The Pension Protection Act of 2006 New EOLI Legislation Potentially Taxes Typical Insurance Arrangements

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1 ALERT: Tax December 2006 EOLI Legislation Potentially Taxes Typical Our previous Alert, The Pension Protection Act of 2006 Changes Affecting Life Insurance Products, reviewed legislation under the Pension Protection Act of 2006 ( PPA ) that affected the taxation of employer owned life insurance, often referred to as EOLI. This Alert reviews in greater detail the potential impact of the new provisions on typical business insurance arrangements, such as insurance funded buy-sell agreements, key-man insurance policies and certain deferred compensation planning structures, like rabbi trusts. Companies involved in such insurance arrangements may now need to comply with specific notice, consent and reporting requirements in order to avoid additional income tax liability. EOLI Summary of Legislation Changes in Taxation. While life insurance proceeds generally are exempt from income tax, 101(j) of the Internal Revenue Code now provides that the applicable policyholder of an EOLI contract, generally an employer, can only exclude from gross income that portion of the death benefits equal to the premiums and other amounts paid by the policyholder for the contract. Any excess proceeds are includible in gross income and subject to federal income tax. EOLI Contracts. An EOLI contract is broadly defined to include any life insurance policy that: 1. Is owned by a person engaged in a trade or business (an applicable policyholder ) and names such person (or a related person ) as the direct or indirect beneficiary. A related person includes (1) family members listed in 267(b), (2) a corporation and an individual who owns more than 50 percent of its stock, (3) a partnership and a person owning more than 50 percent of its capital or profits interest, (4) certain relationships between trust fiduciaries and grantors and/or beneficiaries, (5) a person and a 501 organization controlled directly or indirectly by such person or his or her family, and (6) certain controlled groups of corporations and their employees. 2. Insures an individual who is an employee of the applicable policyholder on the date of the contract s issuance. GREENBERG TRAURIG, LLP ATTORNEYS AT LAW

2 An employee includes an officer, director or a highly compensated employee who (1) owned 5 percent of the employer at any time during the current or preceding year or (2) either (a) received over $100,000 in compensation (inflation adjusted) or (b) at the employer s election, had over $100,000 in compensation and was in the highest paid 20 percent of employees for such year. Notice and Consent. While the definition of EOLI contracts is extremely broad, the new statute offers several exceptions to taxation, provided that the employer meets the following notice and consent requirements prior to the issuance of any policy: Notification. The employee must receive written notification of (1) the applicable policyholder s intent to insure the employee s life; (2) the maximum face amount for which the employee could be insured at the time of issuance of the policy; and (3) the applicable policyholder s status as the intended beneficiary of the insurance policy. Consent. The employee must provide written consent to being the insured under the contract and that coverage may continue after termination of the insured s employment. Where an employer satisfies these requirements and one of the exceptions applies (discussed below), the employer may exclude from its gross income the entire amount of the death benefits received under the EOLI contract. Exceptions. The exceptions to taxation provided by 101(j) cover many of the typical circumstances where a business seeks to insure an employee. They fall into two main categories (1) exceptions based on the status of the insured (i.e., key employee exception ) and (2) exceptions dealing with amounts paid to the insured s heirs (the beneficiary exception ). Again, employers must note that these exceptions apply only to the extent that the employer has met the notice and consent requirements prior to the issuance of the insurance contract. Key Employee Exception. The death benefits under an EOLI contract will not be subject to income tax if the insured is one of the following: 1. an employee (as defined above) at any time during the 12 months prior to death; or 2. at the time the insurance contract was issued, (i) a director, (ii) a highly compensated employee, as described above (but without regard to the employer s election to include the employee in the top-paid group) or (iii) a highly compensated individual (an employee who is one of the five highest paid officers of the employer, a shareholder owning more than 10 percent of the value of the employer s stock, or is among the highest paid 35 percent of all employees). This exception covers many of the employees most businesses seek to insure and would generally be used to exclude the proceeds of a key-man insurance policy. Page 2

3 Beneficiary Exception. The amounts received under an EOLI contract will be excluded from income taxation if they are: 1. paid to (i) an insured s family member (siblings, spouse, ancestors, and lineal descendants), (ii) an individual designated as the insured s beneficiary under the contract (other than the applicable policyholder), (iii) a trust for the benefit of any of the above individuals; or (iv) the insured s estate, or 2. used to purchase an ownership interest in the employer from any person described above (the purchase must be completed by the due date of the tax return for the taxable year in which the death benefits are received), This exception should cover situations involving most insurance funded buy-sell agreements. Reporting Requirements. Regardless of whether an exception applies, an employer who owns an EOLI contract must comply with the return and recordkeeping requirements of 6039I. Effective Date. These new rules apply to EOLI contracts issued after August 17, Application to Business Arrangements Due to the PPA s broad definition of an EOLI contract, the new EOLI legislation almost certainly covers any type of key-man life insurance or insurance held by a company to fund a buy-sell agreement involving an individual who is both an owner and employee. However, the EOLI provisions may also impact insurance arrangements where the employer does not directly own the policy, such as cross purchase buy-sell arrangements, deferred compensation structures (e.g., rabbi and secular trusts), voluntary employment benefit associations ( VEBAs ) and split dollar arrangements. As discussed below, companies involved in any of these arrangements will likely need to satisfy both the notice and consent requirements and the return and recordkeeping requirements to avoid income tax and/or penalties. Buy-Sell Arrangements Redemptions. In this situation, the company has a contractual obligation to buy out the ownership interests of an owner at his or her death and may acquire insurance on the owner s life in order to fund the buy-out. Assuming the owner qualifies as an employee, then the insurance policy would constitute an EOLI contract under 101(j). However, the beneficiary exception should apply, since the company must use the insurance proceeds to purchase the deceased owner s interests. Furthermore, if the insured was a key employee of the business, then the key employee exception will also apply. Of course, the employer must have satisfied the notice and consent requirements to rely on either of these exceptions and will still need to comply with the 6039I reporting requirements to avoid penalties. Page 3

4 Cross-Purchases. Here, the remaining owners of a business, rather than the company, buy the deceased owner s interests and own the insurance policies used to fund the buy-out While the individual owners are not persons engaged in a trade or business, they may be related persons with regard to the employer, thus causing the policy to qualify as an EOLI contract. For example, where there is a buy-sell agreement between owners/employees of a company, and each owner holds a life insurance contract on the lives of the others, the arrangement may constitute an EOLI contract if any one of the owners owns more than 50 percent of the company. In this case, the contract is owned by a person related to the employer and covers an employee. Furthermore, the percentage of an individual s ownership in a company will include attribution for ownership interests held by an individual's family members, as defined in 267(c)(4) (spouse, siblings, ancestors and descendants). Accordingly, in the case of a corporation where the shareholders are two siblings and a parent, all shareholders may qualify as applicable policyholders, and any insurance policy they hold could be deemed an EOLI contract. However, if the notice and consent requirements are met, the key employee exceptions or the beneficiary exceptions will likely exclude the death benefits from tax. Non-Qualified Deferred Compensation Arrangements Rabbi Trusts. Employers frequently create rabbi trusts to fund non-qualified deferred compensation plans, and these trusts will often acquire life insurance policies to take advantage of the tax-free investment growth. Generally, rabbi trusts are classified as grantor trusts for federal income tax purposes, which means that the employer is deemed to own all the trust assets, including any insurance policy. Thus, if the policy insures an employee, it may qualify as an EOLI contract, subjecting the employer to tax under 101(j) and the reporting requirements of 6039I, unless one of the exceptions applies. Secular Trusts. Secular trusts may also be used to fund non-qualified deferred compensation plans. In general, these trusts are non-grantor trusts for income tax purposes, so the employer will not be the deemed owner of the trust assets. However, based on the related person rules, if the employer is both the grantor and fiduciary of the trust, then the employer would be a related person and an insurance policy held in the trust may be deemed an EOLI contract. If the trustee is independent, however, the related person provision will not apply. Other Employer VEBAs. VEBAs are tax-exempt entities where employers can deposit assets, including life insurance policies, to fund certain employee welfare benefit plans. Insurance policies owned by a VEBA may qualify as EOLI contracts based on the "related person" definition. Under 101(j), a tax-exempt organization is a related person with regard to the entity that directly or indirectly controls the organization. Since the employer that creates the VEBA also controls it, the VEBA may be related to the employer. Any policy owned by the VEBA may constitute an EOLI contract, subject to the tax liability and reporting requirements imposed by 101(j) and 6039I, respectively. However, since the Page 4

5 VEBA is a tax-exempt organization, the insurance proceeds payable under the EOLI contract should still avoid income taxation. The VEBA must still comply with the 6039I reporting requirements. Split-Dollar Agreements. Under split-dollar agreements ( SDAs ), an employer and employee usually share an interest in a life insurance policy insuring the employee. There are generally two types of SDAs, the endorsement agreement and the collateral assignment. Endorsement Agreements. Under an endorsement agreement, the employer owns the insurance policy with the death benefit endorsed to the employee. At the employee s death, however, the employer receives a portion of the insurance proceeds, in the amount necessary to reimburse it for the total premiums it paid on the policy by the employer. Since the employer is the owner of the contract and a beneficiary of it, at least to some potion, the EOLI provisions are applicable. However, if the employer only recovers the amount of premiums paid, there are no excess proceeds to tax under 101(j), so no income tax liability should result for the employer. As for the death benefit payable to the employee s beneficiaries, 101(j) only taxes proceeds received by an applicable policyholder or a related person. Thus, unless the employee s beneficiaries are related persons to the employer, the death benefits paid to them should pass tax free. The related person provision could cause problems in a situation where the beneficiary is a more than 50 percent owner of the business (such as when the deceased employee s ownership interest in the business passes to the same beneficiary who receives the insurance proceeds under the SDA). The beneficiary would then be a related party with respect to the applicable policyholder, and, unless an exception applied and the employer had complied with the notice and consent requirements, the proceeds would be subject to tax under 101(j). Collateral Assignments. In this arrangement, the employee owns the policy and collaterally assigns a portion of the cash value and the death benefit to the employer. Since the employer does not own the policy, it should not qualify as an EOLI contract. Again, however, one must watch for application of the related person definition. If the employee owns more than 50% of the employer, then the employee is a related person, and the insurance policy would be an EOLI contract. Benefits would be taxable unless one of the exceptions applies. '(()_ Conclusion The PPA s expansive definition of an EOLI contract, and in particular, the broad reach of the related person clause, means that the new EOLI legislation will affect the majority of business insurance arrangements. Most arrangements will avoid taxation by qualifying for one of the exceptions provided under 101(j). However, employers must comply with the notice and consent requirements before issuance of the contract before any of the exceptions will apply. If the employer does not satisfy these requirements, then the only current remedy is for the employer to cancel the original policy and have a new policy issued after satisfying the notice and consent requirements. Otherwise, none of the Page 5

6 101(j) exceptions will apply. Furthermore, whenever an insurance policy qualifies as an EOLI contract, regardless of whether an exception applies, the employer must satisfy the reporting and recordkeeping requirements of 6039I in order to avoid penalties. Thus, to take a conservative approach, businesses should satisfy the notice and consent requirements for all insurance arrangements insuring any employee of the business, where the employer is a beneficiary of the policy. *Cites: RIA, Complete Analysis of the Pension Protection Act of 2006; Steve Leimberg s Estate Planning Newsletter #1005 (August 9, 2006) at Congress Plants a Landmine, Text of Podcast of August 12, 2006, Joint Committee on Taxation Technical Explanation of the Pension Protection Act of 2006; AALU Washington Report Bulletin No , October 24, 2006; New 101(j) EOLI Rules: Important Planning Considerations, CC 06-41, AUS Online, Advanced Planning Press, LLC, 2006; 101(j). All section references are to sections of the Internal Revenue Code of 1986, as amended. Page 6

7 This Alert was written by Jennifer M. Smith, Rebecca S. Manicone and Jonathan M. Forster in the Tysons Corner office and Steven B. Lapidus in the Miami office. Questions regarding the subject matter of this GT Alert should be directed to Ms. Smith, Ms. Manicone or Mr. Forster at ; Mr. Lapidus at ; or your Greenberg Traurig liaison. Albany Amsterdam Atlanta Boca Raton Boston Chicago Dallas Delaware Denver Fort Lauderdale Houston Las Vegas Los Angeles Miami New Jersey New York Orange County Orlando Philadelphia Phoenix Sacramento Silicon Valley Tallahassee Tampa Tokyo Tysons Corner Washington, D.C West Palm Beach Zurich This Greenberg Traurig ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Traurig is a trade name of Greenberg Traurig, LLP and Greenberg Traurig, P.A Greenberg Traurig, LLP. All rights reserved. Page 7