Group Term Life Insurance and Imputed Income: Do You Have It Right?

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1 Group Term Life Insurance and Imputed Income: Do You Have It Right? Many, if not most, employers make group term life insurance available to their employees on their own lives and, often, on the lives of their dependents. Coverage may be paid for by the employer, the employee, or both, and, if paid by the employee, premium contributions may be made pre-tax or after-tax. The income tax rules attached to this very common employee benefit, however, are, in our experience, less well understood than you might think. Understanding these rules and a thoughtful plan design can help minimize adverse tax consequences. The following summarizes some of the aspects of group term life insurance that employers may want to consider in structuring life insurance benefits. This information is provided for purposes of general education; it should not be construed as legal or tax advice, and employers and employees or other plan participants are urged to consult their qualified advisors regarding the specific consequences of the applicable tax and other rules. Things to remember about group term life insurance: Employer-paid coverage of more than $50,000 on the life of an employee may cause income to be imputed to the employee under Section 79 of the IRC There is no exclusion from gross income for coverage on the life of a spouse or other dependent unless it is employer-provided and $2,000 or less; Code Section 79 does not apply to dependent coverage, which is instead taxed under Code Section 61, and the cost of the dependent coverage may be imputed as income to the employee A plan that is 100% employee-paid may still cause income to be imputed under Code Section 79 if the plan s premium rates straddle the IRS uniform monthly premium rates In determining the cost of insurance under the uniform premium rates, employers are required to use each employee s and/or dependent s age attained as of 12/31 of the year for which the calculation is being made; costs are prorated for coverage of less than a complete month Optional employee life insurance may be paid for with pre-tax contributions if there is also a cafeteria plan in place; remember that pre-tax contributions are treated as employer contributions, so that the insurance would be provided by the employer and coverage over $50,000 subject to imputed income even if there is no straddling 1

2 Optional dependent coverage is not a qualified benefit under a cafeteria plan and must always be paid for with after-tax contributions FICA and Medicare taxes are required to be paid and withheld on income that is imputed to active employees on account of group term life insurance coverage; if the employees are terminated or retired, they must pay those taxes themselves, although the employer must still withhold its portion I Internal Revenue Code Section 79. Under Section 79 of the Internal Revenue Code, employees may exclude from their gross income up to $50,000 (plus the amount, if any, of their after-tax contributions for coverage) of group term life insurance provided by an employer. The cost or value of the life insurance coverage (not the premium), in excess of $50,000 is imputed as income to the employee, and FICA and Medicare taxes must be paid and withheld on those amounts (and paid, but not withheld, for terminated or retired employees who might be covered.) The exclusion is based on the employee s tax year; an employee covered under multiple policies provided by the employer would have only one $50,000 exclusion under Code Section 79 for the year. The value of life insurance coverage is determined using the age-banded Table 1 uniform premiums/$1,000 of monthly coverage provided under Dep t of Treasury Regulations Section (popularly referred to as the Table 1 Rates.) Under the regulations, an employee s age for any year is the age attained as of December 31. The IRS significantly lowered the Table 1 Rates in 1999 but they remain higher than most group premium rates, so that it is relatively common for participants to have income imputed to them for this benefit. Life insurance provided to an employee can qualify as group term life insurance subject to Code Section 79 if it is: provided under a policy carried directly or indirectly by an employer to a group of employees (generally more than 10 and including former and retired employees, but excluding directors and partners), and the policy death benefits are excludible from gross income under Code Section 101(a)(1); that is, they are received under a life insurance contract and paid by reason of the death of the insured (thus, neither the portion of employer-paid premiums attributable to, nor the value of, travel or accidental death benefits are excludible from gross income under Code Section 79), and the amount of insurance provided to each employee must be computed under a formula that precludes individual selection, which, under the applicable regulations, means it can be based on age, years of service, compensation (including multiples of salary) or position. 2

3 For most large employers, the applicable non-discrimination rules are not an issue, but group term life insurance plans may not favor key employees as to either eligibility or benefits; if they do, the key employees must include the entire cost of insurance in their gross income because they lose the Code Section 79 $50,000 exemption. Another issue that sometimes comes up under Code Section 79 is how many policies are in effect; under the applicable rules, two or more policies sold by the same insurer are aggregated and treated as a single policy even if the premiums are actuarially sufficient to support the respective policies, unless the employer elects to treat them as separate policies. To do that, the premiums must be properly allocated to each policy, and each policy must be analyzed as to whether it is carried by the employer, and thus subject to Section 79. II Some plan designs limit employer-paid life insurance coverage to $50,000, and/or allow participants to waive coverage over that amount, so that they can take advantage of the exclusion without having additional income imputed to them. And, for supplemental or optional plans that allow employees to elect life insurance coverage over $50,000, there are generally no tax implications for employees who pay the entire cost of coverage, as long as the employer is not subsidizing, directly or indirectly, the cost of the insurance. In our experience, there are three aspects of group life insurance plans that tend to be problematic for employers: whether the plan is subsidized or otherwise carried by the employer, whether contributions are made by the employer or by the employee; and how to treat dependent life insurance coverage. Employer Subsidy. A plan may be carried by the employer even if it is 100% employee-paid and merely arranged by the employer. Besides being used to determine the cost of insurance, the Table 1 Rates are used to ascertain whether a plan is carried by the employer. A plan is not carried by the employer if the cost of the insurance for all employees is either above or equal to the Table 1 Rates, or below or equal to the Table 1 Rates. But a plan is subsidized and, therefore, carried by the employer within the meaning of Code Section 79, if the plan rates straddle the Table 1 Rates, i.e., the cost for some employees is above those rates, but for some employees is below the Table 1 Rates. Straddling is likely to occur, for example, under a plan that provides coverage at a uniform or composite premium rate; the imputation of income under Section 79 (as well as the exclusion, if applicable) would apply, even if the coverage is 100% employee-paid. However, income is only imputed to an employee whose cost (reduced by the amount of the employee s after-tax contributions) is less than the 3

4 Table 1 Rates; employees whose costs exceed the Table 1 Rates will not have imputed income. Cafeteria Plans. Group term employee life insurance coverage that exceeds $50,000 is a qualified benefit under a cafeteria plan for which contributions may be made pretax. It is important to remember, however, that pre-tax contributions made under a cafeteria plan are treated as employer contributions, not employee contributions; therefore, the cost of the insurance cannot be reduced by the amount of premium contributions in determining how much income to impute. Dependent life insurance coverage is not a qualified benefit under a cafeteria plan. As employers think about designing a supplemental life insurance program, there may be reasons affirmatively to cause a plan to be either subject to, or excluded from, Section 79. For example, if there is no underlying employer-paid base plan, or the coverage under the employer-paid plan is less than $50,000, the balance of the Section 79 exemption can be applied to the supplemental plan. Pre-tax contributions could be made for such coverage but would not be available to reduce the amount of any imputed income. Similarly, the employer should analyze the plan rates in relation to the Table 1 Rates to determine whether the application of Section 79 is more or less advantageous to their workforce - employees whose plan rates are less than the Table 1 Rates may be better off not having Section 79 apply, rather than having income imputed and taxed as ordinary income. Conversely, employees whose plan rates are higher than the Table 1 Rates are better off under getting the Section 79 exclusion because no income will be imputed to them if their coverage exceeds $50,000. If an employer intends to cause a supplemental life insurance plan to be subject to Section 79, the premium rates must straddle the Table 1 Rates, either by using a single premium rate (because it affects participants differently based upon their ages) or by having rates that are lower than Table 1 at some ages (e.g., 65+) and higher at other ages. III Dependent Life Insurance. Dependent life insurance is not subject to Code Section 79 because it is not insurance on the life of the employee. Rather, dependent life insurance is taxed under Code Section 61, and the $50,000 exemption from gross income does not apply to the cost of coverage on spouses and other dependents. Under Code Section 132, it appears that employer-provided dependent life insurance of $2,000 or less still can be excluded from the employee s gross income as a de minimis fringe benefit. However, there exist Dep t of Treasury regulations indicating 4

5 that the cost of employer-provided group term life insurance on a spouse or dependent is not excludible as a de minimis fringe, but they seem not to have become effective yet, as IRS Publication 15-B, The Employer s Guide to Fringe Benefits for Use in 2012 still references the $2,000 exclusion. While the exclusion from income under Code Section 79 does not apply, the IRS has made it clear that the Section 79 Table 1 Rates are to be used to calculate the amount of imputed income attributable to dependent life insurance. The entire fair market cost of dependent coverage is included as income to the employee; it does not appear that the first $2,000 of coverage is excluded from this calculation. As with employee coverage, if the plan premiums are less than the Table 1 Rates, the difference (less the amount of employee contributions for the coverage) is imputed as income and is taxable; if the premiums exceed the fair market cost determined using the Table 1 Rates, no income is required to be imputed. The Table 1 Rates are applied taking into account the dependents age(s), using the Section 79 age as of 12/31 of current year rule, so it is imperative to have spouse birthdates and, to the extent that children s ages approach the age 25 limit of the first Table 1 Rate ageband, child birthdates as well. Spouse and dependent life insurance are not qualified benefits that can be paid for with pre-tax contributions under a cafeteria plan; the cafeteria plan rules reference group term life insurance that is includible in gross income only because it exceeds the Section 79 $50,000 limitation. Therefore, employee contributions for dependent life coverage must always be made after-tax. Currently, same-sex domestic partners cannot be treated as married or spouses under the Internal Revenue Code, and life insurance benefits provided to the same sex partner are included in the employee s gross income, using the Table 1 Rates to determine the cost of coverage. However, same or opposite-sex domestic partners may qualify as dependents under Code Section 152 if they satisfy the applicable definition of a dependent; presumably, dependent coverage of less than $2000 could be excluded from the employee s gross income as a de minimis fringe benefit. Pacific Resources Benefits Advisors, LLC does not provide legal, regulatory or tax guidance or advice. Questions regarding specific issues and application of federal, state and local laws should be addressed by your legal and tax advisors. The information in this document is intended to provide a general overview of the issues contained herein. Pacific Resources makes no representation or warranty as to the accuracy or completeness of the document, and undertakes no obligation to update or revise the document based upon new information or future changes. 5

6 TABLE 1 Uniform Premiums for $1,000 of Group-Term Life Insurance Protection 26 C.F.R (d)(2) 5-year Age Bracket Cost /$1,000 of Protection for 0ne Month Under 25 $ $ $ $ $ $ $ $ $ $ and above $2.06 Sample Calculation: Employee-Paid Life Insurance Age 55 Optional Coverage Amount $100,000* Employee Premium Contributions $252 ($100,0000/$1000 X $0.21 X 12) Table 1 Rate $0.43 Table 1 Cost of Coverage $516 ($100,000/$1,000 X $0.43 X 12) Income Imputed to Employee $264 ($516-$252) Federal Income Tax to Employee (28% $73.92 rate) * Assumes that the Section 79 exclusion has been used up under the base plan. 6

7 Pacific Resources is a leading employee benefits advisory firm servicing large, predominantly Fortune-ranked companies. Headquartered in Chicago, and with locations throughout the country, Pacific Resources partners with clients across a broad spectrum of industries to deliver complete solutions to Life, Disability, Voluntary and other non-medical benefits challenges. For over three decades, Pacific Resources unique, evidence-based insights have shaped innovative employee benefits solutions, impacting the lives of millions of employees in rewarding and binding ways. For more information, visit For more information, contact your Pacific Resources Account Executive or us at [email protected]. 7