What Every Agent Needs to Know About IRC 101(j) and Keyman Insurance

IRC Section 101(j) has a direct impact on the taxation of proceeds from employer-owned life insurance policies, often referred to as "Keyman" or "Key Person" insurance. This provision primarily applies to life insurance policies purchased after August 17, 2006. Here’s how it affects Keyman Life Insurance:
Key Provisions of IRC Section 101(j)

1. Taxation of Death Benefits:

o Under Section 101(j), death benefits from employer-owned life insurance policies are generally taxable unless certain conditions are met.

o If the policy fails to meet these conditions, only the premiums paid on the policy are tax-free, while the rest of the death benefit is subject to income tax.

2. Notice and Consent Requirements:

o To qualify for tax-free death benefits, the employer must provide notice to the insured employee before the policy is issued and obtain their written consent.

o The employee must be informed of the employer’s intention to take out the policy, the maximum face amount, and the employer’s right to keep the policy in force after the employee leaves the company.

3. Coverage for Specific Individuals:

o Tax-free status is generally available only if the insured is either a highly compensated employee or a director at the time of the policy issuance, or if the insured is employed within the 12 months before their death.

4. Exceptions for Certain Situations:

o Proceeds are also tax-free if the employer uses the death benefits to cover costs related to the employee’s death or to pay benefits to the insured's heirs.

5. Annual Reporting Requirements:

o Employers with such policies are required to report the number of employees insured, total coverage, and compliance with notice and consent requirements on Form 8925, filed with their annual tax return.

Implications for Keyman Life Insurance

To maximize the tax advantages of Keyman insurance under IRC 101(j), employers must strictly follow the notice and consent requirements, target coverage for eligible employees, and maintain accurate records and reporting. Failure to comply can result in the loss of favorable tax treatment, significantly impacting the benefits intended to offset business losses due to the death of a key employee.