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GRASSLEY FLOATS NEW PROPOSAL ON EMPLOYEE LIFE INSURANCE

January 15, 2004

Senator Charles Grassley, Chairman of the Senate Finance Committee, has floated a new proposal to tax some employer-owned life insurance. This proposal replaces one passed by the Committee last year, but never enacted. Life insurance proceeds are normally tax-free; the old provision, which would have taxed the proceeds of life policies on former employees if they left service more than one year before death, threatened to kill the market for "key-man" permanent life policies.

The new plan is more narrowly targeted at so-called "dead peasant" policies. The new version would tax life insurance proceeds on employees unless they consent to the coverage in writing. Even with consent, the proceeds will be taxable unless:

- The employee was employed with the beneficiary in the past 12 months, or
- The proceeds were used to fund a purchase of the decedent's equity, as in a buy-sell arrangement; or
- The employee was a director or a "key person" for the company.

A PROBLEM OF PERCEPTION?

This bill is a reaction to the use of "dead peasant" insurance arrangements. In such arrangements, an employer puchased life insurance on large numbers of its rank employees. The employer's goal was not to derive ghoulish profits from the deaths of employees; with a large pool of insureds, insurance companies price policies to collect more in premiums than they pay out in proceeds. The employer's real goal was to take advantage of a perceived tax shelter.

The tax shelter tried to exploit the tax-free build-up of investment value in life insurance policies. The plan was for the employer to deduct the interest on the borrowing while excluding the interest-like return on policy investment build-up. The income and expense would offset before tax, but the deduction for the expense would make the arrangement profitable after-tax.

THIS SHELTER NO LONGER WORKS (IF IT EVER DID)

The IRS never liked these arrangements, and it has been, with a single exception, successful in court fights against these arrangements. Congress settled the issue going forward with legislative changes in the '90s. Still, the myth of heartless employers gleefully profiting from employee deaths has pushed Congress into taking further action against such policies, according to one observer.

The new proposal has a long way to go before becoming law; even if ultimately approved, it will only apply to policies purchased after enactment. In any case, the traditional tax advantages of employer owned "key man" policies appear to be safe.

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