Company-Owned Life Insurance After the Pension Protection Act of 2006: Small Mistakes Can Create Big Tax Problems

Company-owned life insurance (COLI) has long been a valuable planning tool for businesses. When properly structured, it can help fund buy-sell agreements, protect against the financial loss of key employees, finance executive benefit plans, and provide liquidity when it is needed most.

However, many business owners assume that simply purchasing a life insurance policy on an employee guarantees tax-free death benefits.

That assumption can be costly.

The Pension Protection Act of 2006 (PPA) significantly changed the rules surrounding employer-owned life insurance. Today, businesses that fail to follow the law’s notice, consent, and reporting requirements may find that a large portion of the death benefit becomes subject to federal income tax.

Why Congress Changed the Rules

Prior to the Pension Protection Act, some large corporations purchased life insurance on broad groups of employees, including lower-level workers, while retaining the death benefits after those employees left the company. These arrangements became known as “janitor insurance” and generated significant public criticism.

In response, Congress enacted Internal Revenue Code Section 101(j), creating new rules that employers must satisfy to preserve the traditional income tax-free treatment of death benefits.

The Three Requirements Every Employer Must Meet

Before a policy is issued, the employer generally must:

1. Notify the employee in writing that the company intends to insure their life.
2. Obtain the employee’s written consent before the policy is issued.
3. Inform the employee of the maximum amount of coverage and that the employer will remain the beneficiary even if employment ends.

If these steps are skipped—or even completed after the policy is issued—the favorable tax treatment may be lost.

Annual Reporting Is Also Required

Many businesses complete the initial paperwork but forget about the ongoing compliance requirements.

Employers generally must file IRS Form 8925 each year they own employer-owned life insurance. This form reports information about the policies and confirms compliance with the notice and consent rules.

Failure to properly report can create additional complications if the IRS later examines the arrangement.

Not Every Employee Qualifies

The law also limits which employees qualify for the tax-favored treatment.

Generally, the insured individual must fall into one of several categories, including:

1. Directors
2. Highly compensated employees
3. Highly compensated individuals
4. Employees who die while employed
5. Employees who die within 12 months after their employment ends

There are additional statutory exceptions, but businesses should never assume every employee automatically qualifies.

Common Mistakes Businesses Make

Even well-run companies can make expensive errors, including:

1. Purchasing coverage before obtaining written consent.
2. Using outdated or incomplete consent forms.
3. Forgetting to file IRS Form 8925.
4. Assuming older policies automatically comply with current law.
5. Failing to review policies after ownership or corporate structure changes.
6. Not coordinating the insurance with buy-sell agreements or executive compensation plans.

The Financial Consequences Can Be Significant

The tax consequences are often misunderstood.

If the requirements of Internal Revenue Code Section 101(j) are not met—and no statutory exception applies—the death benefit generally becomes taxable to the extent it exceeds the premiums and other amounts paid by the employer.

For companies carrying policies with death benefits of several hundred thousand—or even several million—dollars—the resulting tax liability can be substantial.

What If the Policy Wasn’t Set Up Correctly?

Finding out that a company-owned life insurance policy was not established in compliance with the Pension Protection Act of 2006 does not necessarily mean all hope is lost—but it does mean you should act promptly.

The first step is determining exactly what was missed. In some cases, the issue may simply be an overlooked annual IRS Form 8925 filing. In others, the more serious problem is that the required notice and written consent were never obtained before the policy was issued.

If Notice and Consent Were Never Obtained

Unfortunately, the law is strict. The required written notice and employee consent generally must be completed before the policy is issued. If they were not, obtaining signatures after the fact typically does not restore the tax-free treatment under Section 101(j).

That does not necessarily mean the policy should be surrendered, however. Depending on the company’s objectives and the specific facts, several options may still be available.

Potential Ways to Correct or Improve the Situation

Every situation is different, but your insurance advisor, CPA, and attorney may evaluate options such as:

1. Determine whether a statutory exception applies. Certain employees and circumstances may still qualify for favorable tax treatment under the law.
2. Replace the policy. If appropriate, the business may decide to surrender or replace the existing policy after properly completing the required notice and consent procedures. Any replacement should be carefully reviewed for tax consequences before implementation.
3. Consider a Section 1035 Exchange. In some circumstances, a tax-free exchange into a new policy may be appropriate. A replacement policy must still satisfy all notice and consent requirements before it is issued.
4. Correct missed IRS reporting. If the notice and consent requirements were originally satisfied but Form 8925 was not filed, your CPA may be able to address prior-year reporting through the appropriate IRS procedures.
5. Review your overall planning strategy. Ownership changes, buy-sell agreements, executive compensation plans, or business succession objectives may warrant restructuring the insurance arrangement altogether.

Start With a Compliance Review

Many businesses assume they have a compliance problem simply because they cannot locate the paperwork. Before making any changes, gather the original insurance application, employee consent forms, policy delivery records, and copies of any IRS Form 8925 filings. Sometimes the documentation exists in your attorney’s, CPA’s, or insurance advisor’s files.

A thorough compliance review can identify whether the policy satisfies Section 101(j), whether any exceptions apply, and whether corrective action is available.

Company-Owned Life Insurance Still Makes Excellent Business Sense

None of this means employers should avoid company-owned life insurance.

When properly designed, documented, and maintained, COLI remains one of the most effective financial planning tools available for businesses. It can:

1. Protect against the financial loss of key executives.
2. Fund buy-sell agreements.
3. Finance deferred compensation arrangements.
4. Support business succession planning.
5. Provide liquidity when it is needed most.
6. Help preserve business continuity after the loss of an owner or key employee.

The key is making sure the policy is established correctly from the beginning and monitored throughout its life.

Don’t Assume Your Existing Policies Are Compliant

Many business owners purchased employer-owned life insurance years ago and have never revisited the documentation. Others acquired businesses through mergers or acquisitions and inherited life insurance policies without knowing whether the original compliance requirements were satisfied.

The cost of reviewing an employer-owned life insurance policy is insignificant compared to the potential tax consequences of discovering a compliance problem only after an insured employee dies.

If your business owns life insurance on executives, owners, or key employees, now is an excellent time to conduct a compliance review. Confirm that:

1. The required notice and written consent were obtained before each policy was issued.
2. IRS Form 8925 has been filed each year when required.
3. The insured individuals continue to qualify under Section 101(j).
4. The policies still align with your business succession, executive benefit, and risk management objectives.

At Frost Insurance, we work alongside business owners, CPAs, attorneys, and financial advisors to help ensure employer-owned life insurance strategies are properly implemented and maintained. A proactive review today can help protect the valuable tax advantages Congress intended while avoiding costly surprises in the future.

To learn more about how proactive risk management and personalized advice can protect what matters most, contact Frost Insurance Agency.  Call us at 419-592-4476, email frost@frostins.com, or click here to start a conversation about your risks and goals.

Prefer a face-to-face review? Visit one of our four convenient locations in Archbold, Napoleon, Holgate, or Whitehouse — and let’s build a protection plan, not just a policy.