Bryant - Course 5. Retirement Planning & Employee Benefits. 10. Employer/Employee Insurance Arrangements Flashcards
Younghee and her husband, Doocheol, are co-owners of a Korean restaurant that has achieved regional fame since it opened 10 years ago, garnering many favorable reviews for the quality of its food and service. Both Younghee’s talents as the restaurant’s master chef and Doocheol’s meticulous attention to the details of service are indispensable elements of the business’s success.
Due to Younghee’s established reputation, if she were to die or become disabled to the degree that she could no longer perform her duties as chef, the business would suffer a substantial decline. In fact, it is estimated that total revenue would fall by 50 percent. Were Doocheol to die or be unable to work because of disability, it is estimated that total revenues would suffer a more gradual, but progressively steeper decline, with the result that net family income would fall by one-fourth. Additional compensation would be necessary to secure a replacement of comparable talent and skill. The likelihood of securing a replacement chef of the equivalent talent of Younghee is slim. The likelihood of engaging someone with Doocheol’s managerial talents is high, but it would be necessary to pay a substantial wage.
This is where a good business continuation plan would come into play. Life and health insurance is most often purchased for family or other personal reasons. However, individually issued life and health insurance can serve important business purposes as well. The beneficial uses extend over a range of special business applications, which include key employee indemnification, business continuation arrangements and nonqualified executive benefits.
The Employer/Employee Insurance Arrangements module, which should take approximately five hours to complete, will explain the need for and use of insurance arrangements in businesses.
Upon completion of this module, you should be able to:
* Describe business continuation plans,
* Detail a buy-and-sell agreement and its uses in closely held businesses,
* Explain the purpose of a business overhead disability plan,
* Define the golden parachute plan and its structure,
* Specify the working of split-dollar life insurance and its usage,
* Explain the uses of key employee life insurance, and
* State the tax implications of key employee life insurance and its alternatives.
Module Overview
Many business firms have been built around a single individual whose capital, energy, technical knowledge, experience or power to plan and execute make him or her a particularly valuable asset of the organization and a necessity to its successful operation. Numerous examples illustrate the dependence of a successful business upon the personal equation. A manufacturing or mining enterprise may be dependent upon someone who possesses the chemical or engineering knowledge necessary to the operation’s success. The sales manager of a large business establishment may have made himself or herself indispensable through his or her ability to organize an efficient body of salespeople, to employ the most effective methods of selling and to develop profitable markets.
Economic losses and business instability due to death or disability may be guarded against by making the business itself the owner and beneficiary of appropriate insurance policies on the lives of key employees. In the event of death or disability, the business will be indemnified promptly for the loss of the services of the deceased or disabled employee, and the proceeds received will aid in bridging the period necessary to secure the services of a worthy successor or substitute or to provide general business stability. Anything that stabilizes the financial position of a firm enhances its value and, thereby, improves its general credit rating.
To ensure that you have a solid understanding of employer/employee insurance arrangements, the following lessons will be covered in this module:
* Business Continuation Plans
* Business Overhead Disability Plan
* Golden Parachute Plan
* Split-dollar Life Insurance
* Key Employee Life Insurance
Section 1 - Business Continuation Plans
Businesses whose ownership interests have no ready market are referred to as closely held businesses. They include sole proprietorships, partnerships and closely held corporations. The problems of business continuation are particularly acute for such firms. Typically, these problems arise because the owners themselves manage the firm and receive a salary. The number of owners is small, with the majority of closely held businesses being owned by less than 10 individuals. The ownership interest of the closely held business is not traded on organized exchanges and therefore is not readily marketable. The only persons interested in purchasing such an interest are the other owners or competitors. Yet owner-managers often do not address the problem of business continuation. Very few owners identify a successor or prepare a succession plan.
It is important that the business be stable and continue to run even after the death or disability of any of the owners of a closely held business. Though ownership transfers are always difficult, if care and thought is exercised in business continuation planning, the chances of business survival are high. Life and health insurance can play especially vital roles in this regard. To understand this role, we will review briefly the effects that the death or disability of an owner can have on the stability and continuation of each of the three forms of closely held businesses.
To ensure that you have a solid understanding of business continuation plans, the following topics will be covered in this lesson:
* Sole Proprietorships
* Partnerships
* Closely Held Corporations
* Factors to Consider
Upon completion of this lesson, you should be able to:
* Explain the need for business continuation plans in a sole proprietorship,
* Define a buy-and-sell agreement and its purpose,
* List the types of partnerships,
* Enumerate the potential business continuation problems of a partnership,
* Specify the types of partnership buy-and-sell agreements,
* Describe the uses of life insurance and disability income insurance,
* Explain the function of buy-and-sell agreements in closely held corporations, and
* List the factors to consider in choosing the type of corporate buy-and-sell agreement.
In which type of partnership is each partner fully liable and involved in the management of the firm?
* Limited Partnership
* General Partnership
General Partnership
* In a general partnership each partner is actively involved in the management of the firm and is fully liable for partnership obligations.
Shareholders interests in a buy and sell agreement are determined when a shareholder passes away. State True or False.
* False
* True
False
* Each 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.
What is the total number of policies needed for a cross-purchase arrangement if there are seven employees?
* 42
* 49
* 14
* 7
42
* The formula is n(n-1).
7(7-1) =42
AAA corporation has a stock-redemption plan and is going to have to claim bankruptcy. Creditors can get access to the cash value in the stock-redemption plan. State True or False.
* False
* True
True
* Any policy cash values, and death proceeds are, therefore, subject to attachment by the creditors of the corporation because the policy values are general corporate assets.
Section 1 - Business Continuation Plans Summary
Individually issued life and health insurance can prove to be exceptionally beneficial to businesses, especially closely held ones. Closely held businesses are small, and usually self-managed and administered. These forms are the single proprietorship, partnership and close corporations. However, running these businesses also has its problems and several things must be considered, especially with regard to business continuation plans in case of death or disability.
In this lesson, we have covered the following:
* Sole Proprietorship is an unincorporated business, which is owned and managed by a single person. Upon death, the business is liquidated, leading to a possible loss of the business going-concern value for the proprietor’s heirs. This can be avoided by a properly funded advance agreement. A buy-and-sell agreement between the proprietor and a friendly competitor or an employee could be negotiated and funded by life and/or disability income insurance on the proprietor’s life. This ensures that the business could be sold to either of them.
* Partnerships are a voluntary association of two or more individuals for the purpose of conducting a business for profit as co-owners. The two basic types of partnerships are general partnership and limited partnership. Upon the death of a partner the partnership is dissolved. Lack of arrangements can lead to problems like liquidation of the business at discounted values, or replacing the deceased with an unwanted family member. Similar problems can occur when a general partner becomes disabled and is unable to productively contribute. To avoid the foregoing difficulties, the members of a partnership may enter into a buy-and-sell agreement. These are of two types. Under the entity buy-and-sell agreement, the business itself is obligated to buy out the ownership interest of the deceased or disabled partner. Under the cross-purchase buy-and-sell agreement, each owner binds his or her estate to sell his or her business interest to the surviving owners, and surviving owners bind themselves to buy the interest of the deceased owner. Life insurance and business disability income policies are commonly used to fund business continuation arrangements. Under indemnity disability income policies, insurers must pay the maximum amount specified in the policy, while under reimbursement disability income policies, insurers pay whichever is lesser at the time of the buyout. Insurance proceeds are normally income-tax free, though the premium is not tax deductible.
- Closely Held Corporations also called incorporated partnerships, are closely held businesses in corporate form owned by a small number of persons who manage the firm. The death of a shareholder does not legally dissolve a corporation, but it may lead to business continuation problems. These include sale of stock at unreasonable prices, lawsuits against other shareholders and lack of income in the form of dividends. These and other difficulties can be avoided by a prearranged plan to retire a shareholder’s interest following death or total disability with a properly drawn buy-and-sell agreement. Such agreements may be of the entity or cross-purchase type. The agreement binds the surviving shareholders (cross-purchase) or corporation (stock-redemption) to purchase the stock of the deceased/disabled shareholder at a set price, and obligates the shareholder and/or his or her estate to sell stock to the surviving shareholders. These agreements are commonly funded with life insurance policies. Each shareholder is insured for his stock interest value, the insurance being owned by either the corporation or the other shareholders. Upon the first death among the shareholders, the life insurance proceeds are used to purchase the stock of the deceased person.
- Factors to Consider when choosing the type of corporate buy-and-sell agreement are both financial and otherwise. The relative tax brackets of the corporation and the shareholders influence whether the cross-purchase or stock-redemption approach is used. In a business with many shareholders, the number of policies required in a cross purchase plan increases, whereas under a stock-redemption plan, the corporation need purchase only one policy per shareholder. In a stock redemption plan, the cost basis of shareholders will remain the same while their taxable gain increases. With a cross-purchase plan their cost basis increases while their taxable gain is reduced. Other than these factors, the cross-purchase plan avoids several other issues that might arise with stock redemption. The IRC imposes an accumulated earnings penalty tax on corporations that gather earnings and profits in excess of their requirement. Under a stock-redemption plan, the corporation is the owner and beneficiary of the life insurance policies. Therefore any policy cash values and death proceeds are subject to attachment by the creditors of the corporation. These problems are avoided under a cross-purchase plan. State laws that restrict redemptions, loan limitations in a business that runs mainly on credit, and the IRC’s attribution rules that affect partial redemption of stock are other problems faced under a stock- redemption plan but avoided by a cross-purchase plan.
In a sole proprietorship, who is obligated to liquidate the business upon the death of the proprietor?
* The proprietor’s heirs
* The proprietor’s spouse
* The proprietor’s partner
* The proprietor’s personal representative
The proprietor’s personal representative
* Upon the death of the proprietor, 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.
* In a sole proprietorship, a partner does not exist.
What difficulties can be avoided upon the death of a partner if members of a partnership enter into a buy-and-sell agreement? (Select all that apply)
* Pay heavy taxes for dissolution of the partnership
* It may result in a forced sale of assets at a fraction of their normal value
* Goodwill is completely lost
* Partners may lose their means of earning a living
It may result in a forced sale of assets at a fraction of their normal value
Goodwill is completely lost
Partners may lose their means of earning a living
* The law provides that 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.
What are the rights of a minority shareholder’s beneficiaries in a closely held corporation? (Select all that apply)
* They can exercise control over the management of the corporation
* They are entitled to a proportionate share of dividends
* They have the right to examine corporate records with legitimate reason
* They are entitled to participate in all shareholder activities
They are entitled to a proportionate share of dividends
They have the right to examine corporate records with legitimate reason
They are entitled to participate in all shareholder activities
* Though the minority shareholder’s beneficiaries cannot exercise control in the management of the corporation, they may be able to render life miserable for the survivors. They 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. The majority shareholder’s beneficiaries can enforce their wills on the surviving shareholders, whereas minority shareholder’s beneficiaries generally cannot.
What are some of the problems for a business without a funded buy-sell agreement? (Select all that apply)
* Set value for business
* No identified buyer(s) who must buy
* No established funding
* Family or heirs are required to sell to surviving owners or employees
No identified buyer(s) who must buy
No established funding
Some of the problems for a business without a funded buy-sell agreement are:
* No set value for business
* No identified buyer(s) who must buy
* No established funding
* No requirement for family or heirs to sell to surviving owners or employees
Section 2 - Business Overhead Disability Plan
When business owners and professionals in private practice are disabled, their monthly business expenses can be taken care of by an overhead disability plan. In the case of total disability, a reimbursement-type benefit is paid. To avoid confusion, total disability is uniformly defined in occupational terms. The policies usually come into effect and start paying benefits at the end of 30 or 60 days of disability. This waiting period is usually referred to as the elimination period. During the duration that the disability continues, the policies pay up to a specified amount of benefit each month, until an aggregate benefit amount has been paid. The aggregate amount generally is a multiple of 12, 18, or 24 times the monthly benefit, rather than a specifically limited duration of months. The basic policy waives any premium due during disability.
Some insurers provide cover for partial or residual disability through optional benefits. Others allow the insured to purchase additional insurance at a future time without evidence of good health.
To ensure that you have a solid understanding of the business overhead disability plan, the following topics will be covered in this lesson:
* Covered Expenses
* Benefits Paid
* Tax Ramifications
Upon completion of this lesson, you should be able to:
* List the various covered expenses,
* Explain how benefits are paid, and
* Outline the deductibility of premiums and benefits.
Section 2 - Business Overhead Disability Plan Summary
The overhead disability plan pays a reimbursement-type benefit based on the covered expenses incurred. This payment continues for the duration of the disability until an aggregate benefit amount has been paid.
In this lesson, we have covered the following:
- Covered Expenses are accepted by the IRS as deductible business expenses for federal tax purposes. If there are any recurring expenses incurred by the insured for the functioning of the business or professional practice, then such expenses are also treated as covered expenses.
- Benefits Paid by major insurers are on a cumulative basis. They are generally available for insurance of up to $10,000 a month of covered expenses. Unpaid benefits may be carried over into the future payments.
Section 3 - Golden Parachute Plan
A golden parachute plan is a compensation arrangement that provides special severance benefits to executives in the event that the corporation changes ownership and the covered executives are terminated. An executive who accepts employment with a company that is a potential target for acquisition will often insist on a parachute-type compensation arrangement as a matter of self-protection. Within limits, such agreements are an acceptable compensation practice.
Compensation arrangements of this type have a potential for abuse. Inefficient managers could potentially grant themselves large parachute payments that would act merely as a financial obstacle to acquisition, or would unduly burden successor management. Therefore, Congress added provisions to the IRC that limit corporate deductions for these payments and impose a penalty on the recipient for payments beyond specified limits. These provisions do not generally apply, however, to closely held corporations.
To ensure that you have a solid understanding of the golden parachute plan, the following topics will be covered in this lesson:
* Tax Sanction for Excess Parachute Payment
* Formula
* Definition of Parachute Payment
* Definition of Base Amount
* Exceptions
Upon completion of this lesson, you should be able to:
* State the tax implications of the golden parachute plan,
* Define parachute payment and base amount,
* Specify the formula of calculating excess parachute payment, and
* List the exceptions to parachute rules.
Section 3 - Golden Parachute Plan Summary
A golden parachute plan comes into effect with change of ownership. It provides special severance benefits to executives. Such plans are an acceptable compensation practice and most executives will insist on such a plan when accepting employment with a company that is a potential target for acquisition.
In this lesson, we have covered the following:
* Tax sanction for excess parachute payment specify that no employer deduction is allowed and the person receiving the payment is subject to a penalty tax equal to 20% of the excess parachute payment.
* A formula involving present values and base amount is used to calculate the amount of excess parachute payment. Under code section 280G(b)(1), an excess parachute payment means an amount equal to the excess of any parachute payment over the portion of the base amount allocated to such payment.
- Parachute payment is defined as any compensatory payment made to an employee or independent contractor who is an officer, shareholder, or highly compensated individual that meets a given criteria. The criteria are that the payment must be contingent on a change in the ownership and that the aggregate present value of the payments equals or exceeds three times the base amount. Any amount that the taxpayer can prove is reasonable compensation for personal services rendered before the takeover will not be treated as a parachute payment.
- Definition of base amount means the recipient individual’s annualized includable compensation for the base period, which is the most recent five taxable years ending before the date on which the change of ownership or control occurs.
- Exceptions to the parachute rules are that they do not apply to corporations that have no stock that is readily tradable on an established securities market. The parachute rules also do not apply to payments from small business corporations or generally to payments from qualified retirement plans, and SIMPLE IRAs.
