The general rule under IRC Section 101(a) is death benefits paid with a life insurance policy are not subject to federal income tax, whether or not the policy beneficiary is an individual, business, trust or estate. The longstanding exception to this general rule has been the Transfer-for-Value scenario where a policy, prior to the insured’s death, has been sold by the policyholder to a new owner.
Section 101(j) offers and additional exception to the general rule, one that creates a significant consequence and one that is often overlooked. This provision, which applies to certain Employer-Owned Life Insurance (EOLI) policies, imposes a fare more dangerous tax trap because it does not involve the post-issue transfer of an already existing in-force policy, but instead the commonly encountered situation of business owners taking out coverage on key employees. The 101(j) rule carries with it the risk of a permanent negative impact on the policy’s tax benefit if the administrative steps aren’t precisely followed during the application process.
Click here to download the employer-owned life insurance guide provided by the Principal Life Insurance Company.