10. Employer/Employee Insurance Arrangements

Question 1

closely held businesses

Answer 1

Businesses whose ownership interests have no ready market- majority<10 individuals: sole proprietorships, partnerships and closely held corporations.

Question 2

Sole Proprietorships

Answer 2

unincorporated, simplest form of business to establish/operate

In order to keep going-concern value, sole proprietor should have properly funded advance agreement to sell to prospective buyers in the form of life/disability income insurance / buy-and-sell agreement funded by insurance on the proprietor’s life.

Premiums are not tax deductible, but policy proceeds received would be income-tax free. If key employees are unable to pay required premiums, proprietors could assist through split-dollar arrangement

Question 3

Partnerships

Answer 3

2+ business for profit as co-owners. Most engage in commercial activities:
General partnership: Each partner is actively involved and fully liable
Limited partnership: at least one GP and 1+ LP

Alternative: LLC- taxed as partnership, but with limited liability

Question 4

Problems of Partnerships

Answer 4

-Any changes in membership including death of GP causes dissolution. Liquidation involves forced sale of assets. Difficult to continue without buy-and-sell agreement due to:
-survivors nots being able to raise enough cash at a price that’s fair, and may not even be able to depending on the state, legal and practical complications, loss of GP’s talents, financial drain, nondisabled partners not sufficiently compensated/overburdened

Question 5

Partnership Buy-and-sell Agreements

Answer 5

Value of partnership agreement is determined at agreement or a formula is included in agreement:
- Entity purchase: business is obligated to buy ownership interest (owns and is beneficiary of LI policy on each of the partners’ lives)
- Cross-purchase: each owner buys his/her estate to sell business interest to surviving owners and vice versa (each partners owns and is beneficiary of LI policy on each other’s lives)

business continuation arrangement of professional partnership is usually different, with provision for income from profit sharing arrangement to go to deceased’s estate/heirs for specified period

Question 6

business disability income insurance for business continuation arrangements

Answer 6

provides cash funds to business/partners/small corporations to buy interest of disabled (unable to perform major duties of regular occupation/not actively at associated work) partner/shareholder after 12/24/36 months of disability, based on trigger point when healthy person must buy out disabled insured/owner

Max benefits determined at time of underwriting, based on value of business entity : max insurable =80% of worth for lump sum, reduces after 60, eg 50%@61 and 25% @62

Under indemnity, insurer’s must pay max amount specified regardless of actual value (usually <$350k); under reimbursement , insurers pay lesser of policy benefit/actual value of business at time of buyout (max on $1MM/ind). Future buyout expense option provides owner/insured option of increasing max buyout exp benefit without evidence of insurability

Question 7

Tax implications of buy and sell life insurance

Answer 7

-Premiums are not deductible, proceeds are normally tax free. Cost basis of surviving partner is increased by proceeds received by partnership (entity plan)/amount paid for partner’s interest (cross-purchase plan)

-Purchase price established by agreement would fix value (prior to 10/8/1990 fixed value for tax purposes could be substantially less than FMV). Agreement’s value will take precedence if a bona fide business arrangement, not device to transfer property to family, and has terms comparable to arm’s length transaction

Question 8

Problems from corporate form

Answer 8

-Shareholders of close corporation are usually officers
-owners pay corporate profits to selves as salaries instead of dividend
-no ready market for stocks

Basic operations resemble partnerships, referred to as incorporated partnerships; hence requiring prearranged plan to retire shareholder’s interest following death

Question 9

Majority Shareholder Situation

Answer 9

In the event of a majority shareholder’s death/disability in a closed corporation, the other shareholders have 4 alternatives, which may not be satisfactory:
- accept adult heir of deceased into management
-pay dividends equivalent to deceased’s salary to heir(s)
-admit into active management outside interests to whom deceased’s stocks were sold to
-purchase stock from disabled owner/estate

Question 10

Minority and 50/50 Shareholder Situation

Answer 10

All shareholders have rights, such as being entitled to a proportionate share of dividends, to examine the corporate records with legitimate reason, and generally to participate in all shareholder activities. Lawsuits by disgruntled minority shareholders are not uncommon.
minority shareholders may decide to abandon the business altogether and start out afresh on their own, especially as they may be the ones who understand the business best and are most likely to continue it as a successful going concern.

Question 11

Corporate Buy-and-sell Agreements

Answer 11

-Entity (stock redemption) binds corporation to purchase of deceased/disabled shareholder’s stock
-Cross-purchase binds surviving shareholders to purchase of deceased/disabled shareholder’s stock

shareholder’s interest is valued at the time the agreement is drafted, and it should be revalued periodically, and the agreement amended to incorporate the new values.

Question 12

Use of Life and disabililty Insurance policies in corporate buy-and-sell agreements

Answer 12

• when there are many partners, then entity arrangements: # of policies =# of partners/owners
  -in cross-purchase agreement, each partner will have a policy on every other partner/owner

Question 13

Tax aspects in corporate buy-and-sell agreements

Answer 13

• premiums are not tax deductible and death proceeds/disability income payments (not included in estate unless incident of ownership) not taxable aside from AMT

Question 14

Factors when choosing the type of corporate buy-and-sell agreement

Answer 14

-Taxation: if corp is in lower tax bracket than shareholders, then redemption plan preferred since premium payments would take smaller share of corporation’s after-tax income than shareholder’s
Administration: Under a stock-redemption plan, the corporation need purchase only one policy per shareholder; total number of policies needed for a cross-purchase arrangement is n(n - 1), where n is the number of shareholders
Cost basis: Cost basis remains the same for stock-redemption plan, cost basis increases with cross purchase plan. If the shareholder is likely to retain the stock until death, the stock will obtain a stepped-up cost basis to its then fair market value on the death of the shareholder.
Accumulated earnings >$250k incurs 20% tax, earnings accumulated to meet a corporation’s obligations under a nonqualified retirement agreement should be considered a reasonable business need.
Creditors: Under a stock-redemption plan, the corporation is the owner and beneficiary; therefore cash values and death proceeds are subject to creditors. Does not apply to cross purchase
State law: most state that corporate redemptions can be made only from available corporate surplus
Loan limitations: agreements used by most banks contain a restriction prohibiting the payment of dividends or redemption of stock without the bank’s prior consent. stock redemption agreement needs to be fully funded , otherwise may not be allowed to make redemption
Attribution rules: complete redemption of a shareholder’s stock by a corporation will result in capital gains treatment. The family attribution rules can be waived provided the shareholder retains no interest in the corporation, does not require any interest within 10 years, and files agreement to notify IRS if obtain forbidden interest within 10 years

Question 15

In a sole proprietorship, who is obligated to liquidate the business upon the death of the proprietor?

Answer 15

The proprietor’s personal representative generally is obligated to liquidate the business. The personal representative is usually named in the last will and testament of the proprietor and could be the spouse or heirs of the proprietor

Question 16

What difficulties can be avoided upon the death of a partner if members of a partnership enter into a buy-and-sell agreement?

Answer 16

upon the death of a general partner, the partnership is dissolved. Dissolution of the partnership is not taxed, but the deceased partner’s interest in the partnership may have to be used in paying his or her estate tax. This may result in the forced sale of assets, usually at a fraction of their normal value, and goodwill is completely lost. It usually results in them losing their very means of earning a living.

Question 17

Business Overhead Disability Plan

Answer 17

reimbursement-type benefit based on the covered expenses incurred

Question 18

Covered expenses

Answer 18

Deductible business expenses verified with tax return:
Rent or mortgage payments for the business premises
Employee salaries
Installment payments for equipment, which usually does not include inventory
Utility and laundry costs
Business insurance premiums that are not waived during disability
Recurring monthly expenses part of running business

Question 19

Benefits paid on Business Overhead Disability Plan

Answer 19

Usually on cumulative basis, up to $10k covered expenses. Unpaid benefits may be carried forward

Question 20

Golden Parachute Plan

Answer 20

special severance benefits to executives in the event that there is a change in:
-ownership or effective control of the corporation
-ownership of substantial portion of assets of the corporation
-and aggregate PV of payments=>3x base amount

However there are limits on corporate deductions for these payments and penalties on the recipient for payments beyond specified limits (does not apply to closed corporations)

Question 21

Tax Sanction for Excess Parachute Payment

Answer 21

• no employer deduction
  -person receiving: subject to 20% penalty tax on excess

Question 22

excess parachute payment

Answer 22

parachute payment - (PV of parachute payment)/(PV of all expected parachute payments) x Base amount

Question 23

Base amount definition

Answer 23

three times the individual’s average compensation for the five taxable years ending before the date on which the change of ownership or control occurs

Question 24

Exceptions to parachute rules

Answer 24

• Corporations that have no readily tradable stocks on established securities market, provided that payments are approved by majority of stakeholders who owned >75% of voting power
  -payments from small business corporations, qualified retirements plans, SEPs and SIMPLE IRAs

Question 25

Split-dollar Life Insurance

Answer 25

Arrangement between an employer and an employee, in which there is a sharing of premiums, death benefits, and/or cash values of the life insurance policy; can be between a parent corporation and a subsidiary, or between a parent and a child or in-law

Question 26

Split-dollar Life Insurance Design Features

Answer 26

-cumulative premium paid by the non-owner would be treated under the “loan regime,” where equity or cash value benefits are being enjoyed in addition to pure death benefit.
While the actual individual tax cost is directly related to the level of interest rates (AFR), it is important to note that the shareholder of a C-corporation, in an employment situation, may place money into an individually owned policy without incurring double FICA/FUTA costs as high as 15.3% and at a much lower initial income tax cost (C-corporate tax bracket)
-Economic benefit regime- only benefit being bestowed/measured is pure death benefit

Question 27

Employer-pay-all plan

Answer 27

when employee has limited funds to allocate towards the plan and the employer owns the policy and cash value. Employee cost is limited to tax on Table 2001 cost of pure insurance coverage

If employee owns the policy and cash value, then the split dollar is treated as a loan

Question 28

Cash Value and Death Proceeds Split

Answer 28

• under employee owned plan, purpose of split of cash value/death proceeds is to reimburse employer for its share of premium outlay; however with an equity type plan, the employee must own the policy and treated as Section7872 loan regime so that the plan can also provide deferred compensation/pension element

Question 29

Policy ownership

Answer 29

• endorsement method: employer owns the policy and is responsible to the insurance company for paying the entire premium- employer has greater control and outright ownership of cash value, simpler installation and administration, avoidance of formal arrangement
• collateral assignment method: employee or a third party is the owner of the policy and is responsible for premium payments, employer makes interest-free loans of the amount of the premium the employer has agreed to pay under the split dollar plan. policy is assigned as collateral- gives more protection to employee and beneficiary. easier to implement using existing insurance policies owned by employee, employee may generate tax-free income from policy via withdrawals to basis/loans

Question 30

Policy dividend options

Answer 30

-cash/reduction in employee’s premium share/paid up additions where cash value and death benefit are controlled by employee/one year term insurance (5th dividend option) with death benefit controlled by employee: dividend is taxable income to employee
-paid up additions where cash value controlled by employer and death benefit in excess of cash value controlled by employee: P.S. 58/Table 2001 cost of insurance protection provided by dividend is taxable income to employee

Question 31

Ways to pay off employer

Answer 31

• at rollout, employee buys out employer’s policy rights for cash which can come from any source including policy loan
  -at rollout, the employer provides a relinquishment to the employee of the employer’s rights to the policy
  -gradual buyout of employer’s right by using policy dividend

For C-Corporation shareholders, combining above with selling corporate stock or paying a qualified dividend with a more favioable tax treatment o the shareholder

Question 32

Tax Implications of split-dollar plans

Answer 32

Loan or non-loan transaction
Death benefits- generally tax free (lost if transferred for value from existing corp-owned key employee policy to 3rd party beneficiary, employee owned policy to corporation unless employee is a shareholder or officer, at termination of the plan, do not transfer corporation’s interest in policy to a 3rd party beneficiary)
Employee ownership- if employee had no incidents of ownership, then death benefit is not includable in estate, unless proceeds are payable to employee’s state
Federal gift tax consequences

Question 33

If the employee is a controlling shareholder, where should the incident of ownership be attributed?

Answer 33

If the employee is a controlling shareholder, more than 50% in the employer corporation, the corporation’s incidents of ownership in the policy will be attributed to the majority shareholder.

Question 34

Federal gift tax exclusions

Answer 34

transfer of the policy from the employee to another party is a gift subject to tax, there is a continuing annual gift if the employee pays the premiums, Under an employer-paid loan arrangement, the gift to a third party (e.g. Trust) owner is the imputed income for each year.

gifts to insurance trusts may be considered future interests that do not qualify for the gift tax annual exclusion.

Question 35

Which of the following describes a method of ownership of a life insurance policy subject to a split-dollar arrangement?

Answer 35

endorsement method and the collateral assignment method.

Question 36

Which of the following is true regarding the traditional income tax consequences of a split-dollar arrangement?

Answer 36

The traditional income tax consequences of a split-dollar plan are that the employee is considered to be in receipt each year of an amount of taxable economic benefit. The employer cannot deduct any portion of the premium contribution. Death benefits from a split-dollar plan, both the employer’s share and the employee’s beneficiary’s share, are generally income tax free.

Question 37

Key Employee Life Insurance

Answer 37

insurance on a key employee’s life that is owned by the employer. Death benefit is payable to owner/employer. In closely held corporation, key employee insurance can provide source of liquid assets in corporation

Question 38

When is Key Employee insurance used?

Answer 38

• corporation will incur obligation to pay specified beneficiary/class of beneficiaries at an employee’s death under a death benefit only (DBO) plan
  -an employer has a NQ deferred compensation arrangement with one+ key executives/o/ employees and needs to finance its obligation upon death
  -closely held corporation anticipates need for liquid assets upon death of a key employee to stabilize corporation financially and contribute to employee benefit plans for surviving employees
  -shareholder-employee expects corporation to buy stock from his/her estate as part of estate plan and corporation needs additional liquid assets to carry out purchase

Question 39

tax implication of key employee life ins to employee

Answer 39

-no income tax to key employee or key employee’s estate when corporation owns the policy and receives death proceeds from key employee life insurance
-when corporation is beneficiary, insurance proceeds are taken into account in valuing decedent’s stock, but not included in estate dollar for dollar
-if KE was a majority shareholder (>50%), policy proceeds will be taxed in the insured key employee’s estate as life insurance, policy proceeds of corp owned LI should be payable only to corp/creditors

Question 40

tax implication of key employee life ins to employer

Answer 40

-corp paid premiums are not deductible
-death proceeds are tax free when paid to corporation (except for potential application of AMT-repealed by Tax Cuts and Jobs Act)
-if corp has accumulated earnings of >$250k ($150k for certain service corp), then further accumulation of income to pay premiums potentially exposes corp to accumulated earnings tax. purchase of LI to cover potential loss of bona fide KE should not result in significant risk of accumulated earnings tax exposure

Question 41

Alternatives to KE ins

Answer 41

Personally owned insurance may have better tax advantage if individual owns corporation and corp’s income tax bracket is higher than employee’s tax bracket, can be paid by additional compensation from the corporation in the form of a bonus (must meet reasonable test to be deductible)

Question 42

Under which method for split-dollar life insurance does the employee own the policy and is responsible for premium payments?

Answer 42

Collateral assignment method

Question 43

What is the tax consequence of the death benefit paid under a key employee life insurance policy?

Answer 43

tax-free for regular income tax purposes when paid to the corporation.

Question 44

Under the endorsement method for split-dollar life insurance, who owns the policy and is responsible to the insurance company for premium payments?

Answer 44

the employer owns the policy and is responsible to the insurance company for paying the entire premium.

Question 45

If a business purchases business overhead expense insurance insuring the owner of the business, generally, which of the following statements correctly describes the tax treatment of the premiums and benefits paid under the policy?

Answer 45

The premiums paid by the business are tax-deductible by the business and the benefits paid under the policy are taxable to the business. While the benefits paid are taxable to the business, the benefits will be used to pay deductible business expenses, therefore, no tax liability will be incurred.

Question 46

Each of the following statements regarding a group carve-out life insurance plan is correct

Answer 46

Premiums paid by the corporation are nondeductible if the corporation is beneficiary.
Under a carve-out plan, coverage may vary for each participant.
Most plans involve level-premium insurance contracts with a guaranteed premium.
Underwriting is typically done on an individual basis.