Business-Owned Life Insurance: Handle With Care
Business-owned life insurance (BOLI) serves a number of legitimate purposes, including succession and estate planning. A big advantage of using life insurance is that the proceeds typically are tax free. But there have been abuses, particularly by large companies that purchased insurance on the lives of lower-level employees, often without their knowledge. Indignation over these so-called “janitor policies” led Congress to add Section 101(j) to the Internal Revenue Code (IRC) as part of the Pension Protection Act of 2006 (PPA).
Even though this provision is intended to prevent abusive employment practices, it is broad enough to encompass life insurance used to fund a buy-sell agreement or for other estate planning purposes. So if your business owns or plans to purchase policies on the lives of key employees (including owners), it is critical to comply with Section 101(j) to avoid unintended — and potentially disastrous — tax consequences.
What does Section 101(j) do?
Section 101(j) establishes a general rule that BOLI proceeds are taxable (to the extent they exceed the employer’s basis in the policy); however, it also provides two exceptions. The first exception is for certain owner/employees and highly compensated executives. Unlike rank-and-file employees, the business has a legitimate “insurable interest” in these employees.
The second exception is for BOLI used for certain succession or estate planning purposes. Provided a business meets the notice and consent requirements, the insurance proceeds will not be taxable if they are 1) paid to the insured employee’s estate or heirs (or a trust for their benefit) or 2) used to purchase an ownership interest in the business from the insured’s estate or heirs. Under IRS guidance issued in 2009, the ownership interest must be acquired no later than the due date, including extensions, of the company’s income tax return for the taxable year in which the death benefit is paid.
What is required?
If one of the exceptions applies, a business is not home free yet. To avoid taxation of BOLI, it also must satisfy Section 101(j)’s notice and consent requirements — before a policy is issued. To comply, the business must ensure that an insured employee, including an owner:
- Is notified in writing that the company intends to insure his or her life and of the maximum face amount of the coverage at the time the policy is issued,
- Provides written consent to being insured and to continuation of coverage after his or her employment with the company ends, and
- Is informed in writing that the company will be a beneficiary of the policy’s death benefits.
After the notice and consent requirements are met, the policy must be issued within one year after the consent is signed or before termination of the employee’s employment with the company, whichever is sooner.
What about existing policies?
The requirements described above apply to insurance policies issued after PPA’s effective date (Aug. 17, 2006). They also apply to older policies that are materially modified (by substantially increasing the death benefit, for example) after that date.
If your company owns noncompliant BOLI policies, you may obtain tax-free benefits by surrendering the policies and purchasing new ones that satisfy Section 101(j)’s requirements.
Avoid unpleasant tax surprises
If your business uses BOLI for estate or succession planning purposes, consult your advisors to be sure that your policies comply with Section 101(j)’s requirements. Failure to do so can result in significant, unexpected tax liabilities.
Sidebar: BOLI and the company’s tax return
The Pension Protection Act of 2006 (PPA) also added Section 6039I to the Internal Revenue Code. That section requires companies with one or more business-owned life insurance (BOLI) policies to file an annual return with the IRS showing:
- The number of employees at the end of the year,
- The number of employees insured under BOLI policies at the end of the year,
- The total amount of BOLI in force at the end of the year, and
- The company’s name, address, taxpayer ID and type of business.
The return must also include a representation that the company has a valid consent for each insured employee or, if it does not, the number of insured employees for whom no consent was obtained.
Do not underestimate the importance of ESOP valuations
If you decide to implement an employee stock ownership plan (ESOP) at your company, you will need to have the company appraised by a third-party valuator.
The rules governing these arrangements require valuations to ensure ESOPs pay no more than fair market value for shares of their related companies. Noncompliance with valuation rules could subject your business to costly excise taxes as well as trigger litigation by unhappy ESOP participants. An appraiser will review your company’s financial statements, assessing information such as:
- Historical earnings and projected future earnings capacity,
- Operational history and financial strength,
- Dividend-paying capacity,
- Goodwill and other intangible value,
- Recent stock sales,
- Amount of debt, and
- The regional and national economic outlook.
In addition, the valuator will consider the industry’s history and economic forecast and the market price of publicly traded companies in the same business or similar ones. He or she may even make one or several on-site visits to interview management and other key employees.