Employer-Owned Life Insurance (Part 1 of 2)

by Julie Ngo

There are many situations in the business world where employer ownership of a life insurance contract on the life of an employee plays a vital role in the financial life of the business. For example, employer-owned life insurance (EOLI) can help defray the often high costs involved in recruiting and training an individual to replace a “key” employee. EOLI contracts are also commonly used as a funding source for buy-sell agreements and non-qualified deferred compensation arrangements.

Generally, under federal income tax law, ¹the proceeds of a life insurance contract payable because of the death of the insured are excluded from income. However, under IRC Sec. 101(j) the proceeds of an EOLI contract are generally excluded from income only to the extent of the premiums and other amounts paid by the policyholder for the contract. Any “excess” death benefit above this amount is included in gross income.

ITTC Sec. 101(j) also contains a series of rules which, if followed carefully, allow the total death benefit of an EOLI life insurance contract to be received income-tax free.

Key Definitions

• Employer-owned life insurance contract: A life insurance contract that is (1) owned by a person engaged in a trade or business and under which such person (or a related person) is directly or indirectly a beneficiary under the contract, and (2) which covers the life of an insured who is an employee of the applicable “policyholder” on the date the contract is issued.
• Applicable policyholder: Generally, the person who owns the contract. The term also includes any person who bears a relationship to the owner specified in IRC Sec. 267(b) or IRC Sec. 707(b)(1), or who is engaged in trades or businesses with the owner which are under “common control” within the meaning of IRC Sec. 52(a) or (b).
• Insured: An individual covered by the contract who is a U.S. citizen or resident. If the contract covers the joint lives of two individuals, the term “insured” includes both.
• Employee: In addition to the common law definition the term “employee” includes an officer, director, and highly compensated employee (as defined in IRC Sec. 414(q).

Notice and Consent

Before the EOLI contract is issued, specific “Notice and Consent” requirements must be met.

1. The employee must be notified in writing that the applicable policyholder intends to insure the employee’s life and the maximum face amount for which the employee could be insured at the time the contract is issued.
2. The employee must provide written consent to being insured under the contract and that the coverage may continue after the insured terminates employment.
3. The employee must be informed in writing that the applicable policyholder will be the beneficiary of any proceeds payable upon the death of the employee.

¹ The discussion here concerns federal income tax law. State or local law may vary.

Julie Ngo is a State Farm Insurance Agent located at 28410 Old Town Front Street in Temecula. She can be reached at (951) 695-2625.