Business Uses of Insurance Flashcards
Group Life Insurance
The employer holds a group-term contract, and if it qualifies under Code Section 79, the cost of the first $50,000 of insurance is tax-free to employees. Coverage above $50,000 is included in taxable income. Group-term life insurance will meet Section 79 requirements if:
The insurance provides a general death benefit-accident insurance or life insurance as an incidental benefit in a qualified pension or profit sharing plan is not part of Section 79.
The insurance must be provided to a group of employees as compensation for services.
The insurance policy must be carried by the employer and the requirement is met if the employer pays any part of the cost.
Key Employee Life Insurance
Key Employee Life Insurance
Identify The key persons in the company must be identified
Measure The financial loss that would be caused by the key person’s death is measured
Estimate The effect on profits while a replacement is hired and trained is ascertained
Permission The key person must give permission for purchase of insurance
Purchase Business purchases life insurance for the value measured
Premiums Premiums are paid by the business
Split-Dollar Life Insurance
Split-dollar life insurance plans allow businesses to reward and retain valuable personnel. With this approach, both employer and employee pay a part of the premium for an insurance policy with a savings feature.
Terminating a Split-Dollar Arrangement
Rollout essentially means terminating the split-dollar arrangement by having the covered employee pay off the corporation, that is, terminate the corporation’s policy rights. There are generally three ways to pay off the employer:
At rollout, the employee simply buys out the employer’s policy rights for cash. The cash can come from any source, including a policy loan. (For policy loans, the employee should be a policy owner—the collateral assignment method of ownership). The purchase by the employee is not income-taxable to the employee, but any gain to the employer (proceeds in excess of the employer’s basis) is taxable to the employer.
At rollout, the employer provides, as additional deductible compensation, a relinquishment to the employee of the employer’s rights in the policy. This results in taxable income to the employee in the amount of the employer’s relinquished rights.
The split-dollar plan provides for gradual buyout of the employer’s rights by using policy dividends for this purpose. Dividends so used appear to be taxable income to the employee. At some point, the employer’s rights are fully paid off and the employee is full owner of the policy.
Death benefit of split dollar insurance
With death benefits from a split-dollar plan, both the employer’s share and the employee’s beneficiary’s share are generally income tax free.
The tax-free nature of the death proceeds is lost if the policy has been transferred for value in certain situations. The transfer for value trap should be carefully avoided in designing split-dollar plans.
Employee Ownership
If the employee had no “incidents of ownership” in the policy, the death benefit is not includable in the employee’s estate for federal estate tax purposes unless the policy proceeds are payable to the employee’s estate. If an employee is potentially faced with a federal estate tax liability, all incidents of ownership in the policy should therefore be assigned irrevocably to a third party—a beneficiary or a trust. Proceeds generally should be payable to a named personal beneficiary and not to the employee’s estate.
If the employee is a controlling shareholder, where should the incident of ownership be attributed?
Majority shareholder
Federal Gift Tax Consequences
There may be federal gift tax consequences if a person other than the employee owns the insurance policy used in a split dollar plan. The transfer of the policy from the employee to another party is a gift subject to tax. In addition, 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.
Buy-and-Sell Agreements
A legal agreement for the purchase between the buyer and seller, called a buy-and-sell agreement, must also be arranged before a purchase plan becomes effective. Thus, people need the services of both a lawyer and a life insurance agent to arrange and fund the business continuation plan, which is a buy-and-sell agreement properly funded by life insurance.
Cross purchase plan and Entity Plan
The buy-and-sell plans can be arranged in either of two ways:
The cross-purchase plan is where each partner or shareholder can purchase life insurance on every other partner or shareholder.
The entity plan is where the partnership or corporation can purchase the insurance on each partner or shareholder.
With a cross-purchase plan, the number of policies needed is equal to: n x (n − 1), where n equals the number of partners or shareholders. With an entity plan, the number of policies is equal to the number of partners or shareholders.
Business continuation agreement for corporation
For corporations, the most common types of business continuation agreements are stock redemption plans, also called stock retirement plans, and shareholder cross-purchase plans. The distinguishing feature of the redemption agreement is that the corporation itself agrees to purchase or redeem the stock of the withdrawing or deceased shareholder. In a cross-purchase plan, the individuals agree between or among themselves to purchase the interest of a withdrawing or deceased shareholder.
Business continuation agreement for partnership
In the case of a partnership, the business continuation agreement is the partnership liquidation agreement, where the partnership in effect purchases the interest of the deceased or withdrawing shareholder by distributing assets in liquidation of the partner’s interest, or the partners agree to a cross-purchase similar to the corporate cross-purchase plan.
Use of Business Continuation Agreement
You can use a business continuation agreement:
When a guaranteed market must be created for the sale of a business interest in the event of death, disability, or retirement.
When it is necessary or desirable to peg the value of the business for federal and state death tax purposes.
When a shareholder or partner is unable or unwilling to continue running the business with the family of a deceased co-owner.
When the business involves a high amount of financial risk for the family of a deceased owner and it is desirable to convert the business interest into cash at the owner’s death.
When it is necessary or desirable to prevent all or part of the business from falling into the hands of outsiders. This could include a buyout of an owner’s interest in the event of a divorce, disability, or insolvency, if there is a danger a business interest would be transferred to a former spouse or creditors.
Where it is desirable to lend certainty to the disposition of a family closely held business. Rather than relying on will provisions of a parent to transfer the business interest, a binding buy-sell agreement between parent and child could be used.
Business continuity contingency can be triggered when
- Death
- Disability
- Retirement
But can also include - Divorce
- Loss of professional license
advantages of Non Qualified deferred compensation plan
The design of nonqualified plans is much more flexible than that of qualified plans. A nonqualified plan:
allows coverage of any group of employees, or even a single employee, without any nondiscrimination requirements
can provide an unlimited benefit to any one employee subject to the reasonable compensation requirement for deductibility, and
allows the employer to provide different benefit amounts for different employees, on different terms and conditions.
It involves minimal IRS, ERISA, and other governmental regulatory requirements, such as reporting and disclosure, fiduciary, and funding requirements.
It provides deferral of taxes to employees, but the employer’s deduction is also deferred. The advantage of deferral is debated when income tax rates are relatively low, and there is some expectation of higher rates in the future.
Although the plan generally involves only the employer’s unsecured promise to pay benefits, the plan can provide security to the executive through informal financing arrangements such as corporate-owned life insurance (COLI).
