Who Should Own Business Life Insurance? Business-Owned vs. Owner-Owned Policies

Technical Summary: How Ownership Decides the Tax Regime

Either the business or an individual owner can own a life insurance policy in a business plan, and federal tax law treats the two differently. A contract owned by a business, under which the business is directly or indirectly a beneficiary, that covers the life of an employee on the date it is issued, is an employer-owned contract under section 101(j)(3)(A); a contract owned by the owner of a business to finance buying another owner's interest is not (Notice 2009-48, A-1). Which structure fits turns on the plan's purpose and the business's own facts.

The question usually comes from owners, partners and finance leads who are funding a buy-sell agreement, key-person cover or an executive benefit. The business problem comes first: a buyout obligation, the loss of a key person, or compensation for an executive. Life insurance is the funding mechanism, and its owner decides which rules attach.

In summary, four federal rules turn on ownership:

• A contract owned by a business that is directly or indirectly its beneficiary, and that covers the life of an employee on the date of issue, is an employer-owned life insurance contract (EOLI) under 26 U.S.C. § 101(j)(3)(A).
• A policy owned by an entity's owner, for example to fund buying another owner's interest, is not EOLI under IRS Notice 2009-48, A-1.
• In split-dollar, the named owner generally is the owner under 26 C.F.R. § 1.61-22(c)(1)(i), and that decides the regime.
• Under 26 C.F.R. § 20.2042-1(c)(6), incidents of ownership held by a corporation can be attributed to a decedent who is its sole or controlling stockholder, but not to the extent the proceeds are payable to the corporation; this bears on estate inclusion under 26 U.S.C. § 2042.

Separately, 26 U.S.C. § 264(a)(1) allows no deduction for premiums when the taxpayer is "directly or indirectly a beneficiary." Who receives the proceeds, and its tax effect, is covered on the site's beneficiaries page.

What Policy Ownership Means in a Business Context

A life insurance contract has three roles. The policy owner, also called the policyowner or policyholder, holds the contract's rights. The insured is the person whose life the policy covers. The beneficiary receives the death benefit. One person or entity can hold more than one role.

Ownership rights typically include the right to name or change the beneficiary, to assign or surrender the policy, and to borrow against or withdraw cash value, which is a contract feature of some permanent policies. The estate-tax regulation describes these rights in similar terms. Under 26 C.F.R. § 20.2042-1(c)(2), incidents of ownership include "the power to change the beneficiary, to surrender or cancel the policy, to assign the policy, to revoke an assignment, to pledge the policy for a loan, or to obtain from the insurer a loan against the surrender value of the policy."

In business life insurance ownership, the owner may be the entity itself (a corporation, partnership or LLC), an individual co-owner, or a trust. Whether a business can own a life insurance policy, and whether company-owned or personally owned life insurance fits, both come back to this threshold question.

The mechanics of ownership under a particular policy are set by the contract and by state insurance law, and those rules vary by state. The page How Business Life Insurance Works sets out how the roles fit together.

Applicable Federal Rules That Turn on Ownership

The Internal Revenue Code starts from a broad exclusion for death benefits. Section 101(a)(1) provides that "gross income does not include amounts received ... under a life insurance contract, if such amounts are paid by reason of the death of the insured," except as other provisions limit it. Two of those limits depend on ownership.

Employer-owned contracts. Section 101(j)(3)(A) defines an employer-owned life insurance contract as one that "is owned by a person engaged in a trade or business and under which such person (or a related person ...) is directly or indirectly a beneficiary under the contract," and that "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." Section 101(j)(1) caps the exclusion for such a contract at "the sum of the premiums and other amounts paid by the policyholder for the contract." The cap lifts only if a section 101(j)(2) exception applies and the notice and consent requirements of section 101(j)(4) were met. An exception alone does not lift the cap, and neither does notice and consent alone.

Notice 2009-48. A-1 states that a contract "owned by the owner of an entity engaged in a trade or business (such as for purposes of financing the purchase of an equity interest of another owner)" is not an employer-owned contract. A-3 states that ownership "by a partnership or sole proprietorship does not prevent the contract from being treated as" one. A-5 quotes section 101(j)(5)(A): "employee" includes "an officer, director, and highly compensated employee."

Transfer for value. Section 101(a)(2) limits the exclusion after a policy is transferred "for a valuable consideration," with exceptions. One exception covers 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."

Premiums. Section 264(a)(1) provides that no deduction is allowed for "premiums on any life insurance policy ... if the taxpayer is directly or indirectly a beneficiary under the policy or contract."

Split-dollar. Under 26 C.F.R. § 1.61-22(c)(1)(i), "the person named as the policy owner of such contract generally is the owner of such contract."

Estate tax. Section 2042(2) includes in the gross estate insurance proceeds on a decedent's life if the decedent "possessed at his death any of the incidents of ownership, exercisable either alone or in conjunction with any other person." Paragraph (c)(6) of 26 C.F.R. § 20.2042-1 addresses a decedent who is the sole or controlling stockholder of a corporation, meaning one who owned stock with "more than 50 percent of the total combined voting power." The corporation's incidents of ownership "will not be attributed to the decedent through his stock ownership to the extent the proceeds of the policy are payable to the corporation," and are attributed for any part of the proceeds not payable to or for the benefit of the corporation.

Requirements Triggered by Business Ownership

Business ownership brings conditions and a filing duty that owner-owned policies generally avoid.

Notice and consent. Section 101(j)(4) is met only if, "before the issuance of the contract," the employee:

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

Notice 2009-48, A-7 states that no exception excuses "a wholly-owned corporation and its employee-owner," and that actual knowledge does not replace the written requirement. The Form 8925 instructions add that a consent is not valid unless the contract is issued within a year after the consent is signed, or before the employee leaves, whichever is earlier.

Annual reporting. Section 6039I(a) requires every applicable policyholder owning employer-owned contracts covered by that section to "file a return" for each year the contracts are owned. The return shows the number of employees and the number insured, the total insurance in force, the policyholder's identifying information and type of business, and whether a valid consent exists for each insured employee. Section 6039I(b) also requires the policyholder to keep supporting records. The IRS form for this return is Form 8925.

Premiums. Section 264(a)(1) applies whenever the business is directly or indirectly a beneficiary, whether or not the contract is EOLI.

Split-dollar and estate attribution. For split-dollar, the named owner sets the regime. For estate tax, corporate ownership of a policy on a sole or controlling stockholder can bring in section 2042 for the part of the proceeds not payable to or for the benefit of the corporation. EOLI notice and consent, Form 8925 reporting, split-dollar ownership and estate inclusion under section 2042 each depend on the contracts involved and need individual review with a qualified tax professional.

How the Ownership Rules Work in Practice

The three structures differ mainly in who owns the policy and who receives the proceeds.

Business-owned (EOLI). The business applies for, owns, pays for and is the beneficiary of the policy. The insured is an employee, which under Notice 2009-48, A-5 includes an officer, director or highly compensated employee. The contract is EOLI under section 101(j)(3)(A). The death-benefit exclusion is capped at premiums and other amounts paid unless both an exception and pre-issuance notice and consent are present. Premiums are not deductible under section 264(a)(1), because the business is a beneficiary.

Owner-owned cross-purchase. Each owner applies for, owns and pays premiums on a policy on a co-owner's life, and uses the proceeds to buy the deceased owner's interest. Notice 2009-48, A-1 states that a contract "owned by the owner of an entity engaged in a trade or business (such as for purposes of financing the purchase of an equity interest of another owner)" is not an employer-owned life insurance contract. If the business is directly or indirectly a beneficiary, section 264(a)(1) is still in play. Where only the individual owner is the beneficiary, how the rule applies depends on the facts. The page life insurance for business partners covers partner arrangements.

Split-dollar. T.D. 9092 explains that "it is reasonable to determine tax ownership based on who is the named owner of the policy." Notice 2002-8 describes the two regimes. Where the employer is the designated owner, the benefits to the employee are taxed under the first regime, the economic benefit regime. Where the employee is the owner, the employer's premium payments are treated as loans "if the employee is obligated to repay the employer." That second regime is the loan regime. Under 26 C.F.R. § 1.61-22(j), those regulations apply to a split-dollar life insurance arrangement entered into after September 17, 2003, and an arrangement entered into on or before that date is treated as a new one if it is materially modified after that date. 'Equity' and 'non-equity' split-dollar are industry labels, not regulatory terms. The page split-dollar life insurance treats both regimes.

Partnerships and sole proprietorships. Partnership ownership does not prevent EOLI status (A-3). A sole proprietor's policy "on his or her own life" is not EOLI (A-3).

Controlling shareholders. Under 26 C.F.R. § 20.2042-1(c)(6), a corporation's incidents of ownership are attributed to a sole or controlling stockholder (more than 50 percent of the total combined voting power) for any part of the proceeds not payable to or for the benefit of the corporation, and not to the extent the proceeds are payable to the corporation. Whether that happens depends on the facts of the arrangement.

Who This Page Is For

This page is for owners of closely held corporations, partnerships, LLCs and professional practices who are weighing whether the entity or the individual owners will hold the policy. It also serves:

• C or S corporation shareholders considering an entity-purchase (stock-redemption) buy-sell agreement, where the corporation would own policies on each shareholder.
• Owners in a cross-purchase agreement, where each owner holds a policy on each co-owner.
• Employers considering key-person cover on a key employee, where section 101(j) may apply.
• Executives and employers structuring split-dollar arrangements under 26 C.F.R. § 1.61-22.
• Sole or controlling stockholders who are concerned about corporate incidents of ownership under 26 C.F.R. § 20.2042-1(c)(6).
• Finance leads who need the ownership question settled before they evaluate any strategy.

Firms organized as partnerships face the same threshold question. The site also has a page for law firms. Rules on who may own a professional practice vary by state.