Business Owner - Executive Insurance

All organizations face the need to recruit and retain key employees as well as deal with succession planning concerns. Employers of all sizes recognize the significant impact that a few individuals can have on their organization's growth, profitability, market position, product development, etc. Often these employers are seeking tailored arrangements utilizing compensation, ownership and insurance products to address these needs. 

We have worked with clients to address these needs since our inception by tailoring coverage and plans to meet your needs and budget. 

If you want more information on Business Owner- Executive Insurance for your firm, please feel free to  contact me so we can discuss your concerns and schedule an appointment to review your options.

KEY PERSON INSURANCE

  • Recognizes the significant contributions certain individuals provide the organization.
  • Employers understand the loss of these individuals can creat significant financial consequences to their organization.   
  • Employers seek to establish a safety net to allow time so they may recover from the loss.
  • Key person life and disabilty insurance can provide critical funding during transition periods.
  • Insurance proceeds assure creditors, customers and employees of the organization's ongoing viability.
  • Life insurance cash values can provide needed liquidity when other sources of credit or capital become tight.    

BUY & SELL AGREEMENTS

Buy-Sell Agreements :

Obligates deceased business owner's estate or heirs to sell their interest at a pre-agreed price to the business' surviving owners.It provides business owners certainty about who will purchase the deceased owner's business interest, what the price will be, when the sale will take place, and where the funds will come from.The price established for a business interest in a buy-sell agreement can fix the value for federal estate tax purposes if certain legal requirements are met.

Commonly funded with life insurance, but disability insurance buy out plans are also available.

The two most common arrangements, Entity and Cross Purchase, are discussed below.

The business entity, not the individual owners, agrees to buyout the entity interest. The entity buy-sell agreement can be funded by insurance covering each owner. The amount of insurance approximates the purchase price for the insured owner's share of the business. The purchase price is either specified as a certain fixed amount, or the agreement includes a formula to be used to establish the price. The business entity owns the policies and is the beneficiary of each. If an owner dies or is disabled, the business receives the insurance proceeds, which it uses to buy out the deceased/disabled owner's interest.

Premiums paid for insurance to fund the buy-sell agreement are not tax-deductible and the death proceeds are exempt from federal income tax; however some C corporations may be subject to corporate alternative minimum tax on part of the proceeds.

If a corporate stock redemption agreement is used, there is no increase in basis for a surviving owner's interest. Distributions from a corporation to a shareholder are generally taxed as dividends, but dividend treatment can be avoided if the stock redemption qualifies as one of certain exempted transactions (e.g., a section 303 redemption, or a complete termination of the shareholder's interest). 

Under the cross-purchase agreement, each business owner individually agrees to buy a portion of the deceased owner's interest. To fund a cross-purchase buyout, each owner purchases an insurance policy covering the other owner(s). The total amount of insurance approximates the purchase price of the insured's share of the business. The purchase price is either specified as a certain fixed amount, or the agreement includes a formula to be used to establish the price.

Each business owner/partner owns the policies covering the lives of the other owners and is the beneficiary of those policies. If an owner dies (or is disabled), the remaining owners use the  insurance proceeds to purchase a share of the deceased owner's interest. Cross-purchase agreements commonly provide that the ownership interest of each surviving business owner remains the same so if the relationships are unequal, they remain unequal after the death.

Premiums paid personally by each owner are not tax-deductible. Policy proceeds are generally received federal income tax free. Surviving owners receive a step-up in basis under a cross-purchase agreement that is not available in an entity or stock redemption agreement. Any cash value in policies the deceased person owns covering the other business owners is included in the deceased owner's estate, and could impact the deceased owner's estate taxes payable.

Executive Disability Income Insurance

Group Long Term Disability (LTD) insurance plans commonly replace 50% to 66.67% of income to a stated maximum benefit.

When employers offer employees group disability insurance benefits; their focus is to provide coverage to the widest range of employees. However in some situations their highly compensated employees may not receive the same level of benefits (replacement income) as non-highly compensated employees. As a result, these highly compensated employees may end up with a lower percentage of their income replaced due to the group LTD plan's stated maximum benefit. 

To correct this, an Executive Disability Income Plan can be established to equalize income replacement. These plans may also offer additional coverage not available on the group LTD plan.

Planning note: since highly compensated employee/participants are subject to insurer underwriting standards, some may not qualify for coverage.

 

Split Dollar Life insurance

A split-dollar arrangement is a method of purchasing life insurance in which the premium payments and policy benefits are divided disproportionately in some predetermined way, usually between a business and an employee—but sometimes between two individuals. Split-dollar is a method of buying life insurance, not a reason for buying it. A need for life insurance should always exist before a split-dollar arrangement is considered.

  • In a business setting, split dollar is an executive benefit, with the employee being the insured.
  • The premium payments and proceeds are split between the employer and the employee.
  • It may be used to satisfy the employer's need to provide a valuable fringe benefit to retain a key employee, or to attract a key employee into the business.
  • For the employee, the split-dollar arrangement may provide life insurance protection for survivors at a lower current, out-of-pocket cost than personally purchased policies.

Policy ownership in split-dollar arrangements can be structured in different ways.

The most popular structures are The Endorsement Method & The Collateral Assignment Method.

The method chosen has important tax consequences under final regulations issued by the Treasury Department.

  • Under The Endorsement Method, the employer usually owns the policy and an agreement spells out the employee's rights. Typically, the agreement gives the employee the right to name a personal beneficiary for the employee's share of the death proceeds as prescribed in the split-dollar agreement between the parties.
  • In The Collateral Assignment Method, the employee owns the policy and names a personal beneficiary, but assigns policy benefits to the employer as collateral for the employer's premium advances under the arrangement.
  • Premiums and death proceeds can be split in a variety of ways, as spelled out in the agreement between the parties. 

In an employer-pay-all arrangement, the employer advances the entire premium. The sharing of the death benefit under this arrangement can be designed so that the employer recovers its entire investment (net premiums paid) or perhaps the cash value of the policy at the time of the employee's death. The balance of the proceeds in both instances is paid to the employee's beneficiary.

All such economic benefits must be accounted for fully and consistently by both the owner and the non-owner. Assuming the parties are employer and employee, the employee reports the value of the economic benefits received, reduced by any consideration paid to the employer, as gross income. Final regulations issued in September 2003 provide for two alternative tax regimes governing the federal income taxation of split dollar life insurance arrangements:

  1. The economic benefit regime
  2. The loan regime.

1.) The “economic benefit regime” generally applies to the endorsement method arrangement in which the employer owns the policy and the employee's rights are spelled out in an agreement. Under the economic benefit regime, the owner of the life insurance policy is deemed to provide a taxable economic benefit to the other party to the arrangement.

2.) Under the "loan regime", the non-owner of the life insurance policy (payor) is treated as making loans of all or part of the premiums to the policy owner (borrower). The loan regime applies to an equity collateral assignment arrangement in which the employee owns the policy and uses it as collateral for the employer's advance of premium payments, and the employee has an interest in the policy's cash value.     

The loan regime seeks to account for the benefits provided by the lender (employer) to the borrower (employee) when the loans are "below-market." If a split-dollar loan does not provide for sufficient interest, the loan is below-market and subject to the imputed interest rules. If the split-dollar loan does provide for sufficient interest, then, with some exceptions, the loan is subject to the general rules for debt instruments.

The loan regime does NOT apply to a non-equity collateral assignment split dollar arrangement involving employment or a gift, where the employer or donor is treated as the owner and thus the economic benefit regime applies. In a non-equity arrangement, the employee has no interest in the policy's cash value.

Split dollar is a popular executive benefit that utilizes life insurance to provide a supplemental retirement income and/or pre-retirement death benefit protection. It can be used with a deferred compensation arrangement (benefits paid to the executive's beneficiaries are taxed as ordinary income) or as a stand-alone plan. Using a split dollar arrangement with a deferred compensation plan ensures that the death benefit received by the executive's beneficiaries will be tax-tree.

 

Nonqualified Deferred Compensation
 

  • Nonqualified deferred compensation is an incentive compensation arrangement established by employers to provide retirement income, often with death and disability benefits, only to select employees.
  • The arrangement is a contractual commitment between an employer and an employee (or independent contractor) which specifies when and how future compensation will be paid.
  • When properly arranged, the employees can postpone income taxation on the deferred amounts until benefits are paid.
  • Deferred compensation is "nonqualified." Arrangements do not have to be preapproved by the IRS, and employers can discriminate in favor of selected employees. Also, when properly arranged, they are exempt from the regulatory requirements of ERISA Title I which are applicable to qualified retirement plans.
  • Although deferred compensation do not need to meet the required annual reporting of qualified plans plans, they still must meet section 409A guidelines.  

A nonqualified deferred compensation arrangement typically provides that an employee will receive a stipulated sum for a fixed period of time beginning at a future date such as the employee's retirement. The arrangement may provide that the employee will receive future compensation as a result of a current salary reduction or in lieu of a bonus or salary increase. This is sometimes called a true deferral arrangement.

An alternative to true deferral is the salary continuation arrangement. Here, the employer commits to pay future compensation to the employee in addition to current earnings, which are not reduced by participation in the arrangement.

A common funding option is permanent life insurance due to the tax deferred build up of cash values and potential of self completing funding if there is a premature death.

The employer applies for an insurance policy on the employee's life to "informally fund" its obligations under the agreement subject to the employee's consent under IRC Sec. 101 (j).When the employee satisfies the conditions to receive benefits, the employer begins to pay retirement (or disability) benefits from the policy values, subject to the federal income tax rules regarding policy withdrawals, loans and surrenders.

At the employee's death, the employer uses the insurance proceeds to pay a death benefit to the employee's beneficiary (if the arrangement so provides).

To obtain the desired tax benefits (no tax to employees until benefits are received), a nonqualified deferred compensation arrangement must be considered "unfunded."

  • In an unfunded arrangement, the employee has only a contractual right—an unsecured promise to receive benefits in the future.
  • An arrangement is considered unfunded if there is no reserve set aside to pay promised benefits.
  • Reserves so established remain a general asset of the corporation, subject to invasion by the corporation's creditors

Thus, the employee cannot be entitled to a current beneficial interest in the funds if the arrangement is to be considered unfunded for tax purposes. This is an important point, because employees defer taxation until they actually receive benefits in an unfunded arrangement

If the employer sets aside specific assets to meet its future obligations with the select employee as beneficiary, and these assets are out of reach of general creditors, the arrangement is considered to be funded and the amounts set aside by the employer are currently taxed to the employee.

In order to defer income taxation, benefits must generally be forfeitable if the select employee fails to meet some condition(s) under the arrangement. However, no risk of forfeiture is required if the employer's creditors can reach the arrangement fund. 

 

Death Benefit Only (DBO) Plans

  • Death Beneift Only plans allow firms to offer a benefit to select key employees. 
  • This benefit is used by firms looking to offer a selective plan on a modest budget. 
  • DBO plans are offered to non-owner employees as a benefit to recognize their added value to the firm.
  • DBO plans with term life insurance provide added security to a key employee's family.
  • Normally, DBO plans have premiums paid by the employer on behalf of the employee. When premiums payments are a form of compensation, they are tax deductible to the employer.
  • The key employee reports the added compensation and is responsible for the incremental additional taxes.