The IRS only permits the first $50,000 in term life insurance coverage to be exempt from imputed income in cases where the coverage is provided on a non-discriminatory basis. A plan is considered to be discriminatory if it provides benefits that favor
‘highly compensated employees’ (HCEs). As presently defined under IRC Section 414(q)(1)(B), this would include all employees earning over $115,000 in 2012. A discriminatory plan would provide coverage that either excludes certain employee classes while
covering HCEs or provides benefits for HCEs that are greater than those provided to non-HCEs. The regulations do allow for benefits to differ in proportion to salary (i.e. – a plan providing coverage in multiples of salary to all employees) but otherwise require
consistency in order to meet the non-discrimination
For plans that fail the non-discrimination test, imputed income must also be applied to the first $50,000 in group term coverage for HCEs only (not for non- HCEs).
Tax Implications for Discriminatory Employer-Paid Life Insurance Plans
Under some circumstances, key employees may not be allowed the tax exemption for $50,000 of employer paid life insurance. For the tax exemption to apply to key employees, an employer’s term life plan must meet the Section 79 non-discrimination requirements.
Section 79 does not allow plans to favor key employees in either eligibility or benefits. If the plan design favors key employees, the value of the entire amount of life insurance coverage the employer
provides becomes taxable for those employees only. Separate non-discrimination tests consider eligibility and benefits. The first step in non-discrimination testing should be to identify key employees covered by the life insurance plan. One can then conduct the
eligibility and benefits test to determine whether the plan favors those employees.
Key Employees and Benefits Eligibility Test
The benefits eligibility test is designed to determine whether the plan favors key employees when it chooses who may participate in the employer-paid group life plan.
A key employee is any employee who at any time during the plan year is:
• A more than 5% owner.
• An employee owning more than a 1% interest in the company and whose compensation or income from the employer exceeds $150,000 a year.
• An officer of the employer whose compensation exceeds $165,000 for 2012.
A group life plan is considered discriminatory if it cannot pass at least one of these tests:
1. The plan benefits at least 70% of all employees.
2. At least 85% of all participants are not considered key employees.
3. The plan covers a nondiscriminatory class of employees as determined by the Internal Revenue Service.
4. If premiums are deducted pretax via a cafeteria plan, the plan must satisfy the Section 125 nondiscrimination requirements.
An employer may disregard the following employees when trying to determine whether the plan meets the non-discrimination requirements:
• Workers employed for less than three years.
• Part-time or seasonal employees.
• Employees covered by a good faith collective bargaining agreement between the employer and union.
• Non-resident aliens who receive no earned income from the employer.
Non-discrimination standards apply to current, disabled, former or retired employees. Employers must test life benefits for these classes separately from active employees. Many organizations offer employer paid life insurance to all full-time employees.
Key Employees and Benefit Amount Test
Group life plans cannot offer key employees higher benefits. A plan will automatically pass this test if:
1. The plan provides the same amount of employer-paid life insurance to all employees; for example, a flat $20,000 life benefit to all employees; or
2. The plan determines the benefit amount on a percentage of income and uses the same percentage of earnings for all covered
employees. For example, all eligible employees are covered for an amount equal to their annual earnings. However, even if a plan does not offer the same coverage amount or percentage for all employees, it still may not automatically favor key employees. If employers offer different benefits for different classes of employees, in order to pass the ‘benefit amount’ test, the
organization must determine whether each class can pass any of the eligibility tests described in the previous section. This is confusing but the following example should help.
ABC Company has 500 employees and offers two classes of employer-paid group term life coverage. It offers all 400 of its hourly employees a life benefit equal to their annual earnings. At the same time, it offers 100 salaried employees a life benefit equal to double their annual earnings. No key employees are hourly, and 10 key
employees are salaried. Only salaried employees must meet benefits eligibility standards because that benefit class covers all key employees. Of the 100 salaried participants, only 10 are considered key employees. Since fewer than 15% of the salaried employees are key employees, this plan design would not be considered discriminatory with the current headcounts. The benefit
design passes the second eligibility test described in the previous section: at least 85% of all participants are not considered key employees. If the company adds a third class of employer-paid group
term life coverage with benefits equal to triple annual earnings but offers it only to key employees, then this class would not meet the eligibility test. The plan would be considered discriminatory, and key employees would face tax consequences.
The Internal Revenue Code lists two exceptions to the non-discrimination rules:
1. A church group life insurance plan for church employees. This exception does not apply to church supported institutions of higher learning (other than a school for religious training) or a church supported non-profit medical or hospital facility.
2. Any additional life insurance that employees pay for out-of pocket is not included in the nondiscrimination determination. If this additional life insurance coverage is available only for key
employees, however, then the plan is considered discriminatory. Employers need to review their life coverage annually to make sure the plan doesn’t favor key employees.