Company-Owned Life Insurance: Section 101(j), Form 8925, and Tax Rules

The federal tax rules for company-owned life insurance start from a simple structure and then layer on conditions: the business owns the policy, pays the premiums, and collects the death benefit. Premiums are never deductible. Cash value grows tax-deferred. The death benefit is tax-free only if the employer completed the written notice and consent procedure under Internal Revenue Code Section 101(j) before the policy was issued and the insured falls into a qualifying category. Miss any of that, and the exclusion collapses to the amount of premiums paid, with everything above taxed as ordinary income. Additional rules on modified endowment contracts, interest expense disallowance, transfers, and Section 409A (when the policy funds deferred compensation) shape the total tax picture.

Premiums Are Not Deductible

IRC Section 264(a)(1) prohibits any deduction for premiums on a life insurance policy when the taxpayer is directly or indirectly a beneficiary.¹ Because the company is always the beneficiary on a company-owned policy, every premium dollar reduces retained earnings without producing a current-year tax shield. This is the largest recurring tax cost of holding the policy, and it needs to be built into projections from the start.

Cash Value Growth Is Tax-Deferred

The policy’s internal growth gets favorable treatment even though premiums do not. Cash surrender value increases each year based on the policy’s investment returns or guaranteed crediting rates, and the corporation owes no tax on that annual increase. This deferral lets value compound faster than it would in a taxable corporate investment account, which is why companies often use these policies to match growing nonqualified deferred compensation liabilities over 10 to 20 years.

The Death Benefit Exclusion Under Section 101(j)

Life insurance death benefits are generally excluded from gross income under IRC Section 101(a)(1).² For employer-owned contracts, Section 101(j) narrows that exclusion. If the company fails the gatekeeping requirements, it can exclude only the total premiums it paid; the rest of the death benefit is ordinary income.³

Two conditions must both be met to keep the full exclusion: the employer must complete the notice and consent procedure, and the insured must fit a qualifying category.

Notice and Consent Before Issuance

Before the policy is issued, the employer must complete a three-part written process with the employee to be insured. The employer must notify the employee in writing that it intends to insure the employee’s life and state the maximum face amount. The employee must provide written consent to being insured and acknowledge that coverage may continue after employment ends. And the employee must be informed in writing that the employer will be a beneficiary.²

Timing is defined by IRS Notice 2009-48: a policy is treated as issued on the latest of the application date, the effective date of coverage, or the formal issuance date. If a gap exists between effective coverage and formal issuance, the consent process can be completed during that window.³ Signed consent forms should be retained indefinitely; the IRS can request them at any time, and the death benefit at stake may not become an issue for decades.

Who the Insured Must Be

Even with proper consent, the full exclusion applies only if the insured fits one of the categories in Section 101(j)(2)(A). The most commonly used exception covers any insured who was still an employee at any point during the 12 months before death. A separate exception applies if the insured was a director, a highly compensated employee, or a highly compensated individual at the time the policy was issued.²

These two compensation-based tests are not interchangeable. A highly compensated employee is defined under IRC Section 414(q) by reference to a compensation threshold, set at $160,000 for 2026.⁴ A highly compensated individual is defined by reference to IRC Section 105(h)(5) with a modified threshold: someone in the highest-paid 35 percent of all employees.² Meeting either test at issuance preserves the exclusion regardless of later changes in compensation.

A further exception preserves the exclusion when proceeds are paid to the insured’s family members, estate, or designated personal beneficiaries rather than to the company. Split-proceed arrangements should document which amounts fall under which exception.

The Transfer-for-Value Trap

If a policy is transferred to another party for valuable consideration, the death benefit can lose its tax-free status under the transfer-for-value rule in IRC Section 101(a)(2). The recipient can then exclude only the price paid for the policy plus any subsequent premiums; the rest is taxable. Exceptions cover transfers to the insured, to a partner of the insured, to a partnership in which the insured is a partner, or to a corporation in which the insured is a shareholder or officer.² This is the point where reorganizations, mergers, and buy-sell agreements can wreck years of planning. If a policy will change hands, the entity structure of the recipient needs to be checked against the exceptions before the transfer closes.

Modified Endowment Contract Risk

A policy that is funded too quickly in its early years can be reclassified as a modified endowment contract, which changes the tax treatment of every withdrawal and loan. A policy fails the seven-pay test and becomes a MEC if cumulative premiums at any point during the first seven contract years exceed the amount that would have fully paid up the policy in seven level annual installments.⁵

Two penalties follow. Distributions and loans are taxed on a last-in, first-out basis, so gain comes out before basis and every dollar of gain is ordinary income. Distributions before the recipient reaches age 59½ carry an additional 10 percent tax on the taxable portion.⁶ In the company-owned context the recipient is the corporation itself. MEC classification is permanent for that contract.

A material change, such as increasing the face amount or adding riders, restarts the seven-year testing period with a recalculated premium limit. Before making additional premium payments after any coverage adjustment, the seven-pay test should be rerun. The death benefit itself remains tax-free under Section 101 even if the policy is a MEC, so the exposure is concentrated in companies that plan to access cash value through loans or partial withdrawals during the insured’s lifetime.

Interest Expense Disallowance

Owning a policy can reduce a company’s interest deductions on unrelated debt. IRC Section 264(f) requires a pro-rata disallowance of interest expense based on the ratio of the company’s unborrowed policy cash values to its total assets, and it applies to all policies issued after June 8, 1997.¹ The IRS compares the average unborrowed cash value in the policies to the sum of all assets, including those policies. Whatever percentage the policy values represent becomes the percentage of total interest expense that is non-deductible. For a company carrying significant debt alongside a large portfolio of policies, the disallowed amount can be material.

An important exception exists. The disallowance does not apply to a policy covering a single individual who is a 20-percent owner, officer, director, or employee at the time coverage begins.¹ Most policies on key executives will qualify. Broader employee-group programs need to account for the disallowance in tax projections.

Separately, IRC Section 264(a)(4) prohibits deducting interest on any debt used to purchase or carry a life insurance policy. A narrow exception under Section 264(e) allows a deduction for interest on up to $50,000 of borrowing per insured individual when the insured is a key person, defined as an officer or 20-percent owner, subject to a numerical cap on how many individuals can be treated as key persons.¹

Policy Loans and Surrenders

When a company borrows against a policy’s cash value, the loan is generally not treated as taxable income so long as the policy stays in force. The loan reduces the net cash surrender value on the balance sheet, and interest accrues on the outstanding balance. If the loan is never repaid, the death benefit at the insured’s death is reduced by the outstanding loan amount, and the reduced benefit retains its Section 101 treatment.

The problem surfaces if the policy lapses or is surrendered with an outstanding loan. At that point the company realizes a taxable gain equal to the amount received (including the discharged loan balance) minus total net premiums paid. A policy that has been in force for decades with substantial cash value growth can generate a large taxable event if surrendered carelessly. Model the tax cost before any surrender decision, especially where a policy loan inflates the recognized gain.

Section 409A When the Policy Funds Deferred Compensation

Companies often buy company-owned life insurance to informally fund a nonqualified deferred compensation plan. The plan is a contractual promise to pay an executive in the future and falls outside ERISA’s vesting, funding, and fiduciary rules because it is maintained for a select group of management or highly compensated employees.⁷ The policy’s growing cash value can track the liability; if the executive dies before benefits are due, the death benefit covers the obligation.

The deferred compensation arrangement itself must comply with IRC Section 409A. The penalties for violations are severe: all vested deferred amounts become immediately taxable to the executive, plus a 20 percent additional tax, plus interest at the underpayment rate plus one percentage point running back to the year the compensation was first deferred or vested.⁸ These penalties fall on the executive, but the company usually bears the economic cost because plan documents typically require it to make the executive whole. A 409A violation on a plan with $2 million in deferred compensation can easily generate a combined tax-and-penalty bill exceeding $1 million once retroactive interest is included.

The insurance policy does not create 409A problems on its own. The danger is in how the deferred compensation plan is drafted and administered. Common triggers include allowing executives to change deferral elections after the plan’s deadline, accelerating payments outside the six permitted distribution events, or failing to specify a fixed payment date or schedule. The plan document needs review by tax counsel specifically for 409A compliance, separate from any insurance-related review.

If the plan qualifies as a top hat plan, the administrator must electronically file a statement with the Department of Labor, and each new top hat plan requires its own filing.⁹

Annual Reporting on Form 8925

A company that owns one or more employer-owned life insurance contracts issued after August 17, 2006, must file IRS Form 8925 each year the contracts remain in force.¹⁰ The form is attached to the federal income tax return and reports the number of employees insured, the total amount of insurance in force at year-end, and whether valid consent forms have been obtained for each insured employee.¹¹

The consent disclosure line matters most. Reporting that valid consent was not obtained effectively flags to the IRS that the death benefit on those policies may not qualify for the full Section 101 exclusion. No specific dollar penalty is enumerated in the statute for failing to file Form 8925, but the IRS takes the position that a return filed without required attachments may be treated as incomplete, which can extend the statute of limitations or trigger broader scrutiny. Keep both the consent forms and the annual Form 8925 filings on hand; they are what protects the tax-free status of future death benefits.

GAAP Treatment Differs From Tax Treatment

Financial statement accounting for these policies follows FASB Accounting Standards Codification Topic 325-30. The policy sits as a non-current asset at the amount the company could realize under the contract at the balance sheet date, generally the cash surrender value with any applicable adjustments. Premium payments do not flow through the income statement as expense; paying a premium is treated as exchanging cash for policy value. Only the net change in realizable value hits earnings, so a period in which internal charges exceed cash value growth produces a net charge, and a period where growth exceeds charges produces net non-operating income.

At the insured’s death, the company recognizes a gain equal to the death benefit received minus the policy’s carrying value. Where the policy backed a deferred compensation liability, that gain and the settlement of the accrued liability often offset each other, so the net earnings effect is smaller than the gross death benefit suggests. GAAP does not permit offsetting the policy asset against the deferred compensation liability on the balance sheet even when one funds the other; both appear separately, with the relationship explained in the notes.

1
Office of the Law Revision Counsel. 26 USC 264 – Certain Amounts Paid in Connection With Insurance Contracts
2
Office of the Law Revision Counsel. 26 USC 101 – Certain Death Benefits
3
Internal Revenue Service. Notice 2009-48 – Treatment of Certain Employer-Owned Life Insurance Contracts
4
Internal Revenue Service. 2026 Amounts Relating to Retirement Plans and IRAs, as Adjusted
5
Office of the Law Revision Counsel. 26 USC 7702A – Modified Endowment Contract Defined
6
Office of the Law Revision Counsel. 26 USC 72 – Annuities; Certain Proceeds of Endowment and Life Insurance Contracts
7
Internal Revenue Service. Nonqualified Deferred Compensation Audit Technique Guide
8
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans
9
U.S. Department of Labor. Top Hat Plan Statement
10
Internal Revenue Service. Form 8925 – Report of Employer-Owned Life Insurance Contracts
11
eCFR. 26 CFR 1.6039I-1 – Reporting of Certain Employer-Owned Life Insurance Contracts