 3 The highly compesated requiremet ca be met by ay of the followig: Isured employee has compesatio i excess of the 414(q) limit ($105,000 i 2008) Isured employee is amog the top 35 percet i pay IRC Sec. 105(h) Isured employee ows 5 percet or more of the busiess Isured employee is amog the top 5 highest paid officers of the busiess

8 Relevat IRC Sectios IRC Sec. 267(b) - Relatioships The persos referred to i subsectio (a) are: (1) Members of a family, as defied i subsectio (c)(4); (2) A idividual ad a corporatio more tha 50 percet i value of the outstadig stock of which is owed, directly or idirectly, by or for such idividual; (3) Two corporatios which are members of the same cotrolled group (as defied i subsectio (f)); (4) A grator ad a fiduciary of ay trust; (5) A fiduciary of a trust ad a fiduciary of aother trust, if the same perso is a grator of both trusts; (6) A fiduciary of a trust ad a beeficiary of such trust; (7) A fiduciary of a trust ad a beeficiary of aother trust, if the same perso is a grator of both trusts; (8) A fiduciary of a trust ad a corporatio more tha 50 percet i value of the outstadig stock of which is owed, directly or idirectly, by or for the trust or by or for a perso who is a grator of the trust; (9) A perso ad a orgaizatio to which sectio 501 (relatig to certai educatioal ad charitable orgaizatios which are exempt from tax) applies ad which is cotrolled directly or idirectly by such perso or (if such perso is a idividual) by members of the family of such idividual; (10) A corporatio ad a partership if the same persos ow (A) more tha 50 percet i value of the outstadig stock of the corporatio, ad (B) more tha 50 percet of the capital iterest, or the profits iterest, i the partership; (11) A S corporatio ad aother S corporatio if the same persos ow more tha 50 percet i value of the outstadig stock of each corporatio; (12) A S corporatio ad a C corporatio, if the same persos ow more tha 50 percet i value of the outstadig stock of each corporatio; or (13) Except i the case of a sale or exchage i satisfactio of a pecuiary bequest, a executor of a estate ad a beeficiary of such estate. IRC Sec. 267(c)(4) Family Defied The family of a idividual shall iclude oly his brothers ad sisters (whether by the whole or half blood), spouse, acestors ad lieal descedats. IRC Sec. 707(b)(1) Parter Relatioships (A) A partership ad a perso owig, directly or idirectly, more tha 50 percet of the capital iterest, or the profits iterest, i such partership, or (B) Two parterships i which the same persos ow, directly or idirectly, more tha 50 percet of the capital iterests or profits iterests. IRC Sec. 101(j)(3)(A)(i) Employer Owed Life Isurace Defied The term employer-owed life isurace cotract meas a life isurace cotract which is owed by a perso egaged i a trade or busiess ad uder which such perso (or a related perso described i subparagraph (B)(ii)) is directly or idirectly a beeficiary uder the cotract, ad (ii) covers the life of a isured who is a employee with respect to the trade or busiess of the applicable policyholder o the date the cotract is issued. Ash Brokerage 7609 West Jefferso Blvd. Fort Waye, IN (260) AM-8613 Rev. 05/12