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 3rd 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:
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:
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:
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.