The income taxation of life insurance death benefits seems fairly simple initially. Many people know the general rule that death benefits are not subject to income tax. However, there are exceptions that can apply which will cause the beneficiary to owe income tax on the receipt of death benefits. This article describes certain of these situations.
Generally, the receipt of life insurance death benefits is exempt from income tax.1 Most of the time, this general rule will protect beneficiaries from being taxed upon the death of the insured. However, there are certain exceptions. In those cases, death benefits are subject to income tax. As will be discussed below, some of the more often applicable exceptions relate to either employer owned life insurance2 or transfers for valuable consideration.3 Under the 2017 Tax Cuts and Jobs Act (“TCJA”), a new exception was codified for “reportable policy sales”4 as well as new reporting requirements.5 On October 31, 2019, the IRS released final regulations relating to reportable policy sales and the associated reporting obligations.6
With the TCJA’s doubling of the estate tax exemption as well as the adoption of more favorable tax consequences from life settlement transactions7, it is likely many policyholders will look to engage in transactions involving sales of life insurance policies. Of course, even without these changes, any number of transactions may involve the transfer of a life insurance policy, directly or indirectly. Whenever such a transaction takes place, including M&A transactions involving entities owning life insurance, it is important to consider the tax consequences.
Employer Owned Life Insurance
In 2006, rules were adopted which apply to any “employer-owned life insurance contract.”8 An “employer-owned life insurance contract” is one which:
- Is owned by a person engaged in a trade or business under which such person (or certain related parties) is directly or indirectly a beneficiary under the contract; and
- Covers the life of an insured who is an employee with respect to the trade or business of the applicable policyholder on the date the contract is issued.9
It is important to know that the term “employee” includes not only actual employees, but also owners of at least 5% of the business.10 In these cases, absent qualification for an exception, death benefits will be subject to income tax to the extent death benefits exceed the sum of premiums and other amounts paid for the contract.
The primary exceptions are: (a) amounts paid to family or for family to purchase equity interests in the employer;11 and (b) satisfaction of certain notice and consent requirements.12 The notice and consent requirements are satisfied when the employee:
- Is 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 was issued;
- Provides written consent to being insured under the contract and that such coverage may continue after the insured terminates employment;
- Is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee.13
Satisfaction of these notice and consent requirements avoids income tax on the death benefits subject to certain reporting requirements.14 Anytime life insurance is being purchased in a business context, including insurance funded buy-sell agreements, these requirements should be considered. In Notice 2009-48, the IRS has issued a Q&A which is designed to answer questions about these rules and the related exceptions.
Transfers for Value
Another exception to the general non-taxability of life insurance death benefits is any transfer for valuable consideration.15 When there is a “transfer for value,” death benefits are taxable to the extent death benefits exceed the sum of (a) actual consideration paid for the transfer, (b) and premiums and other amounts paid with respect to the interest in the contract.
The transfer for value rule is often swallowed by its exceptions. The two exceptions are:
- If such contract or interest therein has a basis for determining gain or loss in the hands of a transferee determined in whole or in part by reference to such basis of such contract or interest therein in the case of the transferor (i.e. carry-over basis transactions); or
- If such transfer is to the insured, to a partner of the insured, to a partnership in which the partner is a partner, or to a corporation in which the insured is a shareholder or officer.16
Many standard M&A transactions will fall within one of these exceptions, protecting many business transactions from rendering life insurance death benefits taxable. However, that is not always the case. The IRS has issued Rev. Rul. 2009-14 which provides examples of how the transfer for value rule may apply in three alternative situations. Over the years, there have been a number of Private Letter Rulings addressing when a transfer for value will be deemed to have occurred and when the above-reference exceptions will apply.
Reportable Policy Sales
As part of the TCJA, new rules were adopted for “reportable policy sales.”17 These rules are separate and distinct from the rules applicable to employer-owned life insurance and transfers for value. Therefore, even where those provisions would not cause death benefits to be taxable, a reportable policy sale will trigger taxation.
A “reportable policy sale” is “the acquisition of an interest in a life insurance contract, directly or indirectly, if the acquirer has no substantial family, business, or financial relationship with the insured apart from the acquirer’s interest in such life insurance contract” and “the term ‘indirectly’ applies to the acquisition of an interest in a partnership, trust, or other entity that holds an interest in the life insurance contract.”18
As with the employer-owned life insurance and transfers for value, reportable policy sales are subject to certain exceptions. A full discussion of these exceptions is beyond the scope of this writing, but the general exceptions are as follows:
- Certain transactions involving C corporations when life insurance contracts do not comprise more than 50% of the gross value of assets of the corporation immediately before the acquisition;
- Acquisitions of certain entities owning where life insurance do not comprise more than 50% of the gross value of assets of the entity and the acquirer owns less than 5% of the entity;
- Transfers between entities with the same beneficial owners;
- Transfers between entities consolidated for income tax purposes;
- Transactions with parties having a qualifying substantial relationship to the insured (as clarified under the regulations); and
- Qualifying section 1035 exchanges of life insurance policies.19
In addition to the substantive rules involving reportable policy sales, there are important reporting requirements.20 The addition of reportable policy sales to the landscape of life insurance income tax planning has added significant complexity both substantively and with the new reporting requirements.
Any time parties engage in transaction involving life insurance, these rules should be considered. These transactions include acquisition of life insurance policies in many business contexts, direct transfers of policies, and transfers of interests in entities owning policies. As described above, proper planning can often allow the transaction to qualify for an exception to the rules causing income taxation. When an exception cannot be met, it is important for the parties involved to understand the consequences and plan accordingly. Likewise, when there has been a previous transaction, there may be possibilities to “cleanse” prior failure to comply with an exception to taxation. It is important to involve appropriate planners in any of these situations.
- IRC § 101(a)(1).
- IRC § 101(j).
- IRC § 101(a)(2).
- IRC § 101(a)(3).
- IRC § 6050Y.
- T.D. 9879. https://s3.amazonaws.com/public-inspection.federalregister.gov/2019-23559.pdf
- TCJA § 13521(a) amended § 1016(a) to clarify that the cost basis of a life insurance policy in a life settlement transaction is not reduced by the cost of insurance as previously required under Rev. Rul. 2009-13. For a discussion of this change see Mendelsohn, Jason T., “Spotlight on Life Settlement Transactions: Getting the Best Value,” The Tax Advisor, June 1, 2019, https://www.thetaxadviser.com/issues/2019/jun/life-settlement-transactions-best-value.html#fn_3.
- See supra Note 2.
- IRC § 101(j)(3)(A).
- IRC §§ 101(j)(5)(A) and 414(q).
- IRC § 101(j)(2)(B).
- IRC § 101(j)(2)(A).
- IRC § 101(j)(4).
- IRC § 6039I. Generally, the filing of IRS Form 8925 which is filed each year by the employer.
- See supra Note 3.
- See supra Note 4.
- See supra Note 6.
- See supra Note 5. Generally, the person acquiring a policy in a reportable policy sale must file a return with the IRS and furnish written information to the recipient and the issuer. Additionally, the issuer must file a return and furnish information to the seller. Likewise, there are new reporting requirements for each person making a payment of reportable death benefits. See IRS Forms 1099-LS, 1099-SB, and 1099-R.