A number of your clients could be walking into insurance traps without knowing it.
Insurance professionals can provide a truly valuable service by educating business owners about these overlooked issues and their potential magnitude while providing readily workable solutions. Many of these considerations involve succession planning and keeping the business viable by helping retain its best resources – key employees.
Section 101(j) Considerations
First and foremost, we must confirm that any life insurance owned by the business, in the event of the insured’s death, will be paid income tax free. If proper procedures are not fully followed, death benefits on employer-owned contracts could be subject to income tax. Imagine the reaction from your client if the Internal Revenue Service comes in and takes approximately 40 percent of the policy proceeds at the very moment that cash flow is needed most.
The Pension Protection Act of 2006 created an Internal Revenue Code section, IRC Section 101(j), stating that in order for proceeds from employer-owned life insurance policies to be received income tax free, contracts issued or materially modified must meet certain requirements. One of those requirements is “Notice and Consent.” Before the issue of the contract, the employer must notify the employee in writing that it is purchasing a life insurance contract on his or her life, and the notification must specify the amount of death benefit the employer is seeking to secure. In turn, the employee must consent to the purchase in writing. IRC Sec 101(J) further states that failure to comply could cause the death benefit to lose its tax-favored status and be subject to ordinary income taxes.
IRC Sec 101(j) affects many employer-owned life insurance contracts. It may apply to life insurance policies sold for any of the following purposes:
Stock redemption buy-sell agreements for employee-owners.
Certain split-dollar arrangements.
Family limited partnerships and limited liability corporations where the insured owner also acts as an employee.
Deferred compensation plans.
Supplemental executive retirement plans (SERPs).
If there is any doubt as to whether a policy may be considered business-owned or a business may benefit from a life insurance policy’s death benefit, follow the adage, “When in doubt, fill it out.” Advise the business to complete and retain all notice and consent documents and meet all annual reporting requirements.
Another regularly-neglected trap is leaving a buy-sell agreement unfunded. Time and expense are given to the proper drafting of the agreement; however, attorneys typically do not provide access to funding vehicles. Consequently, if an owner becomes disabled or dies, there is a promise to pay – but with what? The heirs have lost their primary breadwinner and have a formal document stipulating payment, but the business lacks cash. The surviving owners are stuck. This ultimately could lead the business to fail or, potentially even worse, could lead to the unwanted involvement of the deceased owner’s family in the management and profits of the business.
There are only four ways to fund a buy-sell agreement:
Establishing a sinking fund.
Borrowing the funds.
Life and disability insurance proceeds.
The first option offers limited leverage opportunities, can require lengthy amounts of time to fund and may subject the business to additional taxes. The next two choices can prove to be more costly than writing a check. Using life and disability insurance offers substantial financial leverage – a little premium can go a long way – and is the one method that guarantees liquidity exactly when it’s needed.
Key Person Coverage
The purpose of a key person policy is to provide financial help to a business as it goes through a transition period following the loss of a key employee. Proceeds can be used to help locate and retain a replacement, help meet payroll requirements, and help the business maintain its credit with the banks. Banks regularly require key person insurance indemnifying them before executing business loans.
Because the business is the owner, premium payer and sole beneficiary of the policy, the 101(j) requirements previously discussed clearly apply. An additional trap can be created with key person policies if the business seeks to deduct the premiums as a business expense. Although this protection may appear to be a reasonable business expense, premiums on key person policies are not deductible, according to IRC Section 264(a)(1).
An extra trap develops with key person contracts if splitting the benefits between the business and a beneficiary of the insured is desired. However, these complications can be managed if the arrangement is properly treated as an endorsement split dollar agreement.
Endorsement Split Dollar Agreements
The Treasury Department’s final regulations (Rev. Rul. 2003-105; Treas. Reg. Section 1.61-22(b)(1); TD 9092) established that split dollar agreements fall under two tax regimes: the economic benefit regime and the loan regime. Split dollar agreements issued under the economic benefit regime are referred to as endorsement split dollar agreements (ESDAs) and non-equity collateral assignment split dollar agreements (NECAs). The only significant impact of the new regulations on ESDAs was with regard to the annual renewable term rate commonly used to measure the reportable economic benefit (REB). Table 2001 rates replaced the PS 58 rates and more stringent requirements were placed on what carriers could offer as alternative term rates.
The trap associated with ESDAs is that the agreement may be kept in place too long. The REB will increase each year. The economic benefit can seem trivial in the early years of the agreement ($1.10 per thousand at age 40), but it can become sizeable in later years ($11.90 per thousand at age 65) and onerous in even later years ($33.30 per thousand at age 75).
While there are a number of ways that an employer can offer insurance to help key employees provide for their families with death benefit, a properly designed split dollar agreement also offers employers the ability to recover the costs of
providing the insurance. Effective split dollar planning always starts with the exit strategy – avoid the trap.
When it comes to business planning and business-owned life insurance policies, a number of potential planning traps can play havoc with a business’ very survival. While procrastination may prove to be costly, we often can resolve these problems simply by reviewing all business-owned policies, as well as the associated agreements, on a regular basis.