A. Duie Latta, Esquire

Last year, a mammoth piece of tax legislation was signed into law. The Pension Protection Act of 2006 ("PPA") consists of several hundred pages of regulations regarding defined benefit plans, defined contribution plans, individual retirement accounts and various other topics. Among other things, the PPA changed the way that the proceeds of employer-owned life insurance policies are taxed. While this last sentence probably sounds dull enough to make you want to read anything other than this article, the PPA's changes to life insurance taxation could have a significant effect on how your business uses life insurance. If your company is considering obtaining life insurance on its owners or employees, some careful planning today could help you avoid a significant tax bill in the future.

Why It Matters
The PPA's changes to employer-owned life insurance are important because the PPA makes it harder to obtain the favorable tax treatment that has helped to make life insurance policies so desirable.

Some people might be surprised to know that it is common for companies to own life insurance on their employees. There are numerous reasons for this practice. For example, an employer might own "key-person" insurance so that after the death of an essential employee, the employer can use the proceeds to replace the earnings of the deceased employee (or to hire a successor or an interim replacement). Or, a privately-owned company whose owners are active in the business might use the proceeds of a life insurance policy to purchase a deceased owner's share of the business from a surviving spouse or heir. These arrangements are often established in what are called "Buy-Sell Agreements," which commonly use life insurance proceeds to fund a company's purchase of the shares of a deceased shareholder. Life insurance is often used for these agreements because of the favorable tax treatment that life insurance proceeds receive.

As a result of the PPA, in order to obtain favorable tax treatment for employer-owned life insurance, employers must satisfy certain notice, consent, reporting, and various other requirements for such policies. The favorable tax treatment that previously was almost automatically available, now requires careful planning. Additionally, employers have to satisfy the PPA's new recordkeeping and reporting requirements for life insurance policies that they own.

Fortunately for those with pre-PPA insurance, the PPA provisions only apply to employer-owned life insurance policies issued after August 17, 2006. That said, generally speaking, even for contracts issued on or before that date, if there is a material increase in the death benefit of such a contract, it will cause the contract to be treated as a new contract and it will be subject to the PPA.

The PPA's General Rule for Taxing Proceeds
Essentially, the PPA prevents some of the life insurance proceeds that an employer receives (upon death of an employee) from being automatically excluded from gross income under section 101 of the Internal Revenue Code. As a result, unless the employer satisfies one of the PPA's exceptions, a substantial portion of the proceeds of the insurance will be included in the employer's income and taxed as a result. The PPA does this by limiting how much of the proceeds of a life insurance policy the employer can exclude from its gross income. Under the PPA, the general rule is that for an employer-owned life insurance contract, the amount excluded from gross income of the policyholder cannot exceed the premiums and other amounts that the policyholder paid for the contract.

For example, suppose an employer receives $500,000 in proceeds from a policy for which it paid a total of $100,000 in premiums:

• Before the PPA - The entire $500,000 of proceeds had the potential to be automatically eligible to be excluded from the employer's income, and no tax liability would arise from the receipt of the proceeds.
  
  

• After the PPA - Unless the employer falls under the PPA's exceptions, the $400,000 of proceeds in excess of the $100,000 that the employer paid will be included in the employer's income, and subject to income tax. Assuming a 35% tax rate, this means that the $400,000 in excess proceeds will result in a tax liability of $140,000.

The PPA's limitations on employer-owned life insurance were established to eliminate what was perceived as an abuse by several public corporations that were purchasing significant amounts of life insurance on their "rank-and-file" employees. These companies would subsequently collect the tax-free proceeds of the insurance, often years after the employee had ceased to work for them. The PPA is trying to eliminate such practices by limiting favorable tax treatment to policies that meet the Notice and Consent requirements and that insure what might be called "key employees" and "current employees" or pay their proceeds to certain persons.

• is notified in writing that the employer intends to insure the employee's life and of the maximum face amount for which the employee could be insured;
• provides written consent to being insured under the contract and that such coverage may continue after the insured terminated employment;
• is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee.

The conditions that are listed above must be satisfied in order to ensure that all of the proceeds can qualify for the favorable tax treatment. Essentially, the PPA is trying to discourage employers from obtaining life insurance policies on their employees without telling them. Furthermore, the PPA requires employers to file a return that reports the numbers of employees who are insured, the amount of the insurance, and whether the employer has provided notice and consent in accordance with the PPA. The PPA also requires employers to maintain records that are sufficient to determine whether the PPA's requirements for employer-owned life insurance are met.

One way to satisfy the Notice and Consent requirements described above is to have the employee sign a notice and consent acknowledgment document before a life insurance policy is obtained for the employee. This could be accomplished in a "stand-alone" document containing the required notice and consent provisions, or in an agreement such as the employee's Employment Agreement. For employer-owned life insurance on owners who are employees or directors for the business, the Notice and Consent requirements could be contained in Buy-Sell Agreements or Shareholders' Agreements.

Recommendations
There are a number of things that employers should do if they want to retain the option of the favorable tax treatment available to life insurance proceeds.

• Before your company obtains life insurance or changes its existing policies, consult your attorney or tax consultant to make sure the proceeds will qualify for the favorable tax treatment under the PPA.
  
• Before your company obtains life insurance, make sure that it satisfies the PPA's Notice and Consent requirements, either in a "stand-alone" document, a Buy-Sell Agreement, an Employment Agreement, or in some other agreement. Your attorney can prepare such a document for you to use.
  
• Maintain records of who is insured, how much insurance has been purchased, and how you satisfied the Notice and Consent requirements, and be prepared to report this information to the IRS.
  
• Consider creating or updating a Buy-Sell Agreement for your company. Although the PPA's provisions do not require such a document, Buy-Sell Agreements should be periodically reviewed, and can be useful for satisfying the necessary PPA requirements to obtain favorable tax treatment for life insurance. Closely-held businesses especially need to review their Buy-Sell Agreements frequently since their owners' needs can change quickly.

The PPA is a complex piece of legislation, with far-reaching consequences for businesses. In particular, its effect on employer-owned life insurance can have tremendous tax implications. Careful planning and professional legal counsel is essential to yielding the best result for your business. The attorneys at MacElree Harvey can assist your business in utilizing life insurance both effectively and tax-efficiently. Please contact us for any assistance that you require.

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