An insured employee passed away.... Now what?
A while back, a couple unique cases were presented for review. The cases were not related, but both had a common thread which tied them together. Let me explain.
In 2006 the Pension Protection Act was signed into law. Under this new law, modifications were made and code section 101(j) now has an impact on every business owned life insurance policy. If business owners don’t follow the guidelines correctly, death benefit on an employee could be reported as taxable income to the company.
Now to the examples.
A few weeks ago, we reviewed a company census showing insured key employees. This isn’t unusual, but it was a large list of insureds and this company obviously saw the value of those key employees. Internally we had the question as to “why” would a company go to this expense of insuring all these individuals. A quick google search answered that question as we learned that in the early years of the company a key employee passed away which caused great stress and impacted the bottom line. The company had learned how to protect themselves and other employed by insuring their key employees. It should be noted that the policies had been issued within the last 5 or 6 years. Upon review we found that the initial step has been taken to avoid a huge tax consequence. At this point no employees have passed away.
The next case is a similar story with a possible different outcome. The company had purchased insurance on their employees after the 2006 change. The goal was the same, protect the company incase something happened that could disrupt their business. However, these policies are a bit older and upon review the no steps were taken to comply with 101(j). Death Benefits payable under this structure would be taxable. Recently, a key employee passed away and claims are being filed.
The difference between these two cases was found within the carrier’s application. Shortly after 2006 insurance carriers tried to promote compliance to the new 101(j) guidelines. The difficulty is identifying who maintains the responsibility for compliance. It is a taxation issue and typically the company’s accountant, controller, or human resource director should coordinate compliance. Sadly, I’ve yet to meet a CPA who is familiar with the code or even filed the new tax form required. Surly there are very capable tax professionals out there who are aware of this, but for the majority this isn’t on their radar. A few years after 2006, insurance carriers noticed non-compliance and started including the required disclosures within their applications. This single disclosure form is the first step for compliance with 101(j). In the first example, this disclosure form was included with the carrier’s insurance application. In the second example, the form was not included with the assumption that the company would have their own procedures in place for compliance. Today, almost all insurance carriers include this disclosure form in their applications as a back up for companies who may not know about 101(j).
What to do?
Review all business owned policies and ask the employer two questions.
Is there a disclosure and consent form signed by the employee?
Is your CPA filing tax form 8925 for annual compliance?
The initial disclosure must be signed and dated prior to the issuance and delivery of the life insurance policy. If this isn’t done, you cannot make that policy “compliant”. You can’t backdate a disclosure form or a missing tax form. When the 1099 for a death claim all they need to do is look up the annually filed tax forms to verify 101(j) compliance.
How to Fix it?
If caught early enough, you could have a carrier reissue the policy after the correct disclosure and consent has been provided. This won’t work in most cases since discovery is typically made well after the policy has been issued. Another option is increasing the death benefit which causes a reissue from the insurance carrier. This material change in face could be used and disclosures again must be completed. The last step and most common is rewriting a new policy. The guidelines are clear and easy to identify non-compliant policies. A business owner would probably appreciate the comparison between the possible increased premium and the possible income taxes from the death benefit.
Since we are coming to the end of the year, it is a good time to remind business owners, CPAs and human resource departments about this little code that cause big issues.
Please let us know if you need any additional material or have further questions, (800) 418-1788.