Group-term life insurance straddle testing: Avoiding imputed income on voluntary GTL coverage

Question: What is group-term life insurance straddle testing, and why does it matter?

Short answer: Contribution structures for voluntary employee-paid group-term life insurance plans must pass the straddle test to avoid imputed income that applies when a policy is treated by the IRS as carried directly or indirectly by the employer.

Starting point: Section 79 exclusion for employer-provided GTL coverage

Internal Revenue Code Section 79 provides an exclusion from income for the cost of up to $50,000 of coverage under an employer-provided group-term life (GTL) insurance plan.

Example 1:

• Mia works full-time as a waitress at Toretto’s Market and Café.
• The company provides $50,000 of employer-paid basic GTL coverage to all full-time employees.

Result 1:

The full cost of Mia’s GTL coverage provided by her employer is excluded from taxable income under Section 79.

General rule: Imputed income for GTL coverage in excess of $50,000

Employer-provided GTL coverage in excess of $50,000 results in imputed income to the employee. Each $1,000 of GTL coverage in excess of $50,000 is taxable to the employee in an amount that varies by age based on IRS Table I rates.

Example 2:

• Same as Example 1 above, except Toretto’s Market and Café provides employer-paid basic GTL coverage at two times annual compensation.
• Mia’s annual compensation is $40,000, and therefore she receives $80,000 of GTL coverage.
• Mia is 26 years old.

Result 2:

• The first $50,000 of GTL coverage is excluded from Mia’s taxable income.
• The $30,000 of “excess coverage” is subject to imputed income based on Table I rates.
• Mia therefore receives $21.60 in annual imputed income from GTL coverage (30 excess coverage units x $0.06 Table I rate for Mia’s age x 12 months).

Employee-paid voluntary GTL coverage: Avoiding imputed income

Employers often offer employees the option to enroll in voluntary GTL coverage, either to supplement employer-paid “basic” coverage or where the employer doesn't provide coverage. To avoid imputed income for voluntary GTL coverage, the arrangement must meet three requirements to not be considered “carried directly or indirectly” by the employer:

1. The employer can't pay for any part of the voluntary GTL premium;
2. The employee can't pay for any part of the voluntary GTL premium on a pre-tax basis (i.e., through the Section 125 cafeteria plan); and
3. The voluntary GTL rates for the employee cost of coverage must pass the straddle test.

The first two requirements are relatively straightforward. Employers can't contribute to a fully employee-paid voluntary GTL coverage option, and employers typically take voluntary GTL employee contributions on an after-tax basis.

Note: Taking employee contributions for voluntary GTL coverage on a pre-tax basis through the Section 125 cafeteria plan subjects coverage amounts in excess of $50,000 to imputed income in the same manner as employer-provided coverage. This is generally less desirable and therefore a relatively uncommon practice. (Prop. Treas. Reg. §1.125-1(k))

The GTL rates must also satisfy the third requirement — passing the so-called “straddle test”—to prevent employee-paid voluntary coverage from being subject to imputed income.

The straddle test for employee-paid voluntary GTL coverage

The straddle test rules (as in the Section 79 GTL nondiscrimination rules) require that the employer avoid a contribution structure whereby one or more employees pay less than the Table I cost of their GTL coverage, and one or more other employees pay more than the Table I cost of their GTL coverage. Policies with contribution structures that fail to meet this standard “straddle” the Table I rates and are thereby considered “carried directly or indirectly” by the employer, resulting in imputed income.

One straightforward way employers can ensure the rate structure passes the straddle test is to confirm that contribution rates fall below Table I levels at every age band and rate class. If every employee is charged less than their Table I cost, no employee is charged more, and the arrangement can't “straddle” Table I rates. If any employees are charged less than their Table I cost (e.g., younger employees) while any other employees are charged more (e.g., older employees), the IRS would view the contribution structure as “straddling” the Table I rates.

The implicit rationale for the rule is that straddling GTL rates has the effect of subsidizing or redistributing premium costs in favor of certain employees, producing rates that likely wouldn't be available absent employer involvement. The arrangement is thereby considered “carried” by the employer instead of a true voluntary plan. The effect of failing this “straddle test” is to subject voluntary coverage (aggregated with any employer-paid basic coverage) in excess of $50,000 to imputed income, reduced by the employee’s after-tax contributions.

Example 3:

• Brian O’Conner works as a mechanic at the Racer’s Edge.
• The company doesn't offer employer-paid basic GTL coverage, but it offers Brian the option to purchase employee-paid voluntary GTL coverage on an after-tax basis.
• Brian enrolls in $75,000 of voluntary GTL coverage at open enrollment.
• The company’s contribution structure for voluntary GTL coverage ensures no employee is charged less than their Table I cost while another is charged more.

Result 3:

• Brian’s voluntary GTL coverage isn't subject to imputed income.
• The company’s voluntary GTL coverage isn't considered carried by the employer because the employer doesn't contribute to the premium, employees pay for coverage exclusively on an after-tax basis and the contribution structure passes the straddle test.

Additional consideration: Separate treatment of basic and voluntary policies

Employers often offer both employer-paid “basic” GTL coverage and voluntary “supplemental” GTL coverage. This common arrangement presents a taxation question: Can the employer treat a) the basic GTL as carried by the employer, and b) the voluntary supplemental GTL as not carried by the employer? Fortunately, the answer is “yes.”

Employers generally want to take advantage of both the Section 79 exclusion from income for up to $50,000 of GTL coverage with respect to the basic employer-paid benefit and avoid imputed income for the voluntary supplemental GTL coverage paid for by employees on an after-tax basis. The employer-paid basic GTL benefit is clearly carried by the employer because it is paid for by the employer, and therefore both the $50,000 coverage exclusion and imputed income for coverage amounts in excess of $50,000 apply.

The voluntary supplemental GTL coverage must be treated as provided under a separate policy to avoid being carried by the employer along with the basic GTL coverage. Failure to treat them as separate policies would subject combined basic and voluntary coverage in excess of $50,000 to imputed income, reduced by the employee’s after-tax contributions.

Even where both benefits are provided by the same insurance carrier, employers may elect to treat the voluntary supplemental employee-paid GTL benefit as provided under a separate policy if the premiums are “properly allocated” between the policies. IRS guidance suggests a number of factors that can show proper allocation, including independently determined premiums, no loading expenses allocated or shifting reserves between the policies, separately determined dividends and rate credits, independent finances, and separately developed experience rating.

Where the employer elects to treat the policies separately and the premiums are “properly allocated,” each policy (basic and voluntary) is tested separately to determine whether it is “carried directly or indirectly by the employer,” and the voluntary policy can thereby avoid imputed income.

Example 4:

• Roman Pearce is 33 years old and employed as a driver for Barstow Demolition Derby.
• The company offers employees employer-paid basic GTL coverage at two times their annual compensation, and voluntary supplemental employee-paid GTL coverage.
• Both GTL benefits are offered through the same insurance carrier, but the employer elects to treat them separately and the premiums are “properly allocated” between them.
• Employees pay for the voluntary supplemental GTL benefit on an after-tax basis, and the contribution rates pass the straddle test.
• Roman’s annual compensation is $60,000 (resulting in $120,000 in basic employer-paid GTL coverage), and he enrolls in $250,000 of voluntary supplemental GTL coverage.

Result 4:

• The first $50,000 of employer-paid GTL coverage is excluded from Roman’s taxable income.
• The $70,000 of “excess coverage” is subject to imputed income based on Table I rates.
• Roman therefore receives $67.20 in annual imputed income from GTL coverage (70 excess coverage units x $0.08 Table I rate for Roman’s age x 12 months).
• Roman’s voluntary employee-paid supplemental GTL isn't treated as carried by the employer and therefore isn't subject to imputed income.

Reminder: GTL plans must also pass section 79 nondiscrimination tests

GTL plans must also pass the Section 79 nondiscrimination tests to ensure that key employees don't lose the $50,000 exclusion and have the entire cost of their employer-paid GTL coverage become taxable.

There are two main components to Section 79 nondiscrimination testing:

1. Eligibility Test: Employers must offer GTL coverage based on nondiscriminatory eligibility classifications; and
2. Benefits Test: Employers must make available to non-key employees all GTL benefits that are made available to key employees.

The Section 79 GTL nondiscrimination rules generally require that the type and amount of benefits provided under a GTL plan be available on the same terms to key employees and non-key employees.

How the straddle test keeps voluntary group-term life coverage free of imputed income

Employers should work with their GTL insurance carriers and advisors to ensure that their voluntary GTL contribution structure passes the straddle test to avoid unnecessary adverse tax consequences for employees. Where structured properly, employers and employees can enjoy the Section 79 exclusion for the first $50,000 of basic employer-paid GTL coverage, while still avoiding any imputed income for the voluntary employee-paid GTL coverage.