As you may be aware, only the first $50,000 of employer provided group-term life insurance is excludable from an employee's taxable income. The Internal Revenue Code Section 79 provides for the $50,000 exclusion for policies that are carried directly or indirectly by the employer. As long as the total amount of the group-term life insurance does not exceed $50,000 it is not a taxable event. Once the amount does exceed the threshold amount, then it is subject to income, social security and Medicare taxes.
IRS Premium Rates
Coverage exceeding $50,000 is taxed based on arbitrary "costs" assigned by the Internal Revenue Service ("IRS"). The determination of these costs are based on the IRS Premium Rate Tables found in Publication 15-B. Generally, these costs bear no relationship to the premiums an employee would pay if he were to purchase the coverage outside his employer's plan. Many employers provide group-term life insurance to employees equal to a percentage of salary (e.g., 1½ times salary). This may result in significant taxable income to highly paid employees and executives.
Option Opt of Coverage
Accordingly, these employees may prefer to obtain insurance coverage in excess of $50,000 outside of their employer's plan. In order to accommodate this desire, the IRS permitted, in private letter rulings, arrangements in which employers give highly paid employees the option to elect or decline all or a portion of their coverage in excess of $50,000 annually; thus, permitting employees to reduce the taxable cost of life insurance coverage over $50,000.
"Carried Directly or Indirectly"
Be aware that the IRS considers a policy to be carried directly or indirectly if the employer pays any cost of the life insurance or arranges for the premium payments and the premiums paid by at least one employee subsidize those paid by at least one other employee. So, a highly compensated employee who has more than $50,000 coverage on a plan that is considered "carried directly or indirectly" would be subject to taxable income on the portion of the premiums that exceed the limit. This is true, even if the employee is paying the full cost they are charged, because the IRS reasons that the amount of the premiums are lower because of the bargaining power of the employer, thereby making a benefit to the employee. [See Employer's Tax Guide to Fringe Benefits, IRS publication 15-B.]
A plan is not considered "carried" by the employer if the employees are paying for the cost of coverage and the employer is not redistributing the cost of the premiums. Such a system results in no tax consequences. [See 26 CFR 1.79-0.]
Separate Determinations per Policy
The IRS also allows there to be more than one policy offered to employees. If there is more than one, a combined test is used to determine whether the policies are considered "carried" or not. However, Regulation 1.79 provides for the policies to be tested separately, such that an employer could offer a "carried" plan and a non-carried plan. This works only if there is no cross-subsidation between the plans.
On October 16, 2015, the IRS issued a private letter (PR: 201542003) that allows for optional life insurance coverage offered to employees not to be deemed "carried" by the employer. This ruling was based on the facts that the life insurance premiums were paid for with after-tax dollars and the rates did not straddle the rates found in Table 1 of Publication 15-B and that the policy was entirely separate from other benefits offered. This determination would allow highly paid employees to obtain life insurance in amounts greater than $50,000 and not be subject to taxes on the premiums.
Bear in mind that private letter rulings from the IRS, while instructive, are only valid for the taxpayer requesting the determination. However, it appears that an employer could offer an optional group-term life insurance plan to meet the needs of highly paid employees that would not be taxable if:
- The life insurance coverage provided under the plan is a uniform percentage of salary;
- The election is available to all employees within the group, not just a select group of employees;
- No additional compensation is paid to an employee electing to reduce coverage;
- The basic plan and the optional plan are entirely separate with no premium loading allocated between the policies;
- The optional plan was paid for by the employee with after-tax dollars; and
- The premiums were either all at or below Table 1 rates or were all at or above Table 1 rates (not rates on above and below Table 1 rates.)