I was very annoyed. It was the first application that I took for a key-person life insurance policy after August 18, 2006. The underwriter kicked the application back because the insured-employee did not sign the "Notice and Consent" form, acknowledging that the employer was both the owner and beneficiary of the policy. When I suggested to the underwriter that we get this signature at delivery, he informed me that the policy would not be issued until the signed "Notice and Consent" was received. This was bull, I never had to get this form in the past. So, what was the big deal?

It turns out that this is a very big deal. The rules had changed, and a new subsection had been added to §101 of the Internal Revenue Code. The general rule of that subsection is that employer-owned life insurance death proceeds are taxable to the beneficiary to the extent they exceed cost basis, unless the requirements of 101(j) are met. So where did this subsection come from? Previously, my knowledge of 101(j) was non-existent – I even thought it might be an off-ramp on the famous 101 freeway in Los Angeles. Knowing that I couldn't change the map, I needed to learn more and find a way to navigate my client through 101(j).

Here is what I found out. Congress adopted these rules to prevent the perceived abuses of what was sometimes referred to as "janitor life insurance," issued for windfall profits. These plans proliferated in the 1980's as a form of Corporate-Owned Life Insurance, or COLI.

In a typical broad-based leveraged COLI transaction, a corporate employer would purchase policies on masses of lower-level employees, sometimes without the employees' knowledge or consent. When an insured employee died, the company received the death benefits, and the employee's family typically received either a small portion of the proceeds or nothing. These policies could remain in place even after the employee quit or retired.

In 2006, this all changed.

The COLI Best Practices Provision within the Pension Protection Act of 2006 became law on August 17, 2006. This provision was designed to codify industry best practices regarding employer-owned life insurance and amend the Internal Revenue Code by introducing conditions that must be met in order to exclude from gross income the proceeds from business-owned life insurance. The Act amended Section 101 of the Internal Revenue Code by adding subsection (j), "Treatment of Certain Employer-Owned Life insurance Contracts." Briefly, the new subsection treats all employer-owned life insurance death benefits as taxable income, to the extent the proceeds exceed the premiums paid. It also provides for exceptions to this rule, most notably requiring that the insured-employee sign a "Notice and Consent" form acknowledging that the employer is the owner and beneficiary of the policy.

[Related: The New Law for Business Life Insurance: Understanding Section 101(j) and Repairing Noncompliance]

Because of that change, employers today who purchase key person insurance and other forms of employer-owned life insurance need to watch out for a potentially costly trap — if the proper forms aren't completed before the policy is issued, the death benefit is taxable, when it would otherwise be tax-exempt. "The result is draconian," says Jonathan Forester, a tax lawyer with Greenberg & Traurig in McLean, VA. "If you're expecting a death benefit of $10,000,000 and the IRS says you owe taxes, giving up 50%, if you're a widow counting on these proceeds, that's devastating."

In a recent conversation with a hedge fund manager who bought $100 million of corporate-owned life insurance on his partner, but hadn't complied with the rules of §101(j), we mulled over the options available to remedy the problem:

• Go back to the carrier to get the policy reissued – providing that the carrier is willing and able to do this.
• Cancel the original policy and issue a new one hoping that the employee is still insurable.
• Do nothing and hope for the best – a gamble you do not want to take.

As you can see, the options are limited, difficult and potentially downright dreadful. Now, I am no longer annoyed and have accepted reality. IRC Section 101(j) is far more important than my original take, and compliance with its requirements before policy issue is imperative for both you and your client.

An ounce of prevention avoids a ton of liability.

An excellent resource on §101(j) is a "White Paper" from Principal Financial Group. It is a comprehensive piece that covers most of the details of IRC Section 101(j) in a "Question and Answer" format. For example:

• If the general rule of Section 101(j) is that employer-owned life insurance death proceeds are taxable, then how do death proceeds payable to an employer, from employer-owned contracts, qualify as tax-free under the general rule of IRC Section 101(a)?
• Are death benefits from employer –owned policies payable to an insured employee's heirs eligible for tax-free treatment under 101(j)?
• What information must be furnished to the IRS in order to meet the new information return requirements?

As you complete annual reviews for your business clients there may be opportunities where replacement of non-compliant policies could save your clients thousands if not millions in income-taxable death benefit. It will be worth your time to know the rules.

Download the "White Paper" and become familiar with Section 101(j). There are opportunities waiting for you.