The Greatest Tax per Dollar |

Recently we were engaged by a CPA to help clean up a mess that will create a huge and completely unnecessary income tax for their client, and a likely lawsuit to them as the advisor. What could possibly cause such havoc?

A business owner client has become terminal and in review of their life insurance they’ve discovered that the policies are owned by the business, however in our audit we notated that no one had filed any Notice & Consent forms that are required by federal law IRC 101(j), and under the ruling the death benefits will now be considered ordinary income to the business and fully taxed.

That’s right, a tax-free death benefit would now become income-taxed unnecessarily because someone forgot to file a few pieces of paper.

A Bad Idea: Donating 50% of your Death Benefit Proceeds to the IRS

The crazy thing is the policies were term policies with nominal premiums. So how do these numbers sound: Annual premium paid of $4,000 x 6 years (not deductible), and a taxable death benefit of $5,000,000. So the client would have paid in $24,000 total and yet pay a tax of $2,000,000+. Sound like a bad trade-off? It is. In fact, the EOLI violation tax often represents the highest tax paid per dollar outlaid.

That’s not the only economic damage, what happens to the client’s financial plan if they only now receive 1/2 of the death benefit proceeds that they needed for their planning? It fails, that’s what happens.

Who is Responsible for this 101(j) Failure?

Unfortunately for the advisor, if the policies are income-taxed then they will likely be sued, the question is will their malpractice cover advice on life insurance policies as a non-licensed professional? If not, the tax liability will now be their personal liability. Unfortunate for all.

This is the 3^rd time in the last 6 months we have seen this planning error by a trusted advisor/professional. And the only reason these were discovered was because receipt of the benefit is now forthcoming, but they were not able to figure out a solution so needed to hire us resolve the problem. This is a problematic issue. A trusted advisor should not be putting their clients and themselves at unnecessary risk. So let’s give you the 101 basics of 101j.

Recap of EOLI 101(j) Requirements

There is a maze of complexities and detailed scenarios under the law but the general premise includes these main points:

All employer owned life insurance policies issued after enacted date of August 17, 2006.
Includes business (entity purchase) buy-sell, key person, 409A deferred compensation, split dollar, et al.
Notice & Consent forms must be issued to Employee PRIOR to policy issue and annual premium payments, and recorded with Employer form 8925 filed with IRS annually. There are some exceptions but often not met.
One missed filing fails the requirements test, and is subject to potential income taxation.

If you have business life policies and need more information on the complete legislation and how it may impact your policies, please contact us and we will send you a EOLI 101(j) compliance package.

A Real Expensive Issue that Plagues the Industry

So here are a couple of reality checks:

Every time we’ve analyzed business policies in our Risk Reviews, and the policies were issued after Aug 2006, they have failed the proper reporting.
These policies will either lapse or pay claims. On the later, there will be massive unneeded taxation that someone will likely get sued for malpractice. We can’t imagine a case where the amount was small enough the advisor would escape lawsuit by their client.
Advisors tend to want to put their head in the sand and hope the issue will just go away. It won’t. So fix the problem, and fix it now, or reap the whirl-wind!

How to Fix the Problem

Here’s what you shouldn’t do. Don’t decide to retroactively manufacture documents. If Form 8925 is not filed to the Service, then they have the timing to prove the Notice-Consents weren’t done properly. You would also be at risk of fraud. Don’t play this game.

So here’s your legitimate options:

Write new policies: this obviously only works with healthy clients. In the above scenario the client would not qualify so this is not an option. There are other obvious repercussions with rewriting policies including the economic feasibility including increased premiums. Be careful in replacing policies.
Change of Ownership: you can assign and transfer ownership of the policy from the business to an outside party, such as the insured, and back to the business. However, if cash value policies you may trigger tax with the transfer, so be careful.
Recharacterize the policy for Private Retirement. You can transfer the policy to a PRT to facilitate your current plan. The PRT is tax-neutral to ensure all the death benefits are retained in full, tax-free. You also add the asset protection element to your current plan as death benefits paid from a PRT are exempt from creditors. But this tactical planning requires expertise so be careful not to unnecessarily trigger other issues.

The Bottom Line: Be Careful! Hire an expert that is aware of all the ramifications and implications and can help mitigate or at least substantially reduce both client and advisor risk. More importantly, now that you know about this insidious tax land-grab, don’t ever buy a policy with the business/employer as owner without ensuring ALL proper administration is properly in place BEFORE you implement them.

In this way, you can ensure not to forfeit half your tax-free death benefits to the IRS. Why would anyone possibly want to do that?? Because they don’t know what they don’t know, and the IRS likes it that way.

Do you want a short checklist to see if you qualify or violate 101(j) requirements? Click here for more info.

The Greatest Tax per Dollar…and Totally Unnecessary