It is not uncommon for businesses to purchase life insurance on key management personnel. Once commonly referred to as "key man" insurance, such policies now are referred to as "key employee life policies." A key employee life policy is used as a risk management tool to mitigate the impact of the sudden, unexpected loss of an integral member of the management team. Historically, the death benefits received by the business from a key employee life policy usually have escaped taxation. The Pension Protection Act of 2006 ("PPA"), however, changed the tax treatment of proceeds received under such policies.

Before enactment of the PPA, the proceeds from a key employee life policy received by the business owning the policy (the "Policyholder") were not taxable to the Policyholder except in limited situations. Under the new rules, the proceeds of such a policy are taxable to the Policyholder to the extent that they exceed the amount of the premiums paid by the Policyholder on the policy, unless an exception applies. The new treatment of key employee life policy benefits is intended, at least in part, to curb abuses such as an employer taking out a life insurance policy on a rank and file employee, often without the insured's knowledge (generally referred to as a "janitor policy"), to provide a tax-free cash windfall to the employer upon the death of the employee, possibly years after the employee has left the employer, even though the employee's death does not have a significant impact on the operation of the Policyholder's business.

The PPA implicitly acknowledges the utility and legitimate purposes of a key employee life policy through the provision of specific exceptions to the general rule that the proceeds of such a policy are taxable to the Policyholder. To qualify for these exceptions, the person whose life is insured ("Covered Person"): (1) must be notified of the fact that a policy will be taken out on his or her life and of certain information regarding the proposed policy; (2) must provide written consent to the Policyholder, and (3) must fall within one or more specified categories of persons.

There currently are no provisions for curing a defect in the notice and consent requirements after a key employee life policy has been issued. Accordingly, it is extremely important that these requirements be satisfied prior to the issuance of such a policy in order to avoid income taxation on the proceeds. If the notice and consent requirements are met, benefits under a key employee life policy generally will be excluded from the Policyholder's gross income if the Covered Person was employed by the Policyholder at any time during the 12-month period prior to the Covered Person's death, was a director of the Policyholder at the time the policy was issued, or was a "highly-compensated employee."

If the Covered Person does not fall into one of the categories that qualify the policy proceeds as non-taxable, the Policyholder still may avoid tax liability if the proceeds are paid to the Covered Person's family or designated beneficiary or are used by the Policyholder to purchase the Covered Person's ownership interest in the Policyholder from the Covered Person's estate or beneficiaries. However, if the person or entity receiving those proceeds has a relationship with the Policyholder that falls within the definition of a "Related Person" under the PPA, those proceeds still will be subject to taxation unless another exception applies. The PPA describes who constitutes a Related Person by reference to several sections of the Internal Revenue Code.

In addition to changes to the rules for taxation of the proceeds from a key employee life policy, the PPA also added annual reporting and record keeping requirements for Policyholders. Penalties for failure to comply with these reporting and record keeping requirements have not yet been published.

Although the rules have been changed, it is still possible, with appropriate planning and implementation, to protect your business from the effects of the loss of a key employee through the use of key employee life insurance. Failure to follow the new rules under the PPA likely will result in an unexpected tax liability. The end result would be a significant reduction in the assistance provided by a key employee life policy during the transition period following the death of a key member of the management or ownership team.

For more information on key employee life policies and the taxability on their benefits contact Deborah B. Andrews; John P. Crolle; Richard J. Crow; Merrill G. Jones, II; or A. Rexford Willis, III.