WEALTH PRESERVATION AND TAX PLANNING ALERT www.bergersingerman.com May 2012 IRS Allows Buy-Sell Agreement and Life Insurance Applications to Satisfy Notice and Consent Requirements of Tax Code Section 101(j) Under current tax law, certain technical notice and There are certain exceptions to this general rule of taxation for employer-owned life insurance contracts. One of these exceptions applies if the amount of the death benefits was received by the insured individual who (i) was an employee of the applicable policyholder at any time during the 12-month period ending on his or her death, or (ii) at the time the contract was issued, was a director or certain highly compensated individual. Another exception applies to death benefits paid to a member of the insured’s family or to any individual who is the designated beneficiary of the insured under the contract (other than the applicable policyholder), or to death benefits used to purchase an equity interest in the applicable policyholder from a family member, trust or estate of the insured. consent requirements must be satisfied in order for employer-owned life insurance proceeds to be received tax-free. These provisions would typically affect “buysell” agreements funded by life insurance policies owned by the employer which are issued after August 17, 2006. On April 27, 2012, the IRS, in a ruling of first impression, issued Private Letter Ruling 201217017 in which a closely-held corporation failed to comply with these technical notice and consent requirements. In that ruling, the IRS examined the totality of the documents provided by the employer to its shareholder-employees in order to determine whether “in substance” these notice and consent requirements were satisfied even though “in form” these notice and consent requirements were not satisfied. These exceptions, however, apply only if each of the following notice and consent requirements are satisfied before the issuance of the life insurance policy: General Gift Tax Provisions General Provisions of Code Section 101(j) The Pension Protection Act of 2006 added Tax Code Section 101(j) which provides certain notice and consent requirements that must be satisfied in order for employer-owned life insurance proceeds to be received tax-free. Specifically, in the case of an “employer-owned life insurance contract,” the amount of death benefits excluded from the gross income of the applicable policyholder under Code Section 101(a) shall not exceed the amount of premiums and other amounts paid by the policyholder for the contract, which means that any excess death benefits will be fully taxable. An “employer-owned life insurance contract” means a life insurance contract which (i) is owned by a person engaged in a trade or business and under which that person (or related person) is directly or indirectly a beneficiary under the contract, and (ii) covers the life of an insured who is an employee of the applicable policyholder on the date the contract is issued. • 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 policy is issued; • The employee provides written consent to being insured under the policy and that such coverage may continue after the insured terminates employment; and • The employee is informed in writing that an applicable policyholder will be a beneficiary of any proceeds payable upon the death of the employee. IRS Notice 2009-48 In 2009, the IRS issued Notice 2009-48 that provided guidance concerning the treatment of employer-owned life insurance contracts under Code Section 101(j). In question 13 of that Notice, the IRS granted a remedy for certain employer-owned life insurance contracts that inadvertently failed to comply with the notice and (continued on next page ) BOCA RATON MIAMI FORT LAUDERDALE TALLAHASSEE WEALTH PRESERVATION AND TAX PLANNING ALERT www.bergersingerman.com May 2012 (continued from previous page) consent requirements of this Code Section. The Notice stated that the IRS would not challenge the applicability of an exception based on an inadvertent failure to satisfy the notice and consent requirements if: • The applicable policyholder made a good faith effort to satisfy those requirements, such as by maintaining a formal system for providing notice and securing consents from new employees; • The failure to satisfy the requirements was inadvertent; and • The failure to obtain the requisite notice and consent was discovered and corrected no later than the due date of the tax return for the taxable year of the applicable policyholder in which the employer-owned life insurance contract was issued. This Notice did not permit the failure to provide the required notice and consent to be corrected after the due date of the applicable policyholder’s income tax return for the year in which the employer-owned life insurance contract was issued. IRS Private Letter Ruling 201217017 The taxpayer in this ruling was a closely-held corporation whose shareholders were also employees of the corporation. The corporation and its shareholders entered into a buy-sell agreement which provided for the purchase by the corporation of each shareholder’s stock in the corporation upon the shareholder’s death or termination of employment with the corporation. The buy-sell agreement provided that the corporation would obtain life insurance on the life of each shareholder, and that the corporation would be the owner and beneficiary of that life insurance. If the buy-sell agreement were terminated or if a shareholder disposed of his or her interest in the corporation, the shareholder had the right to purchase the life insurance policy insuring his or her life from the corporation. Any policy not purchased by the shareholder would remain the property of the corporation. The corporation purchased life insurance contracts covering certain of it shareholders. The process of purchasing these life insurance contracts required that each affected shareholder complete an application for insurance. This application stated that the corporation would be the owner and beneficiary of the policy and the amount of coverage obtained. Prior to purchasing these life insurance contracts, the corporation did not obtain from any affected shareholder separate documentation which advised the shareholder that the corporation intended to insure the shareholder’s life and the maximum face amount for which the shareholder could be insured at the time the contract was issued, nor did the corporation inform the shareholder that the coverage may continue after the shareholder terminates his or her employment with the corporation. Similarly, the corporation did not obtain separate documentation from the affected shareholders prior to the issuance of the life insurance policies regarding each shareholder’s consent to being insured. The corporation did not obtain such documentation until after the life insurance policies were issued and after the due date of the corporation’s income tax return for the year in which such policies were issued. While noting that the corporation did not obtain from each shareholder documentation which contained all of the information required by Code Section 101(j), the IRS, after considering all of the corporation’s documentation, as a whole, concluded that the required notice and consent requirements were met before the issuance of the life insurance contracts, as follows: • Through the buy-sell agreement and the life insurance application, each shareholder was notified in writing that the corporation intended to insure the shareholder’s life; • Through the life insurance application, each shareholder was notified in writing of the maximum face amount for which the shareholder could be insured at the time the life insurance contract was issued, in dollars; (continued on next page) BOCA RATON MIAMI FORT LAUDERDALE TALLAHASSEE WEALTH PRESERVATION AND TAX PLANNING ALERT www.bergersingerman.com May 2012 (continued from previous page) • By signing the buy-sell agreement, each shareholder consented that such coverage may continue after the shareholder terminates his or her employment with the corporation; and • Through the buy-sell agreement and the life insurance application, each shareholder was informed in writing that the corporation will be the beneficiary of any proceeds payable upon the death of the shareholder. As a result, the IRS ruled that the life insurance contracts issued by the corporation did satisfy the notice and consent requirements of Code Section 101(j). Practical Significance of this Ruling Although the above-referenced ruling is not binding authority, it is encouraging to note that the IRS did not take a hard-line position with respect to this notice and consent issue (i.e., requiring separate notice and consent) but rather looked at all of the documentation provided by the employer to the shareholders to determine whether, in substance, the required information was provided by the corporation to the shareholders and whether the shareholders signed documents which, in substance, contained the relevant disclosures, thus evidencing their required consent to the issuance of the life insurance policies. The IRS in this ruling took a practical approach to this issue regarding the required notice and consent for purposes of Code Section 101(j). Taxpayers who find themselves in a similar situation involving a buy-sell agreement which was previously funded by employer-owned life insurance policies, and where there was a lack of specific documentation expressly satisfying the notice and consent requirements of Code Section 101(j), may take comfort BOCA RATON MIAMI in this ruling by examining all of the documentation, including the buy-sell agreement and the insurance application, to determine whether, in substance, the required information was provided to the shareholders and whether the shareholders signed documents which, in substance, contained the required disclosures. The information in this newsletter is of a general nature only and is not intended to be relied upon as, nor a substitute for, specific professional advice. Berger Singerman is not responsible for any loss or damage occasioned to any person in connection with acting on or refraining from action as a result of any material in this publication. The hiring of a lawyer is an important decision that should not be based solely on advertisements. Before you decide, ask us to send you free written information about our qualifications and experience. WEALTH PRESERVATION AND TAX PLANNING GROUP Nick Jovanovich (954) 712-5144 [email protected] Michael Harris (561) 893-8717 [email protected] Curtis Hunter (305) 982-4070 [email protected] Daniel Mielnicki (561) 893-8705 [email protected] Marian Nease (561) 893-8710 [email protected] Sheldon Polish (954) 712-5132 [email protected] William Shaheen (561) 893-8732 [email protected] FORT LAUDERDALE TALLAHASSEE