Keyman Insurance: IRS Safe Harbors for Tax-Free Income

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IRS Safe Harbors for Tax-Free Treatment of Keyman Insurance Death Benefits



Both the Notice and Consent and at least one of the four safe harbors specified in the new law must be in place to keep the death benefit income tax free.

Beware of the tax-traps lurking on keyman, key person life insurance.

Beware of the tax-traps lurking on keyman, key person life insurance.



Safe Harbor 1: Key Person (The insured) is a key person at policy issue. This safe harbor (unlike the others) provides certainly at the time the policy is issued that the death benefit will continue to be income tax free. The employer must keep good records. Possibly many years from now, when the employee dies, the employer may have to prove that the employee satisfied the key person rules when the policy was issued. A key person for these purposes is someone who, at policy issue:

  • Was a director of the employer.
  • Was a 5% or greater owner in the year before policy issue.
  • Received compensation of for policies issued in 2015, employee earned in excess of $115,000 in 2014; for policies issued in 2016, and employee earned in excess of $120,000 in 2015 (adjusted for inflation).
  • Was one of the five highest paid Officers.
  • Was among the 35% highest paid employees.

You cannot know if the remaining safe harbors are available until the employee dies. Until then, the employer won’t know for sure if the death benefit is taxable or not taxable.

Safe Harbor 2: Current Employee The insured was an employee any time in the 12-month period before death.

Safe Harbor 3: Death Benefit Paid to the Insured’s Heirs

  • A member of the insured’s family (spouse, parents and grandparents, children and grandchildren, brothers and sisters).
  • An individual the insured named (other than the employer).
  • A trust set up for anyone in those first two groups of people.
  • The insured’s estate.

Although this may avoid income tax on the death benefit, it does create a split dollar arrangement. If the employer owns the policy and the person named as beneficiary is any of these people, the arrangement is, by definition, split dollar. The employee will be taxed on the economic benefit provided by the policy.

Safe Harbor 4: Buy-Sell Funds Death benefits remain income tax free if used to buy the insured’s interest in the employer (equity, capital or profits) from someone listed in Safe Harbor 3.

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