Taxability of death benefits?

[Guest jayback]

If an employer is the beneficiary of a life insurance policy with respect to an employee, and the employer transfers the proceeds from the policy up to a certain limit to the employee's survivor upon the employee's death, are the benefits taxable to the survivor or would the exclusion under Section 101 apply to the transfer of life insurance proceeds as well? Or would this be considered a self-insured death benefit, the ($5,000) exclusion for which was repealed?

[Ron Snyder]

This is not a black-letter area of law. IRC Section 101(a) states that death proceeds of life insurance are tax-exempt. Since the employer receives those death proceeds, it would be entitled to receive them tax-free. Many companies fund executive deferred compensation arrangements through life insurance with the death proceeds providing a reimbursement of costs to the employer.

What is the nature of the payment to the employee's survivor? Is it a group-term life insurance benefit? Is it key man insurance? Or buy-sell? What documentation exists relative to this arrangement? These are the keys.

I have seen opinion letters to the effect that the death proceeds of life insurance paid to the employer pursuant to an employer-provided death benefit plan can be passed on to the employee's named beneficiary tax-free. The theory is a quasi-trust conduit, but it would likely only work under the following circumstances:

1. The policy is for the purpose of providing a death benefit to the employee.

2. The death proceeds are never used by the employer for any purpose other than to be passed on to the beneficiary. (Preferably, the funds are never deposited to the general bank account of the employer, but are kept separate.)

Of course, this raises several questions: (1) Does the employer declare the death proceeds as taxable income? (2) Does the employer, therefore, get an offsetting tax deduction for the payment to the beneficiary? (3) Is the payment subject to withholding taxes? And mainly: (3) Why not simply name the beneficiary in the insurance policy and avoid all doubt who is supposed to get the tax-free benefit?

[Kirk Maldonado]

I think that taking the position that the exclusion applies to the beneficiary is a very aggressive position.

If the people thought that the IRS would approve such an arrangement, they would have gotten a private letter ruling on this point, instead of an opinion letter from a law firm.