Providing employee life insurance that qualifies as group-term life insurance.

Editor:

Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Washington, DC

Facts: Pottery, Inc. is owned equally by Laurie Peters and Sandy Simon. There are seven employees, including Laurie and Sandy. The corporation has operated at a profit for the last three years. Laurie and Sandy feel the corporation's success is due in large part to the efforts of their employees. Therefore, they have decided to provide a fringe benefit for the employees, but only if the corporation can deduct the benefit for all employees beginning Jan. 1, 1999, including the shareholders. Laurie and Sandy discussed several benefits with the employees, who indicated they preferred life insurance, but only if it could be provided to them tax-free. Laurie and Sandy have met with the corporation's insurance agent to determine the amount of life insurance coverage the corporation can afford. The following coverage amounts are based on 150% of each employee's compensation.

Employee   Coverage   Age

Laurie     $80,000    42
Sandy       78,000    38
Pamela      60,000    34
James       45,000    28
Hillary     52,000    33
Cynthia     32,000    26
Curtis      55,000    39

Issue: How can the corporation deduct tax-free life insurance coverage provided for its employees?

Analysis

The tax adviser should consider whether the proposal submitted by the insurance agent would qualify as group-term life insurance. If it does, the corporation can deduct the life insurance and the employees can exclude it from income under Sec. 79.

To qualify as group-term life insurance, a plan must meet four requirements. Insurance provided by Pottery, Inc. for its employees would meet three of the four requirements:

1. It would be provided under a policy owned by the employer.

2. The death benefits provided under the policy would qualify for exclusion from income.

3. Individual selection of coverage amounts would be precluded, because the amount of coverage provided for each employee would be based on compensation.

The fourth requirement for qualification as group-term life insurance is that a plan be provided for a group of employees. Generally, to qualify as group-term life insurance, a policy must cover 10 or more full-time employees. However, even if a policy covers fewer than 10 employees, it can still qualify as group-term life insurance if all of the following requirements are met:

1. The insurance is provided to all full-time employees of the employer or, if evidence of insurability affects eligibility, to all full-time employees who provide satisfactory evidence of insurability to the insurer.

2. The amount of insurance provided by the policy is computed either as a uniform percentage of compensation or on the basis of coverage brackets established by the insurer. The amount computed under either method may be reduced for employees who do not provide the insurer satisfactory evidence of insurability.

3. Evidence of insurability affecting an employee's eligibility for insurance or the amount of insurance provided to that employee is limited to a medical questionnaire completed by the employee that does not require a physical examination.

Because the plan will cover all employees, it will qualify as group-term life insurance even though it covers fewer than 10 employees.

However, if the company adopts the plan proposed by the insurance representative, those employees receiving more than $50,000 in coverage will have to include the excess in income. The amount included in income is not the cost of the premiums paid by the employer, but an amount determined on the basis of five-year age brackets prescribed by regulations. The uniform premium cost table provided by the Service was initially published in 1966 and revised in 1983 to reflect changes in mortality since 1966. Proposed amendments to Regs. Sec. 1.79-3 have been issued, revising the table effective July 1, 1999. The uniform premium rates under the proposed revision are lower for all age groups than the rates under the current regulations. The following table provides the old and the new rates:

Uniform Premiums for $1,000 of
Group-Term Life Insurance Protection
(5-year age bracket cost per $1,000 of
protection for one month)

                          New cost
Five-year                  (after
bracket        Old cost   6/30/99)

Under 25            .08        .05
25 to 29            .08        .06
30 to 34            .09        .08
35 to 39            .11        .09
40 to 44            .17        .10
45 to 49            .29        .15
50 to 54            .48        .23
55 to 59            .75        .43
60 to 64           1.17        .66
65 to 69           2.10       1.27
70 and above       3.76       2.06

The cost of coverage exceeding $50,000 to be included in income is determined on a monthly basis and computed by taking into account all group-term life insurance policies covering the employee's life in force during the year. As a result, if an employee works part-time for two employers and receives $50,000 in coverage from each, the employee can exclude from income only $50,000 of coverage. The cost of the second $50,000 must be included in income by that employee.

To determine how much each employee has to include in income, the number of thousands of dollars of insurance in excess of $50,000 (computed to the nearest tenth) is multiplied by the appropriate amount in the IRS table. This figure is then multiplied by the number of months that amount of coverage was provided to the employee during the year.

Based on the Uniform Premium Cost Table in effect during the year, the individual employees would have to include in income the following amounts for coverage provided for them for a full year:

Amount to be included in income

            1/1/99-     7/1/99-
Employee    6/30/99     12/31/99     Total

Laurie     $30.60(*)   $18.00(**)   $48.60
Sandy       18.48       15.12        33.60
Pamela       5.40        4.80        10.20
James          --          --           --
Hillary      1.08        0.96         2.04
Cynthia        --          --           --
Curtis       3.30        2.70         6.00

(*) [($80,000 - $50,000)/$1,000] X .17 X 6 (months)

(**) [($80,000 - $50,000)/$1,000] X .10 X 6 (months)

Conclusion

The tax adviser should recommend that Pottery, Inc. establish a group-term life insurance plan covering all seven employees. The corporation could deduct the premiums and the employees could exclude the insurance from income to the extent the coverage did not exceed $50,000. To the extent the coverage exceeded $50,000, the employees would have to report income.

The tax adviser should warn the clients that, even though the plan qualifies as group-term life insurance, this does not guarantee it will be nondicriminatory. Once a plan qualifies as group-term life insurance, it still has to meet certain nondiscrimination requirements for the key employees (including owners) to exclude from income the coverage provided on their behalf.

Forms, Elections and Implementation

The amount to be included in income must be reported on the employee's Form W-2 in the boxes for:

1. "Wages, tips, other compensation;" and

2. "Social security wages" and "Medicare wages and tips" (the taxable portion is subject to Social Security and Medicare taxes, as well as income tax), but only if the employee's income has not already exceeded the wage bases for these taxes for the year in question. In addition, the cost of coverage over $50,000 should be reported in Box 13 and properly coded in accordance with W-2 instructions.

Editor's note: This case study has been adapted from PPC Tax Planning Guide--Closely Held Corporations, 11th Edition, by Albert L. Grasso, R. Barry Johnson, Linda Ketter Craig, Lewis A. Siegel, Joan Wilson Gray, James F. Carpenter and Richard L. Burris, published by Practitioners Publishing Company, Fort Worth, Tex., 1998.3