A common business planning technique for small, closely-owned businesses is the purchase of life insurance policies to fund cross-purchase provisions in shareholder or membership agreements. Additionally, many small businesses obtain key-man life insurance to provide funds to the business in the event of the death of a key employee. A newly-enacted law impacts the tax treatment of these policies. The new legislation was enacted to address the concern of Congress over the investment of large corporations in life insurance policies insuring the lives of rank-and-file employees who were not even aware of the insurance coverage, which was payable to the corporation. However, the language of the new provision reaches many more situations than the large corporation scenario.

The receipt of life insurance proceeds upon the death of the insured is generally a tax-free event, although there are exceptions to this general rule. The Pension Protection Act of 2006 created another exception to the tax-free receipt of life insurance proceeds by enacting Section 101(j) of the Internal Revenue Code. Under Section 101(j), proceeds from certain employer-owned life insurance contracts must be included in the gross income of the beneficiary of the policy. Section 101(j) applies to life insurance policies issued after August 17, 2006, except that it does not apply to certain contracts issued after August 17, 2006 pursuant to a tax-free exchange for a contract issued prior to August 17, 2006, where the new contract insures the same individual as the exchanged contract. Additionally, certain material changes to an insurance contract made after August 17, 2006, such as a material increase in the benefits to be paid on death, will cause that contract to be treated as a new contract.

In determining whether Section 101(j) applies, the first question is whether or not there is an employer-owned life insurance policy. Generally, a life insurance policy is “employer owned” if the policyholder is engaged in a trade or business and the policy covers the life of an insured who is an employee with respect to that trade or business. In addition to traditional salaried employees, the definition of an employee for this test specifically includes an officer or director.

Small business owners may have employer-owned life insurance policies. As an example, Consider a “key employee” policy, in which a corporation buys insurance on the life of an officer of the corporation. In this situation, the corporation is the employer, and the officer is an employee. This policy would be “employer owned” even if the officer was himself a shareholder of the corporation.

Another example is a cross-purchase agreement in which shareholders of a closely held business buy life insurance on each other in order to fund buy-out provisions of shareholder agreements, and to aid in business succession so that the death of one shareholder does not disrupt the business. If the insured shareholder works as an employee of the business, or as a director or officer, then the insured shareholder is an employee for purposes of the test. Presently, it is unclear as to whether the shareholders who own the insurance policy are considered to be “engaged in the trade or business” of the corporation such that the insurance is “employer owned.” However, until the Internal Revenue Service (“IRS”) issues guidance to the contrary, it is recommended that corporations and shareholders in cross-purchase situations assume that the requirements of Section 101(j) apply. The application of this new provision is not limited to these two examples; instead, these examples are meant to show how the new provision might apply to situations commonly encountered by small business owners.

The determination of whether a life insurance policy is an employer-owned life insurance policy is made at the time the proceeds are paid. At that time, Section 101(j) will not apply if: (1) (a) the insured has been an employee at some time during the 12-month period before the insured’s death, or (b) the insured was a director, highly compensated employee1 or a highly compensated individual2 at the time the contract was issued; and (2) the “notice and consent” requirements are met. The “notice and consent” requirements are that (i) the insured receive written notice prior to the contract being issued, stating the amount of the contract, the fact that the policy may continue after the insured terminates employment, and the fact that the employer is the beneficiary of the proceeds of the policy; and (ii) the insured provide written consent prior to the purchase of the contract, such consent acknowledging the information contained in the written notice.

Hand-in-hand with Section 101(j), Congress also enacted an information reporting requirement in Section 6039I. In December of 2007, the IRS issued temporary regulations regarding Section 6039I. Under Section 6039I, for each year that an employer owns a life insurance policy, regardless of whether notice and consent have been provided, the employer must provide the IRS with an information return outlining: (1) the number of employees of the employer at the end of the year; (2) the number of such employees insured under such contracts at the end of the year; (3) the total amount of insurance in force at the end of the year under such contracts; (4) the name, address, and taxpayer identification number of policyholder and the type of business in which the policyholder is engaged; and (5) that the policyholder has a valid consent for each insured employee (or, if not all such consents are provided, the number of insured employees for whom such consent was not provided).

1 A highly compensated employee is a defined term for tax purposes. It includes a person who (i) was a “five percent owner” at any time during the preceding year or (ii) for the proceeding year had compensation from the employer in excess of $100,000 and the employee was in the “top paid group” of employees for such preceding year; “five percent owner” means an employee who owns more than five percent of the outstanding stock of the corporation or stock possessing more than five percent of the total combined voting power of all stock of the corporation, or five percent of the capital or profits interest in the employer; “top paid group” means the group consisting of the top twenty percent of employees when ranked on the basis of compensation paid during the year

2 A highly compensated individual is a defined term for tax purposes. It includes an individual who is one of the five highest paid officers, a shareholder who owns more than ten percent in value of the stock of the employer, or is among the highest paid thirty-five percent of all employees.

Because this legislation is newly enacted, there is little guidance, along with no indication of whether any alleviation of the burdensome requirements for small businesses will be forthcoming.

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