Leimberg’s - SFSP



Leimberg’s

Think About It

Think About It is written by

Stephan R. Leimberg, JD, CLU

and co-authored by Linas Sudzius

SEPTEMBER 2009 # 403

CHOOSING THE RIGHT

BUSINESS-SPONSORED LIFE INSURANCE PLAN

Introduction

Life insurance professionals who work with closely held business owners must often help choose the right ownership and payment structure for the coverage. In selected cases, fairly sophisticated strategies—such as financed premium, pension-owned coverage or 412 (e)(3) plans—can fit a client’s needs.

However, most instances of business-related permanent life coverage involve choosing between three more pedestrian business sponsored life insurance plans:

1. Bonus plan

2. Split dollar plan

3. Key employee insurance plan

Which one is the right choice for a particular client?

Picking the right kind of business sponsored life insurance plan depends on many factors:

• Is the insured an owner of the company, or a non-owner employee?

• What are the marginal income tax brackets of the company and the insured?

• What is the purpose of the coverage?

• How important is control of the insurance policy for the insured or the company?

• How much negotiating power does the insured have relative to the company?

In this issue, we’ll consider the types of answers that may indicate a preference for one plan over another. We will also identify those circumstances where a client may be better served by purchasing coverage with personal funds rather than business dollars.

Bonus Plan

A bonus plan, sometimes also called an executive bonus plan or Section 162 plan, involves having the employer pay the premium for an insurance policy, but treating the premium payment as a taxable bonus to the employee. The tax authority for the plan is Section 162 of the Internal Revenue Code, which says an employer may take a tax deduction for all reasonable, ordinary and necessary expenses of the business.

The bonus plan is not a reason to purchase life insurance, but rather a way to pay for coverage the employee needs or that serves an employee retention/reward business purpose.

How It Works

Under a bonus plan, the employer and the selected employee enter into an agreement under which the employer will pay the employee “extra” to cover the premium for a life insurance plan. The employer has the ability to pick and choose who among the employee group will be part of the plan.

The participating employee owns the coverage and names a personal beneficiary for the death benefit. The employee exercises all ownership rights over the policy. While the plan is in effect, the employee relies on the employer to continue making premium payments. If the employer stops contributing premiums, the employee must make any necessary payments, or surrender the coverage.

The employee, as owner, has the freedom to access the policy’s cash values, change the beneficiary or surrender the coverage. The employee may also designate a third party, such as an irrevocable trust, to be the owner.

The employer may pay the bonus to the employee, who in turn writes a personal check for the policy premium. In the alternative, the employer may make the premium payments directly to the insurance company.

Key Characteristics

What are the key characteristics of a bonus plan that will help a client decide whether it’s the right fit?

1. The employee owns the coverage. In fact, the employer cannot keep any ownership control over a bonus plan and maintain the plan’s other characteristics.

2. The employer gets a tax deduction for the amount of the bonus dedicated to the plan, provided the compensation package is reasonable.

3. If the employee leaves employment or if employment performance suffers, the employer may generally stop contributing to the plan.

Variations

The simplest bonus plan variation is where an employee designates a third party, such as an irrevocable trust, to be the owner of the life contract. When a third party is the owner, the value of the bonus is still taxable as income to the employee. The employee is treated for income tax purposes as if he owned it and for gift tax purposes is considered to be making a gift to the third party (e.g. trust or adult child) in the amount of the bonused premium.

Single, Double and Custom Bonuses

A single bonus plan is one where the employer pays the employee a bonus exactly equal to the amount of the premium. The employee is responsible for the income tax associated with the bonus.

A double bonus (sometimes called a gross-up bonus) plan commits the employer to paying the premium plus the projected tax to the employee on the overall bonus. Say for example that the annual premium for the life policy is $1,000. Assume that the employee is in a 28% marginal tax bracket. The double bonus would be $1,389. After the employee pays tax on the double bonus, the net amount remaining would be the $1,000 needed to cover the premium.

It’s also possible to configure custom bonuses. These might be used in those cases where the employer wants to help an executive pay the premium for needed life insurance, but wants the employee to make a premium contribution from the employee’s own funds.

Restricted Bonus Plans

Under a normal bonus plan, the participating employee has complete control over the policy, including having the right to surrender the coverage at any time. Some employers may object to giving the employee that much control.

For those cases where the employer wants to encourage certain employee behavior, the restricted bonus plan was created. The restricted bonus plan is created by an agreement between the employer and employee, and the terms of the agreement apply to the policy.

Typically, the restricted bonus agreement limits the employee’s right to access the policy’s cash values during early years. When the employee reaches retirement age, the restrictions are usually lifted.

However, the restricted bonus plan may not give the employer any ownership or beneficial interest in the policy. If the employer has such rights in the life policy, it cannot take a tax deduction for the bonus. See Section 264 of the Internal Revenue Code.

Where the Bonus Plan Fits

In many cases, a bonus plan is the best choice for the owner of a business—even a 100% owner—to pay for needed insurance.

If the company’s income tax bracket is higher than the owner’s personal tax bracket, a bonus plan may make sense. Say that Jared is the owner of Jeweler’s World, Inc., organized as a C corporation. Say also that Jeweler’s World pays corporate income taxes at a 34% rate. If Jared is in a combined personal income tax bracket of 28%, the personal bracket is lower than the corporate bracket. Imagine that Jared is considering how to pay the $1,000 premium.

Since in the example Jared controls both the corporate and his personal tax arenas, it makes sense to generate a deduction worth a savings of $340 in corporate taxes in exchange for a personal tax liability of $280.

Note that the tax bracket spread between the company and the owner/employee is only possible when the business is organized as a C corporation. Since proprietorships, LLCs and S corporations are pass-through entities, there is no tax leverage in using a bonus arrangement for the owners.

Using a bonus plan to pay for the business owner’s personal life insurance also makes sense when:

1. Coverage is needed for life coverage to fund a cross-purchase buy-sell agreement,

2. The owner is determined to write a business check for personal insurance, and

3. The owner intends to use the policy’s cash value only for retirement or other personal needs.

A bonus arrangement can also be the right way to pay for needed personal coverage for a non-owner key employee. A bonus plan should be considered

1. When business tax deductibility is a more important goal than

a. Control of the policy, or

b. Control over the employee’s behavior;

2. Or when the employee benefit must be simple to implement and administer, and the employee needs coverage.

Split Dollar Plan

A split dollar plan is a sophisticated way to pay for needed business life insurance coverage. In addition to its business application—which we are focusing on here—split dollar may also be used in family situations. Family split dollar allows coverage to be funded primarily by a family member with the money to pay the premium.

A business split dollar plan, involves splitting up the premium obligation and the life policy benefits between the employer and the employee. There is no direct Code Section on split dollar, but split dollar plans have been the subject of Revenue Rulings and other tax authority for more than 50 years.

How It Works

Under a split dollar plan, the employer and employer enter into an agreement regarding how the premium and policy benefits will be split. One simple method of splitting involves having the employer own the policy’s cash value, and the employee controls the policy’s death benefit in excess of the cash value. This configuration is sometimes called endorsement method split dollar.

Under a typical endorsement method arrangement, the employer pays most of the planned premium for the policy. The employee contributes an amount of premium equal to the current value of the policy’s death benefit. The employee’s premium contribution usually increases as the employee gets older, as the potential to realize the death benefit in any given year increases.

In the event of the employee’s death, the employer receives an amount equal to the cash value, and the employee’s personal beneficiary gets the rest. If the plan is terminated prior to retirement, the employer keeps the cash value, and the employee must either surrender the policy or come up with personal funds needed to keep it in force.

Key Characteristics

While a bonus arrangement can have a written agreement to spell out its terms, there must be a written agreement if the parties want to be sure the tax characteristics of the split dollar plan are respected. Writing a split dollar agreement usually requires an attorney to be involved in the process, which may practically prevent its consideration in certain circumstances.

Here are some other key characteristics of a split dollar plan that will help a client decide whether it’s the right fit:

1. The employee and employer share control of the coverage. The specific nature of the shared control is spelled out in the split dollar agreement.

2. The employer DOES NOT get a tax deduction for the amount of the bonus dedicated to the plan; however, under a split dollar plan, the employer generally recovers some or all of its costs of participation.

3. If the employee leaves employment or if employment performance suffers, the employer may generally stop contributing to or otherwise terminate the plan.

4. There is ongoing administration required for split dollar plans, especially related to tax result tracking.

5. Planning for termination of the plan can be tricky. In general, the employee’s premium contribution obligation increases the longer the plan stays in effect. At the employee’s planned retirement age, the contribution obligation may exceed the policy’s planned premium. If the employee hopes to continue coverage after retirement, the alternatives for doing so may be limited and expensive.

Variations

Split dollar has been configured in so many ways that it is impossible to list all variations here. The endorsement method is the simplest to explain. Most variations can be combined with a bonus plan to limit or eliminate employee’s contribution.

The design of split dollar plans is driven in large part by tax considerations. Since 2001, the IRS has recognized two different regimes under which split dollar arrangements are taxed.

Under the economic benefit regime, the value of the employee’s right to the death benefit (the economic benefit) is measured each calendar year. The economic benefit is calculated using the government’s Table 2001, or, if lower, the insurance company’s qualifying alternate annual renewable term rates. If the employee accrues any interest in the policy’s cash value, that growth is part of the economic benefit as well.

If the employee contributes an amount equal to or greater than the economic benefit, there are no additional income tax consequences to the employee with regard to the annual value of the plan. If the employee contributes less than the economic benefit, the difference between the economic benefit and employee’s personal contribution is taxable income to the employee.

Under the loan regime, the employer’s premium payments are treated as loans to the executive.  If the employee pays the employer interest on the loans at or above the applicable federal rate (AFR), the employee pays no additional income tax with regard to the annual value of the plan.

If the executive does not pay adequate interest to the employer, the employee will be taxed on the difference between the AFR interest and the actual interest. 

Under a loan regime plan, the employee usually owns the policy and its cash value, and assigns a collateral interest in it to the employer to secure the loan.

Where Split Dollar Fits

In many cases, a split dollar plan makes sense for the owner of a business to implement for himself. Here are some examples.

The business owner may be able to take advantage of a low interest rate environment to create personal arbitrage in a loan regime split dollar plan.

Say for example that the government’s approved loan interest rate is 4%, and is expected to remain that way for the foreseeable future. Say also that the life policy is crediting interest at 5%. Under those circumstances, the owner/employee can essentially borrow money from the business at 4% while earning 5%, creating arbitrage for himself in the form of cash value growth.

The owner of a business with serious estate tax issues may also decide to use split dollar to control the gift tax costs associated with third party ownership.

Say the business owner is 55 years old, single, has two kids and has a taxable estate of $17 million. The owner is worried about the projected estate tax hit of about $6 million at his death. The owner wants to purchase life insurance owned by an irrevocable life insurance trust (ILIT) to cover the estate tax. The annual premium for the plan based on the insured’s risk classification is $70,000.

Funding the premium directly with personal money creates a gift tax issue, as the $70,000 annual premium exceeds the $26,000 annual gift tax exclusion amount based on two trust beneficiaries. The business owner decides to implement an economic benefit split dollar plan with his business. In the first year, the approximate economic value, using Table 2001, would be $25,000.

Split dollar may also be used to pay for cross-purchase life insurance on business owners to fund a buy-sell agreement. Split dollar can partly alleviate differences in personal premium associated with the risk classifications between two or more insureds.

For the non-owner key employees of a business, split dollar may be the right fit when:

• Control over the policy’s cash value by the employer is a more important goal than

▪ The employer’s tax deduction, and

▪ Simplicity of the plan; or

• The employer hopes to use the policy’s cash value for business purposes later, but wants the employee’s family to have potential access to a tax free death benefit now.

Key Employee Insurance Plan

Split dollar and bonus plans are designed to help in cases where personal insurance coverage is needed. Key employee insurance is owned by and payable to the business, and its primary purpose is to serve as a business “shock-absorber” and/or meet other business needs. However, a key employee insurance plan can also act as a substitute for needed personal coverage in circumstances involving both business owners and key employees.

How It Works

The employer owns insurance on the life of an employee. The employer is beneficiary of the policy and pays the non-deductible premium.

Key Characteristics

The insurance part of a key man plan is simple: the employer controls the contract completely. The insured employee, other than signing the initial application as insured and acknowledging that the employee has had proper notification regarding the coverage, has no direct interest in the insurance at all.

Variations

The insured may have an indirect interest in a key employee plan.

For example, if the insured is an owner of the business—especially a sole owner of the business—while the policy’s death benefit is paid to the employer, the employee and his family will maintain indirect control of it.

For a non-owner employee, a key man insurance policy may be the informal financing vehicle for some type of deferred compensation agreement. For example, say that ABC Corporation agrees with Paul, a key employee, to provide compensation in addition to his current salary but not pay it until some later year. For instance, assume that under the agreement, the corporation promised to pay Paul a lump sum of money if he stays with the company until retirement. If Paul dies prior to retirement, the company promises to pay Paul’s family an amount equal to Paul’s current salary each year for ten years.

To informally finance its obligation under the agreement, ABC Corporation owns insurance on Paul’s life.

Even though ABC is the owner and beneficiary of the policy, Paul has an indirect interest in it, because it is being used to help ABC keep its promise to him.

While implementing key man coverage is simple, creating an indirect interest for the employee under a deferred compensation is not. Any such plan requires the active involvement of an attorney to draft the agreement, as well as careful administration of the plan to avoid unwanted tax results.

Where a Key Man Insurance Plan Fits

For an owner/employee of a business, key man insurance coverage makes sense to consider in some cases:

• When the business income tax bracket is temporarily lower than the personal bracket, key man coverage may be cheaper than personally-paid coverage. However, when the owner/employee or his beneficiaries want to convert business-owned proceeds to personal money, there may be an extra tax cost for doing so that doesn’t exist under personally-paid or bonus-paid coverage.

• When the primary motivation for the coverage is to meet business rather than personal needs such as loan repayment or operations, key man insurance may be more efficient than personal coverage.

• When having the business recover its costs—and possibly more—from the policy is important.

• When money is needed to fund a redemption-style buy sell agreement, business-owned life insurance is usually the right fit.

For a non-owner employee, key employee insurance may also make sense in these cases:

• Key employee life insurance can informally finance a non-qualified employee benefit agreement between the employer and employee.

• When the employer’s control of the coverage is more important than any other consideration, key employee coverage is the right fit.

• When having the business recover its costs—and possibly more—from the policy is important.

• When the primary motivation for the coverage is to meet business needs rather than the employee’s personal needs, key man is also the right fit.

Conclusion

Life insurance professionals who work with business owners must be prepared to help their clients decide whether using the business to pay for needed life insurance makes sense.

Bonus plans, split dollar plans and key man life insurance plans are the most common ways for closely held business owners to pay for needed life insurance. For business owners, the decision regarding which plan to choose is driven primarily by cash flow and tax considerations.

For non-owner employees, the employer is usually the decision-maker regarding plan design. Deciding on the proper plan requires weighing the relative importance of deductibility, control of the policy, cost recovery, simplicity and the needs of the employee.

Would You Like to Turn this Month’s Issue of Think About It Into a Dynamic Presentation for Your Next Company Meeting?

Tired of boring presentations at company meetings? Want to spice things up with a fun, interactive session focused on increasing results? Make the current issue of Think About It work for you and your producers!

Linas Sudzius, J.D., CLU, ChFC, one of the authors of Think About It, will show you how to use the information in the attached newsletter to make more money.

|[pic] |Linas is one of the principals of the ICS Law Group, PC. The ICS Law Group provides estate planning |

| |legal services to individuals, and non-litigation legal services to business owners. Its principal |

| |office is in Franklin, Tennessee. |

| | |

| |Linas worked for a Chicago-based insurance company as their Director of Advanced Sales and most recently |

| |as their Chief Marketing Officer. |

| | |

| |Linas also co-authors the publication Think About It with Steve Leimberg. |

Linas is now scheduling 90 minute and half-day presentations for early 2010. Contact Brenda Harvill at 615-224-1291 or brenda.harvill@ for availability and pricing information.

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