Life Insurance as an employer-provided benefit

September 26th, 2019

Ellisa H. Culp, Eric D. Penkert, Thomas M. Christina

Ogletree, Deakins, Nash, Smoak & Stewart, P.C.


The structure of life insurance plans

Life insurance is among the most common employer-provided benefits and there are a few options that employers have: Employers may either:

  1. structure their life insurance plans to pay 100% of the cost of the life insurance (a non-contributory arrangement)
  2. require employees to share all or a part of the cost of life insurance ( a contributory arrangement).

The amount of employer-provided life insurance under a typical plan is either:

  1. a flat dollar amount, such as a $10,000 death benefit
  2. based on a multiple of annual pay over a specified period, such as two times annual base pay during the trailing 12 months preceding death).

Types of life insurance policies

Life insurance products vary in purpose and complexity. The following descriptions provide basic information regarding some of the policy provisions typically associated with certain types of policies.

Term life

The simplest form of life insurance is term insurance that provides insurance protection in the event of death (a death benefit) if the death occurs during a specified period of time (referred to as the “term” of the policy). Term life insurance is considered “temporary insurance” because it pays a specific sum (the “face amount”) to the insured’s designated beneficiary if the insured dies within the period covered by the policy. The primary disadvantage to a term life insurance policy is that the insured’s beneficiaries are entitled to death benefits only if the insured dies while the policy is in effect.

Whole life

Whole life insurance, on the other hand, can provide permanent life insurance protection for the insured’s entire life, usually up to age 100 (subject to compliance with the policy’s terms). A whole life policy is contractually guaranteed not to lapse, provided that sufficient premiums are paid each year to keep the policy in force. Besides permanent lifetime insurance protection, whole life insurance typically features a savings element that allows the insured to build cash value on a tax-deferred basis. A portion of the premiums paid are used to build up the savings element of the policy and are invested by the insurance company. The interest rate return on the insurer’s investment is added to the savings portion of the policy. This is how the policy builds cash value. The following three most common types of whole life insurance are:

  1. Traditional whole life - Traditional whole life insurance policies have a savings element (cash value) that grows tax-deferred in investments selected by the insurance company. If the contract is set up properly in advance, the insured can build up enough cash value to stop paying premiums by a certain age, or to borrow from the cash value (take a policy loan) during his/her lifetime on a tax-advantaged basis.  Generally, whole life insurance premiums do not increase during the insured’s lifetime (as long as the insured pays the planned amount and repays any policy loans). One disadvantage to a traditional whole life policy is that it does not offer premium or face amount flexibility since the policy terms (face amount and premium) remain fixed for life.
  2. Universal life - Universal life insurance is a flexible-premium, adjustable benefit, life insurance policy. Like traditional whole life insurance, universal life insurance features a savings element that grows on a tax-deferred basis. A portion of each premium is invested by the insurance company, often in bonds, mortgages, and money market funds. Universal life insurance policies generally guarantee a minimum rate of return, which means that, no matter how the investments perform, the insurance company will guarantee a certain minimum return on the insured’s money. If the insurance company does well with its investments, the interest rate return on the accumulated cash value will increase. The accumulated cash value may be used as a source of retirement income, or allow premium leveling (enabling the insured to pay a flat premium for life but to use the cash value to offset the increased cost of insurance as the individual ages), or provide for a vanishing premium (that is, to pay premiums for a period of time that are sufficient to build a cash value to pay all future premiums after a fixed period in time). However, if the policyholder borrows against the cash value, or if the insurance company’s investments perform poorly, the cash value may not grow sufficiently to cover future premium payments and the insured will have to continue to pay premiums to keep the coverage in force.
  3. Variable life - Variable life insurance is called “variable” because it allows the insured to allocate a portion of the premium dollars to a separate account comprised of various investment funds within the insurance company’s portfolio, such as an equity fund, a money market fund, a bond fund, or some combination thereof.  Hence, the value of the death benefit and the cash value may fluctuate up or down, depending on the performance of the investment portion of the policy. Although most variable life insurance policies guarantee that the death benefit will not fall below a specified minimum, a minimum cash value is seldom guaranteed. A variable life insurance policy is considered a securities contract because of the investment risks that are built into the policy. As a result, it is regulated as a security under federal securities laws.

Special features of whole life plans

Earnings on the investment options in a variable life insurance policy are tax deferred until the insured surrenders the policy. The insured can apply interest earned on the investments toward the premiums. However, since the insured assumes all of the investment risk, when the investment funds in the savings account perform poorly, less money is available to be applied toward premiums.  As a result, the insured may have to pay more than they can afford to keep the policy in force. Poor fund performance also means that the cash and/or death benefit may decline, though never below a defined level. Also, the insured cannot withdraw from the cash value during his or her lifetime.

Universal life and variable life products may be participating or non-participating policies. With a participating policy, the policy holder receives dividends based on the insurance company’s investment performance, mortality experience, and expenses, and the policyholder shares with the insurance company the risk that the insurance company’s investment performance and mortality experience will be favorable, limited to the total premium paid. In contrast, the policyholder of a non-participating policy pays a set premium that is not affected by the insurance company’s mortality experience and investment performance.

Life insurance policies may offer accelerated death benefits in the event that the insured becomes terminally or chronically ill. These amounts are treated as amounts paid by reason of the death of the insured. While accelerated death benefits paid to a chronically ill individual are subject to a $360 (for 2018) per day limitation, there are no limits on accelerated death benefits that are paid to terminally ill persons. Moreover, the payments made to a chronically ill person must be for costs incurred by the insured for qualified long term care services provided to the insured that are not reimbursable under Medicare, other than as a secondary payer.

A “chronically ill person” is a person who meets either one of the following criteria:

  1. is not terminally ill and who has been certified as being unable to perform without substantial assistance in at least two daily life activities (such as eating, toileting, bathing, dressing, continence, and the like) for at least 90 days
  2. is a person with a similar level of disability.

A person may also be considered chronically ill if the individual requires substantial supervision to protect himself/herself from threats to his/her health or safety because of cognitive impairment. This condition must be certified by a healthcare practitioner within the past 12 months. A “terminally ill person” is a person who has been certified by a physician as having an illness or a physical condition that can reasonably be expected to result in a death within 24 months following the certification.

Comparing the costs of each plan

Term life premiums are low compared to premiums for other types of life insurance that build cash value. Under a term life insurance policy, the insured pays only for the cost of insurance (COI) necessary to keep the life insurance policy in force, an amount that depends primarily on the age and health of the insured at the time the individual applies for coverage. Under a yearly renewable term policy, the COI is determined at the time the insured applies and the cost increases at each policy anniversary because the risk of death increases as people get older.  Under a level term policy, the COI remains level during an initial guaranteed period and then increases sharply. Term insurance is also generally less expensive than whole life insurance, especially for employees who are in good health up to about age 50. After that age, premiums become progressively more expensive as the probability of a loss due to death increases (the mortality rate).

Whole life insurance is more expensive because the policyholder is paying not only for insurance but also for the investment portion of the policy. However, premiums charged during the insured’s later years may actually be lower under a whole life policy because a portion of the actual COI in a whole life policy is funded through the accumulated cash value of the policy.

Advantages of group term life insurance

Employer-provided group term life insurance offers a number of advantages over individual term life insurance. Some of these advantages include the following:

  • protection furnished at a minimum cost so that even if the employees pay 100% of the premium, they still experience savings
  • protection provided for families of employees who may be uninsurable due to health status because evidence of insurability is generally not required if an employee enrolls when they are first eligible for coverage
  • more affordable, group-rated premiums for older employees
  • exclusion of the cost of the first $50,000 of employer-paid group term life insurance from the employee’s taxable income.

Note:

Even though group term life coverage is usually guaranteed when an employee elects the benefit when first eligible, most plans reserve the right to deny or limit coverage to employees who decline coverage when first eligible, but who subsequently apply for coverage.

Favorable tax treatment of group term life insurance coverage

One of the most significant advantages to employer-provided group term life insurance coverage is the favored tax treatment it receives. Generally, only the employer-paid cost of employer-provided group term life insurance exceeding $50,000 of coverage is includable in the employee’s gross income. However, even the cost of coverage in excess of $50,000 may be excluded from gross income for employees who have terminated employment due to disability and employees who terminate their employment because they have reached retirement age under the employer’s retirement plan. The “cost” of group term life insurance, for purposes of the gross income exclusion, is determined by reference to a uniform premium table issued by the Internal Revenue Service (IRS).

To qualify for the exclusion from gross income, the group term life insurance plan must meet all of the following requirements, plus a non-discrimination standard:

  1. the insurance must provide a general death benefit that is excludable from gross income (accidental death, travel, and double-indemnity insurance for accidental death are not general death benefits and do not qualify as group-term life insurance)
  2. the insurance must be provided for all employees or for a group of employees that is fewer than all employees if membership in the group is determined on the basis of age, marital status, or factors related to employment (if the group includes fewer than 10 employees, special rules described herein apply)
  3. the insurance must be provided under a policy carried directly or indirectly by the employer
  4. the amount of insurance provided must be based on factors such as age, years of service, compensation, or position.

Note:

Life insurance provided to a group of employees does not generally qualify as group term life insurance unless it is provided to a group of at least 10 full time employees at some time during the year. However, there are two exceptions to the 10-employee rule.

First exception

The 10-employee rule does not apply if:

  • Coverage is provided to all full time employees (if evidence of insurability affects eligibility, coverage must be provided to all full time employees who provide evidence of insurability that is satisfactory to the insurer).
  • The method for computing the amount of insurance coverage is fixed. (Coverage amounts are computed as either a uniform percentage of compensation or on the basis of coverage brackets established by the insurer. No bracket may exceed 2½ times the next lower bracket and the lowest bracket must be at least 10% of the highest bracket. Separate brackets may be established for employees age 65 or older.)
  • The evidence of insurability concerning eligibility for coverage or the amount of insurance is limited to a medical questionnaire completed by the employee that does not require a physical examination.

Second exception

The 10-employee rule does not apply for multiple employer arrangements if all three of the following conditions are met:

  1. the insurance is provided under a common plan to the employees of two or more unrelated employers
  2. the insurance is mandated for all employees of employers who belong to or are represented by a union or other organization that carries on substantial activities besides obtaining insurance
  3. evidence of insurability does not affect an employee’s eligibility for insurance or the amount of insurance provided to that employee.

In applying the exceptions, employees may be excluded if they are denied coverage on account of any one or more of the following criteria:

  • they have not yet satisfied the policy’s service requirement (which may not exceed six months)
  • they are part time employees customarily working 20 hours or less in any week, or five months in any calendar year
  • they are 65 years or older.

When applying these rules, insurance is deemed to be provided to an employee who elects not to receive insurance as long as the employee is not required to contribute to the cost of benefits other than life insurance to receive life insurance.

The definition of a key employee

A key employee is an employee who falls into one or more of the following three categories at any time during the plan year:

  1. an owner earning more than $180,000 for 2019 (adjusted for inflation)
  2. a 5% owner
  3. a 1% owner earning more than $150,000.

Discriminatory plans

If a qualified group term life insurance plan is discriminatory, the exclusion for the cost of the first $50,000 in coverage is not available to key employees. However, the exclusion would still be available for non-key employees.

A group life plan is discriminatory if it discriminates in favor of key employees with respect to eligibility to participate (eligibility test) or the type and amount of benefits available (benefits test).

  • Eligibility test - To meet the eligibility test, at least one of the following criteria must be met:​
    • the plan must benefit 70% or more of all employees
    • 85% of all employees who are participants under the plan may not be key employees
    • if the plan is part of a cafeteria plan, the criteria of Internal Revenue Code (IRC) Section 125 must be met
    • the plan must benefit a class of employees found by the U.S. Treasury Secretary not to be discriminatory.
  • When performing the eligibility test, a plan can exclude any of the following people from consideration:
    • employees who have not completed three years of service
    • part time or seasonal employees
    • employees covered under a collective bargaining agreement if the benefits provided under the plan were the subject of good faith bargaining
    • non-resident aliens who received no income constituting income from sources within the United States.
    • Note:

      Employees performing services for the employer must be included in the test.

  • ​Benefits test - To pass the benefits test, all benefits that are available to employees who are key employees under the plan must be available to all other participants. However, a group term life insurance plan may offer different amounts of life insurance to employees as long as the amounts of life insurance under the plan bear a uniform relationship to the total compensation or basic rate of compensation for employees (for instance, everyone is entitled to one, two, or three times compensation).

Tax considerations and the cost of group term life insurance

The cost of group term life insurance in excess of $50,000 (or, if the plan is discriminatory, the cost of the entire amount of group term life insurance for key employees) less any amount paid by the employee toward such coverage, is includable in gross income as wages subject to Federal Income Contributions Act (FICA) tax. The cost of group term life insurance is determined on the basis of uniform premiums computed on the basis of five-year age brackets prescribed by U.S. Treasury regulations.  Employees who elect coverage in excess of $50,000 and who must contribute toward the cost of such insurance must pay their share on an after-tax basis.

Group term life insurance benefits provided by employers are deductible by the employers as a business expense.

Tax considerations and the cost of permanent life insurance

Under permanent life insurance arrangements, such as whole, universal, and variable life insurance, the cost of the permanent benefits less the amount paid for the permanent benefits by the employee is includable in the employee’s income. All or part of the dividends under the policy may also be includable in the employee’s income depending on whether the employee contributes toward the purchase of the permanent benefits.

The cost of the permanent benefits is calculated on the basis of a policy year and is employee specific. The cost for each employee is computed by multiplying:

  • the net single premium for insurance (the premium for one dollar of paid-up, whole life insurance) at the employee’s attained age at the beginning of the policy year
  • by the difference between the employee’s “deemed death benefit” at the end of the policy year and the employee’s “deemed death benefit” at the end of the preceding policy year.

When a policy year does not coincide with the employee’s tax year (for instance, if the employee’s tax year is a calendar year, but the policy year runs April 1 through March 31), the cost of the permanent benefits is allocated between the employee’s tax years to determine how much is includable in the employee’s income for his/her tax year.

A “deemed death benefit” at the end of a policy year for an employee is calculated by dividing:

  • the net level premium reserve at the end of the policy year for all benefits provided to the employee by the policy, or if greater, the cash value of the policy at the end of the policy year
  • by the net single premium for insurance at the employee’s age at the end of that policy year.

Part or all of the dividends under a qualifying life insurance policy providing permanent benefits are includable in the employee’s taxable income, depending on whether the employee contributes to the cost of the permanent benefit. When the employer pays for the cost of all of the permanent benefits, all of the policy dividends that are actually or constructively received by the employee are included in the employee’s income. When the employee contributes toward the cost of the permanent benefits, the portion of the dividends that are includable in the employee’s income is equal to the amount calculated as follows:

  1. Add the sum of the total amount of the dividends actually or constructively received by the employee from the policy in the employee’s current tax year and in all prior tax years and the sum of the total permanent benefit costs for the current and all prior taxable years.
  2. Subtract from the total derived in step 1 the sum of all of the following:
  • the total amount of the premiums for the permanent benefits that are or were included in the employee’s income in the current and all prior tax years
  • the total amount of dividends included in the employee’s income in all prior tax years
  • the total amount paid by the employee for the permanent benefits in the current and prior tax years.

Split-dollar, reverse split-dollar, and company-owned life insurance

In a split-dollar plan, the employer and employee join in purchasing an insurance contract on the employee’s life in which there is a substantial savings element. The employer pays the part of the annual premium that represents the increase in the cash value each year and the employee pays the balance of the annual premium. When the insurance proceeds are paid out, the employer is entitled to receive, out of the policy’s proceeds, an amount equal to the cash value, or at least a portion of the cash value that is sufficient to reimburse the employer for its share of the premiums paid. The employee’s beneficiary is entitled to the remainder of the proceeds. One advantage to this type of arrangement is that, after the initial premium, the employee’s share of the annual premiums rapidly decreases so that the employee obtains valuable insurance protection with a relatively small cash outlay in the early years and at little to no cost in later years.

The tax effect of a split-dollar life insurance arrangement depends on how and when the arrangement is or was set up. If the contract is owned by the employee and the employer pays the premiums but will be entitled to recoup the premiums paid from policy cash value or amounts payable on the death of the employee, the employer’s premium payments are generally treated as loans to the employee and the amount of the cash value will be treated as a below-market loan, subject to imputed interest rules. If the contract is owned by the employer, the annual increase in cash value and the cost of the life insurance protection are generally taxable to the employee as compensation.

The value of all policy dividends an employee receives also is includable in taxable income, even if the dividends are used to purchase additional insurance. All premiums paid by the employee are offset against the value of the benefits the employee receives from the split-dollar arrangement. Neither the employer nor the employee is entitled to a deduction for premiums paid on a split-dollar arrangement.

In a reverse split-dollar arrangement, the employer and employee split the premium payments and, upon the employee’s death, the employee’s beneficiary receives the amount of employee’s premium payments plus the cash value. The employer receives the balance of the insurance proceeds. Employers frequently use a reverse split-dollar life insurance policy to protect themselves from the loss of business in the event the employee dies. Since the employer will receive the actual amount of insurance coverage, the employee is not taxed on the cost of current life insurance protection. As with regular split-dollar life insurance, the employer may not deduct the premiums it pays for reverse split-dollar insurance. Any dividends paid on the policy that are used by the employer to pay premiums are includable in the employer’s gross income.

Separate sets of rules prescribed by the IRS apply to arrangements that were either entered into after September 17, 2003 or materially modified after that date, and those arrangements that were made before September 18, 2003 and have not been materially modified after September 17, 2003. In addition, because split-dollar life insurance arrangements typically provide for deferred compensation, IRC Section 409A generally applies. Finally, publicly traded companies may be precluded from maintaining a split-dollar life insurance arrangement for their key employees as such arrangements are generally considered to be loans to such executives. Employers should contact their tax advisor and/or legal counsel before entering into or modifying a split-dollar life insurance arrangement.

Employer owned life insurance, often called company owned life insurance (COLI), may be used to finance the cost of employee death benefits or retirement benefits if the COLI contains a cash build-up feature. Under this kind of arrangement, the employer owns the policy and pays the beneficiary upon the death of the insured.  

For COLI policies issued after August 17, 2006 (including policies that were issued before this date but have a material increase in the death benefit or other material change after this date), employers must include the proceeds of insurance on the lives of employees and former employees in taxable income to the extent the proceeds exceed the premiums and other costs paid by the employer, unless either one of the following criteria apply:

  1. certain notice and consent requirements are met
  2. one of the exceptions discussed herein applies.

The notice and consent requirements are met if, before the policy is issues, all three of the following criteria are met:

  1. the employee is notified in writing that the employer-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
  2. the employee provides written consent to being insured by the employer and acknowledges that the coverage may continue after the employee terminates employment
  3. the employee is informed in writing that the employer will be a beneficiary of proceeds payable at the employee’s death.

If the proper notice and consent requirements are met, death benefit proceeds are excludible from the employee’s gross income if any of the following criteria apply:

  • ​Exceptions based on the insured’s status with respect to the employer:
    • the insured was an employee (defined as an officer, director or highly compensated employee) of the employer-policyholder at any time within 12 months of death
    • the insured is a director or a highly compensated employee or individual at the time the policy is issued (subject to certain limits).
  • Exceptions for amounts paid to the insured’s heirs:
    • the proceeds are paid to a family member, a designated beneficiary of the insured under the policy, a trust established for the benefit of a family member or designated beneficiary, or the estate of the insured
    • the proceeds are used to purchase an equity interest in the employer from any person described previously.

The employer must also file an informational return (Form 8925) with the income tax return for each tax year after November 13, 2007. The return reports all of the following:

  • the number of employees the policyholder had at the end of the tax year
  • the number of employees who were insured under the policy at the end of the tax year
  • the total amount of employer-owned life insurance in force at the end of the tax year
  • confirmation that the employer has a valid consent to insure for each employee insured under the policy
  • the number of employees who are covered under the policy for whom the employer does not have a valid consent.

Social Security tax on life insurance plans

Taxable group term life insurance provided to retirees is subject to social security taxes. This rule applies to any payment for group term life insurance to the extent that the payment constitutes wages and is for coverage for a period in which an employment relationship no longer exists between the employee and the employer.

Converting coverage when employees lose eligibility

State insurance laws usually provide for a mandatory conversion right in group term life policies when covered employees lose coverage under the group policy because of loss of eligibility due to termination, retirement, reduction of hours, and the like. A conversion right gives an employee the right to convert his/her group life coverage to an individual policy of any type without providing evidence of insurability, if the conversion occurs within 31 days of the loss of group term life coverage. However, conversion rights may only be available if the group policy is still in force.

Some states require group term policies to include provisions that grant a conversion right, with certain limitations on the amount of coverage, for employees who have been covered by a group policy for at least five years before the termination, even when the group policy is cancelled.

Death benefits and tax considerations

Insurance provided on the life of an employee’s spouse or children as part of a group term life insurance contract carried by an employer is not taxable to the employee as long as the related death benefit on a dependent does not exceed $2,000. Life insurance in excess of this amount may be a “de minimis” fringe benefit if it can meet the general standards of a de minimis fringe benefit.  “De minimis” means lacking significance or importance, so minor as to merit disregard. Chapter 14, Other fringe benefits, discusses de minimis fringe benefits in more detail. In making this determination, only the excess of the cost of insurance over the amount paid by the employee in after tax dollars is considered. No income exclusion is available if the life insurance is purchased through a cafeteria plan.

Self-insured death benefit plans

An employer may elect to pay death benefits under a plan out of the employer’s general assets rather than through an insurance policy. Employers who self-insure death benefits are typically large employers with a strong financial position and enough employees to spread the cost and risk of a disproportionately large number of deaths in a given year. These employers often establish a tax vehicle called a Voluntary Employee Beneficiary Association (VEBA) to hold contributions made by the employer and, if applicable, by participating employees, because earnings on the accumulated funds in a VEBA can accumulate tax free.

Death benefits in small amounts paid by an employer under a self-insured plan are generally regarded as a form of employee compensation and are taxed to the beneficiary when received.

Accidental death and dismemberment coverage

Accidental death and dismemberment benefits are generally payable when an insured sustains bodily injuries solely through violent, external, and accidental means, and as a direct result of the bodily injuries, independently of all other causes, and within a fixed period afterwards, the insured loses his/her life, limb, or eyesight. These benefits may be provided automatically through a group life policy or may be provided through a separate policy. Since benefits are paid only in the event of a covered loss that occurs as a result of an accident, the cost of such insurance tends to be relatively low. As a result, many employers elect to offer a basic level of coverage at no charge to employees who elect life insurance.

Accidental death and dismemberment policies may be written to cover only non-job related accidents. However, they also may be written to provide 24-hour coverage. This means that the policy would provide coverage for benefits in the event of an accidental death or dismemberment that occurs at any time, including the time the covered individual is working.

An accidental death and dismemberment plan is an Employee Retirement Income Security Act (ERISA) welfare benefit plan when the employer intends to provide the benefits and is clearly involved in the plan administration. As a result, it is subject to ERISA’s reporting and disclosure obligations, rules governing fiduciary conduct and “prohibited transactions,” and rules on participant benefit claims.

Employer contributions toward accidental death and dismemberment insurance are neither taxable income to employees nor are they subject to employment taxes, provided the plan is non-discriminatory and qualified under the IRC.

The exclusion from the employee’s gross income applies whether the plan is self-funded or provided through insurance. The benefit payments under such plans for the loss of a limb or other body part also are excluded from employees’ incomes as long as the payments are unrelated to an employee’s absence from work. Any contributions employees make toward their employer-sponsored accident coverage must be made with after-tax dollars, unless the accident insurance is a “qualified benefit” under a cafeteria plan, in which case employee contributions may be made with pre-tax dollars. For more information, see also Chapter 8, Cafeteria plans.