Business Life Insurance Checklist: Questions to Settle Before You Buy

The Checklist: Questions to Settle Before the Policy Is Issued

Area 1: Ownership and insurable interest

• Who will own the policy: the business, a co-owner or a trust?
• Does the owner have an insurable interest under the applicable state's law? State rules vary.
• For a buy-sell agreement, will the arrangement be a cross-purchase or an entity purchase? In a cross-purchase, each owner owns a policy on the others. In an entity purchase, also called a redemption, the business owns the policies.
• If the business is the owner, is it an "applicable policyholder"? Under § 101(j)(3)(B), that is the owner engaged in a trade or business, and the term includes certain related persons and businesses under common control.

Area 2: Premium payment and deductibility

• Who pays the premiums, and is the business "directly or indirectly a beneficiary"? If it is, § 264(a)(1) allows no deduction for those premiums.
• For an executive bonus arrangement, the business pays a premium on a policy the executive owns, as compensation. "Section 162 plan," "executive bonus plan," "restricted executive bonus arrangement" (REBA) and "double bonus" are industry terms. They are not qualified plans, and they are not terms defined in the Code or regulations.
• Section 162(a)(1) allows a deduction for "a reasonable allowance for salaries or other compensation for personal services actually rendered." The bonus is generally income to the employee. Whether a bonus is reasonable, and whether it is deductible, turns on the facts. How these rules affect cost is explained in business life insurance cost.

Area 3: Death-benefit tax treatment

• Will proceeds be paid to the business or to a co-owner? The answer determines which rules apply. Beneficiary choices are covered in naming a business as beneficiary.
• Has the policy been transferred, or will it be? Under § 101(a)(2), after a transfer for valuable consideration the exclusion "shall not exceed" the consideration paid plus the premiums and other amounts the transferee pays afterward.
• Does an exception apply? The rule does not apply to a transfer with a carryover basis. It also does not apply to a transfer "to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer." A co-shareholder is not on that list.
• For an employer-owned contract, does § 101(j) apply? If it does, is there both a § 101(j)(2) exception and pre-issuance notice and consent? The fuller tax picture is explained in business life insurance tax treatment.

Area 4: EOLI notice, consent and Form 8925

Under § 101(j)(4), before issuance the employee must be:

• notified in writing that the policyholder intends to insure the employee's life, and of the maximum face amount;
• asked to give written consent to being insured, and to coverage continuing after employment ends;
• informed in writing that the policyholder will be a beneficiary.

Other questions in this area:

• Does a § 101(j)(2) exception apply? The insured may have been an employee within the 12 months before death. The insured may have been, at issuance, a director, a highly compensated employee, or a highly compensated individual, under the definitions § 101(j)(2)(A)(ii) cross-references, with "35 percent" substituted for "25 percent" in the latter. Alternatively, proceeds may go to the insured's family, designated beneficiary, trust or estate, or be used to buy an equity interest from those persons.
• Who counts as an employee? Notice 2009-48 (A-5) confirms that "employee" includes an officer, director and highly compensated employee.
• Is a wholly owned corporation exempt? No. Notice 2009-48 (A-7) states that § 101(j)(4) gives no exception for a wholly owned corporation and its employee-owner. It adds that actual knowledge cannot substitute for written notice and consent.
• Does Form 8925 apply? The Form 8925 instructions define "policyholder" as an applicable policyholder under § 101(j)(3)(B). Who must file, and when, is stated in those instructions and is confirmed for each business.

Area 5: Business purpose and documentation

• Is the business purpose documented: key-person protection, buy-sell funding, loan collateral or an executive benefit?
• Does a written buy-sell agreement name the funding mechanism, and do the beneficiary designations match it and any loan agreement?
• Does SBA SOP 50 10 8.1 call for insurance and a collateral assignment on this loan?
• Will the policies be revisited when ownership, key personnel or business value changes?

Hypothetical example: a three-owner S corporation

This example is hypothetical. It assumes an S corporation with three equal shareholders, each working in the business as an employee. The corporation plans an entity-purchase buy-sell funded by policies it will own on each shareholder.

1. Ownership: the corporation owns three policies, one per shareholder, and is the beneficiary of each.
2. Premiums: the corporation is a beneficiary, so § 264(a)(1) allows no deduction for any of the three premiums.
3. Employer-owned status: the corporation is engaged in a trade or business and is the beneficiary, and each insured is an employee at issuance. Under § 101(j)(3), each policy is employer-owned.
4. Notice and consent: each insured needs three written items before issuance. Three insureds times three items each equals nine written items, all completed before issuance.
5. Exceptions: a shareholder who is a highly compensated employee at issuance may meet the status exception. Proceeds used to buy shares from a deceased owner's estate may meet the heirs exception. Either exception counts only together with step 4.
6. Reporting: Form 8925 is considered for the corporation as an applicable policyholder.

The example shows the sequence of questions. It does not predict any reader's result.

Common Gaps That Create Tax or Coverage Problems

Most problems trace back to an answer settled late or not at all.

1. Notice and consent after issuance. Section 101(j)(4) requires both "before the issuance of the contract." Notice 2009-48 (A-13) says the statute has no correction provision. It adds that the IRS will not challenge an exception if three conditions are met: a good-faith effort was made, the failure was inadvertent, and the failure was corrected no later than the due date of the return for the year of issue. Consent cannot be corrected after the insured has died.
2. Relying on an exception alone. A § 101(j)(2) exception lifts the cap only for a contract "with respect to which the notice and consent requirements of paragraph (4) are met."
3. Overlooking Form 8925. The form is a separate item from notice and consent, and its own instructions govern filing.
4. Labeling instead of analyzing. If the business is directly or indirectly a beneficiary, § 264(a)(1) disallows the premium deduction whatever the arrangement is called.
5. Agreement and ownership misaligned. Entity-owned policies funding a cross-purchase, or owner-held policies funding a redemption, can put proceeds in the wrong hands. Fixing that may require a transfer, which raises § 101(a)(2) questions.
6. No review after a business event. A departure, an ownership change, a valuation shift or a loan payoff can leave coverage or ownership out of step with the plan.
7. Misreading the SBA rule. SBA SOP 50 10 8.1 requires life insurance only in its stated circumstances. For each policy it requires, the SOP says SBA Lenders "must obtain a collateral assignment" that is "acknowledged by the Home Office of the Insurer" and "must ensure that the Applicant/Borrower pays the premiums on the policy."

When to Get Individual Advice

Several items on this checklist turn on facts that a general page cannot know. These include notice and consent under § 101(j), Form 8925 reporting, premium deductibility under § 264(a)(1), executive bonus deductibility and reasonableness of compensation, transfers of policies between owners, SBA or lender collateral assignment requirements, and business valuation for buy-sell funding. All of them need individual review of the contracts involved by the insurers and a qualified tax professional.

The deciding facts are the business form, the ownership structure, the insured's status on the issue date, the policy terms, and the specific loan or agreement. Who owns the contract matters: Notice 2009-48 (A-1) states that a contract owned by the owner of an entity engaged in a trade or business is not an employer-owned contract, and A-3 states that ownership by a partnership or sole proprietorship does not prevent a contract from being treated as one.

State law adds another layer. Insurable interest, beneficiary designation, replacement and free-look rules vary by state, and they are confirmed with an insurance professional licensed in the relevant state. Notice 2009-48 is described here as of its date. Whether later guidance modified it is confirmed before relying on it.