Insurance - Ch 5 Flashcards
Premium payments on life insurance policies are not tax deductible, with a few rare exceptions.
For example, group term insurance premiums on insurance protection of up to____________________________are deductible by the employer and not included in the income of the employee.
Premium payments on life insurance policies are not tax deductible, with a few rare exceptions.
For example, group term insurance premiums on insurance protection of up to $50,000 are deductible by the employer and not included in the income of the employee.
A final exception to the rule that premiums are not income tax deductible applies to the payment of premiums on a policy for which a ___________________________________________________________. In this case, the premiums are treated as a cash contribution to the charity. The deductibility of charitable contributions is limited based on the donor’s adjusted gross income.2
A final exception to the rule that premiums are not income tax deductible applies to the payment of premiums on a policy for which a
charity is the owner and beneficiary.
In this case, the premiums are treated as a cash contribution to the charity. The deductibility of charitable contributions is limited based on the donor’s adjusted gross income.2
Dividends are treated as a ______________________________ and are therefore not subject to income tax.
A dividend distribution does, however, __________________ in his or her life insurance policy.
If dividend distributions exceed the owner’s basis, the owner would be subject to ____________________________, since he or she has already recouped the capital investment in the life insurance policy
Dividends are treated as a
“return of premium (a rebate of previously taxed income) “
and are therefore not subject to income tax.
A dividend distribution does, however,
“reduce the owner’s basis “
in his or her life insurance policy.
If dividend distributions exceed the owner’s basis, the owner would be subject to
“ tax on those excess dividends, “
since he or she has already recouped the capital investment in the life insurance policy
Owners may also withdraw cash value from permanent life insurance policies without being subject to income tax. Withdrawals are treated ___________________________________________________________.
The exception to this FIFO treatment for withdrawals or loans is an _____________________________________________.
For MECs, earnings come out first and are taxable as ordinary income, which is taxed at the taxpayer’s highest marginal income tax bracket. In addition, taxable earnings distributions from a MEC are subject to a 10 percent penalty tax if the owner is under age _______________>
Owners may also withdraw cash value from permanent life insurance policies without being subject to income tax. Withdrawals are treated
“first as a distribution of basis
(which are not subject to income tax) using the first-in, first-out, or FIFO, method of accounting. “
The exception to this FIFO treatment for withdrawals or loans is an” MEC, which follows last-in, first-out (LIFO) rules. “
For MECs, earnings come out first and are taxable as ordinary income, which is taxed at the taxpayer’s highest marginal income tax bracket. In addition, taxable earnings distributions from a MEC are subject to a 10 percent penalty tax if the owner is under age “ 59 1⁄2 “
When a policy loan from a MEC is taxable, the taxable amount of the loan ______________________________________for calculating taxes on future withdrawals.
When a policy loan from a MEC is taxable, the taxable amount of the loan
“increases the cost basis in the policy”
for calculating taxes on future withdrawals.
COST BASIS FOR NON-MEC LIFE INSURANCE ?
COST BASIS FOR NON-MEC
Premiums paid (less premium for certain riders)
< Previous withdrawals (up to total premiums; FIFO)
< Dividends >
______________________________________________________
= Cost basis
Dividend distributions from life insurance policies are taxable to the policy owner.
a. True b. False
b FALSE
COST BASIS FOR MEC INSURANCE POLICY
COST BASIS FOR MEC INSURANCE POLICY
+ MEC Premiums paid (less premium for certain riders)
+ Taxable loans
- Previous withdrawals in excess of earnings (LIFO)
- DividendS
______________________________________________________
= Cost basis
When the policy owner no longer has need for the death benefit protection and sells the policy to another party, the acquiring owner will receive an income tax-free death benefit upon the death of the insured.
a. True b. False
false
A life insurance policy sold from a shareholder in a corporation to the corporation (the business entity) is an exception to the transfer for value rule, allowing the corporation to receive the death benefit income tax-free.
a. True b. False
true
Nonqualified deferred compensation plans allow the employer to take a current tax deduction for compensation expense while the employee can defer the income tax on the compensation.
a. True b. False
b. False
- Deferred compensation plans are generally structured so that employees benefiting under the plan will avoid constructive receipt.
a. True b. False
A TRUE
A substantial risk of forfeiture is the risk that the employee will leave the company prematurely and take the plan assets with them.
a. True b. False
B, FALSE
For contributions to a deferred compensation plan to be taxed because of the economic benefit doctrine, there must be no restrictions or risks that the funds would not be paid to the employee.
a. True b. False
A TRUE
life insurance is commonly used to informally fund NQDC plans that include a preretirement death benefit due to the proceeds being available to pay the promised benefits and the tax deferral of the cash build-up within the policy.
a. True b. False
TRUE
Under a split-dollar plan using the endorsement method, the employer owns the policy on the life of the employee and the employer pays the premium.
a. True b. False
TRUE
Key person insurance premiums are not deductible by the employer until the death benefit is paid.
a. True b. False
false
Key person life insurance is designed to protect the business, not the key employee or the key employee’s family.
a. True b. False
True
A Sec. 162 bonus plan provides a method for the business to provide additional benefits to a key employee at a low net cost to the employer.
a. True b. False
True
Buy-sell agreements
Arrangements that require the sale and purchase of securities owned by one individual to another following a specified triggering event, such as the death of a business owner.
Chronically Ill
Chronically Ill -
A person is chronically ill if within the past 12 months, a health care practitioner has certified that the individual has been unable to perform, without substantial assistance, at least two activities of daily living (eating, bathing, dressing, transferring, toileting, and continence) for at least 90 days. A person is also chronically ill if substantial supervision is required to protect that person from threats to health and safety due to cognitive disability (such as advanced stages of Alzheimer’s disease or senile dementia)
Constructive Receipt
Constructive Receipt -
Establishes when income is includible by a taxpayer and therefore subject to income tax. Income is constructively received in the taxable year during which it is credited to the employee’s account, set apart for him, or otherwise made available so that he may draw upon it at any time or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given
Cross-Purchase Buy-Sell Agreement -
Cross-Purchase Buy-Sell Agreement - An arrangement between individuals who agree to purchase the business interest of a deceased owner.
Deferred Compensation Arrangements -
Deferred Compensation Arrangements -
An arrangement to pay an executive compensation in a future year.
Economic Benefit Doctrine -
Economic Benefit Doctrine -
An employee will be taxed on funds or property set aside for the employee if the funds or property are unrestricted and nonforfeitable even if the employee was not given a choice to receive the income currently.
Entity Purchase (Redemption) Agreement - T
Entity Purchase (Redemption) Agreement -
Type of buy-sell agreement that obligates the business entity to purchase an owner’s interest in the entity upon that owner’s death.
Key Person Insurance -
Key Person Insurance -
A life or disability insurance policy on a key person whose death or disability would cause a substantial hardship to the business. The business is the owner, payer, and beneficiary of the death benefit (or disability income benefit), so that the business is protected against the unexpected loss of the employee due to death or disability
Life Settlement - A policy owner sells a ?
Life Settlement -
A policy owner sells a life insurance policy to a third party for more than the cash surrender value, but less than the death benefit value.
In most cases, the insured is neither terminally nor chronically ill (in which case accelerated benefits or a sale to a qualified viatical settlement provider would be more advantageous).
The owner simply does not want the policy any longer and determines that he or she may be able to sell it for a larger amount than could be obtained through surrendering the policy
Rabbi Trust -
Rabbi Trust -
A revocable or irrevocable trust that is designed to hold funds and assets for the purpose of paying benefits under a nonqualified deferred compensation arrangement.
assets in a rabbi trust are for the sole purpose of providing benefits to employees and may not be accessed by the employer, but they may be seized and used for the purpose of paying general creditors in the event of a liquidation of the company. Assets within a rabbi trust are not currently taxable to the employee.
Salary Reduction Plans -
Salary Reduction Plans
- A nonqualified plan designed to receive deferral contributions from executives to reduce their current taxable income
Sec. 162 Bonus Plan (Group Carve Out) - A fringe benefit ?
Sec. 162 Bonus Plan (Group Carve Out) -
A fringe benefit offered to a select group of executives where the employer pays a salary bonus to the executive for the purpose of paying premiums on a permanent life insurance policy owned by the executive. A double bonus may be paid so that it covers the taxes due on the premium bonus, resulting in a net cost of $0 to the employee.
Secular Trusts - Irrevocable trusts designed ?
Secular Trusts -
Irrevocable trusts designed to hold funds and assets for the purpose of paying benefits under a nonqualified deferred compensation arrangement.
A secular trust does not create a substantial fist of forfeiture to the employee.
Assets set aside in a secular trust results in immediate inclusion of income to the employee.
Sinking Fund - A sinking fund is a fund established ?
Sinking Fund -
A sinking fund is a fund established by a company to pay for future expenses or to retire debt or fulfill another obligation such as the obligation to repurchase stock from a retiring owner/ employee. It is created by setting aside income over a period of time (generally years)
Split-Dollar Arrangement - A discriminatory employee benefit plan using ?
Split-Dollar Arrangement -
A discriminatory employee benefit plan using life insurance.
The employer and employee share the cost of a life insurance policy on the employee (usually permanent insurance such as whole life insurance or variable universal life insurance).
Typically used by businesses to provide low cost insurance to key employees.
Substantial Risk of Forfeiture - An income tax concept that ?
Substantial Risk of Forfeiture -
An income tax concept that relates to when income is subject to income tax.
A substantial risk of forfeiture exists when rights in property that are transferred are conditioned, directly or indirectly, upon the future performance (or refraining from performance) of substantial services by any person, or the occurrence of a condition related to a purpose of the transfer and the possibility of forfeiture is substantial if the condition is not satisfied
Supplemental Executive Retirement Plans (Salary Continuation Plan, SERP) -
Supplemental Executive Retirement Plans (Salary Continuation Plan, SERP) -
Nonqualified deferred compensation arrangements designed to provide additional benefits to an executive during retirement.
Terminally Ill -
Terminally Ill -
Under tax law, a person is terminally ill if a physician has certified that death expected within 24 months
Viatical Settlement -
Viatical Settlement -
The sale of a life insurance policy to a third party viatical settlement provider when the insured is terminally or chronically ill.
TAXATION OF LIFE INSURANCE BENEFITS
RECEIVED DURING LIFE
TAXATION OF LIFE INSURANCE BENEFITS
RECEIVED DURING LIFE (1 OF 3)
The tax treatment of lifetime benefits is dependent on the cost basis of the policy.
- The total premiums paid, less the cost of certain riders (e.g., waiver of premium and accidental death riders), are the starting point for determining cost basis.
Dividends__________________________________
* NOT taxable, considered a return of basis (or premiums)
* If dividends exceed premiums, then the dividend is taxable
TAXATION OF LIFE INSURANCE BENEFITS
RECEIVED DURING LIFE (2 OF 3)
Withdrawals
IF NOT MEC: ?
IF MEC ?
TAXATION OF LIFE INSURANCE BENEFITS
RECEIVED DURING LIFE ( 2 OF 3)
Withdrawals
IF NOT MEC: FIFO basis
- If NOT a Modified Endowment Contract (MEC), then withdrawals taxed on a FIFO basis.
-Loans are not taxable; however, they accrue interest and any outstanding loans plus interest reduce the death benefit upon the death of the insured.
IF MEC
* If policy is MEC, then withdrawals/loans are taxed on a LIFO basis.
- Taxed as ordinary income until all earnings have been distributed.
- Taxable distributions subject to a 10% penalty if prior to age 59½.
- When a policy loan from a MEC is taxable, the taxable amount of the loan increases cost basis for calculating taxes on future
withdrawals/loans.
TAXATION OF LIFE INSURANCE BENEFITS
RECEIVED DURING LIFE ( 3 OF 3 )
Cost basis Summary
_______________________
TAXATION OF LIFE INSURANCE BENEFITS
RECEIVED DURING LIFE ( 3 OF 3 )
Cost basis Summary
___________________________________________________________________
NON - MEC
Premiums paid
- Previous withdrawals (up to total prem FIFO)
- Dividends
= COST BASIS
___________________________________________________________________
MEC
Premium paid
+ Taxable Loans
- Previous withdrawals
- Dividends
=Cost BAsis
TAXATION OF LIFE INSURANCE ON POLICY
SURRENDER ?
How to take cash values ?
Death benefit of life insurance is mostly TAXFREE .
TAXATION OF LIFE INSURANCE ON POLICY SURRENDER
- If surrenders the policy prior to death, the insured may take the cash value as:
- Lump Sum
- Interest Only
-Installment Payments
TAXATION OF LIFE INSURANCE SECTION
1035 EXCHANGE
TAXATION OF LIFE INSURANCE SECTION 1035 EXCHANGE
* Section 1035 allows for tax-free exchange of some Insurance polices.
-Exchange must be made directly from insurance company to insurance company.
-Old and new policy must have same insured
CANNOT 1035 exchange ANNUITY to LIFE
TAXATION OF LIFE INSURANCE TRANSFER FOR VALUE
- Death benefits become ?
exceptions ?
TAXATION OF LIFE INSURANCE TRANSFER FOR VALUE
- Death benefits - taxable to transferee to the extent proceeds exceed basis.
_______________________________________________________________________ - EXCEPTIONS to Transfer for Value Rule is when a policy is:
-Transferred to the Insured- Transferred to a Business partner of the insured
- Transferred to a Partnership in which the insured is a
partner - Transferred to a Corporation in which the insured is a
shareholder or officer - Transfer that results in carryover basis from transferor to
transferee, such as a gift or property settlement in a DIVORCE
LIFE SETTLEMENTS
LIFE SETTLEMENTS
* The policy owner sells the life insurance policy to a third party.
-Sale is for more than the cash value and less than the
death benefit value.
- The purchaser is making the purchase as an investment and will be subject to the transfer for value rule.
- Buyer must report sale/purchase to the IRS.
- Tax consequences to seller will be part return of basis, part ordinary income, and potentially some capital gain
ACCELERATED DEATH BENEFITS
Terminally Ill Insured
- Terminal illness is defined under tax law as having a life expectancy of ?
ACCELERATED DEATH BENEFITS:
Terminally Ill Insured
* Terminal illness is defined under tax law as having a life expectancy of 24 months or less.
- Accelerated death benefits provision or rider entitles a qualified insured to receive an advance on a portion of the death benefit.
- If the insured is terminally ill, the actual use of funds
does not impact tax treatment.
- If the insured is terminally ill, the actual use of funds
- Policy remains in force and any remaining death benefit is paid to the named beneficiary
VIATICAL SETTLEMENTS
Terminally or Chronically Ill Insured
VIATICAL SETTLEMENTS
Terminally or Chronically Ill Insured
- Policy of a terminally or chronically ill insured is sold to a licensed viatical settlement provider.
- Terminally ill insured
- The gain on the sale of the policy will not be subject to
income tax regardless of how funds are used.
DEATH BENEFIT - TAXABLE TO THE VIATICAL CO.
-Chronically ill insured
The gain on the sale of the policy will not be subject to
income tax if the proceeds are used to pay long-term care
costs
BUY-SELL AGREEMENTS (1 OF 2)
BUY-SELL AGREEMENTS (1 OF 2)
- Arrangements that require the sale and purchase of a business interest owned by one individual to another upon the occurrence of a specified triggering event.
- To plan for the orderly transfer and control of a business
- To create a market for stock that is not traded on an
exchange - To plan for liquidity in the estate of a deceased business owner
BUY-SELL AGREEMENTS (2 OF 2)
- Common triggering events include ?
BUY-SELL AGREEMENTS (2 OF 2)
- Common triggering events include:Death of the business owner - CAN USE life insurance
Disability - CAN USE LIFE INSURANCE
Divorce
Retirement
Withdrawal from the business
ENTITY PURCHASE (STOCK REDEMPTION)
AGREEMENTS
Entity Purchase
ENTITY PURCHASE (STOCK REDEMPTION) AGREEMENTS
Entity Purchase
- business buys life insurance on each key EE
- Simplest form of buy-sell agreement
- NO STEP-UP BASIS
- Business - buys an owner’s interest upon a triggering event
- To fund the purchase obligation under an entity-purchase buy-sell agreement:
-The business can acquire a life insurance policy on the
owner’s life with a death benefit sufficient to cover the
purchase amount
ENTITY PURCHASE AGREEMENTS:
DISADVANTAGES ?
ENTITY PURCHASE AGREEMENTS:
DISADVANTAGES
Will increase the surviving owners’ taxable gain upon sale of their interest (versus a cross-purchase agreement).
NO STEP UP BASIS
CROSS-PURCHASE AGREEMENTS
Cross-Purchase
CROSS-PURCHASE AGREEMENTS
Cross-Purchase
- An arrangement between owners who agree to purchase the business interest of a deceased owner
- To fund a cross purchase agreement with life insurance:
Each party to the agreement purchases a life insurance policy on the life of the other parties - More than two owners:
The number of life insurance policies that must be
purchased grows by the factorial N(N-1)
CROSS-PURCHASE AGREEMENTS:
ADVANTAGES AND DISADVANTAGES
Advantages ?
Disadvantages ?
CROSS-PURCHASE AGREEMENTS:
ADVANTAGES AND DISADVANTAGES
Advantages_______________
* The ability to increase the surviving owners’ basis in their share of the business entity
* Life insurance owned by business owners outside of a corporation does not trigger any potential accumulated earnings tax
* GET STEP - UP BASIS
Disadvantages_________________
* When there are more than three owners, the large number of policies required may be burdensome.
WAIT-AND-SEE BUY-SELL AGREEMENTS
WAIT-AND-SEE BUY-SELL AGREEMENTS
- Using this approach, the business has the first option to purchase the interest of a deceased owner.
- The surviving owners of the company are given the next
opportunity to purchase the deceased owner’s interest. - If the surviving owners do not exercise their right to purchase the interest, any interest remaining is purchased by the business
TAX-RELATED ISSUES FOR BUY-SELL
AGREEMENTS
Entity Purchase
Cross Purchase
TAX-RELATED ISSUES FOR BUY-SELL AGREEMENTS
Entity Purchase__________________________________
* The business is the owner, premium payer, and beneficiary of a life insurance policy on each owner.
- Premiums are NOT TAX DEDUCTIBLE.
-Death benefit is received tax free if IRC§101(j) notice and consent rules are followed.
Cross-Purchase___________________________________
* Premiums paid by each owner are not tax deductible and the death benefit is received tax free, provided that there is no transfer for value
NONQUALIFIED DEFERRED COMPENSATION
- A nonqualified deferred compensation plan may be used to provide ?
NONQUALIFIED DEFERRED COMPENSATION
*Used to provide retirement, disability, and/or death benefits to a select group of key employees.
- FLEXIBLE , CAN DISCRIMINATE
AVOIDS ERISA RULES
- Flexible rules than qualified retirement plans and the ability to discriminate in favor of key executives.
-Trade-off is the tax treatment: employer gets a tax
deduction when the employee receives taxable income. - Used as “golden handcuffs” to retain key employees.T
TYPES OF NONQUALIFIED DEFERRED
COMPENSATION (NQDC)
Salary Reduction Plans
TYPES OF NONQUALIFIED DEFERRED COMPENSATION (NQDC)
Salary Reduction Plans
* Allows employee to defer compensation to a future year.
- High tax bracket executives may find this attractive.
- LOWER TAX BRACKET IN RETIREMENT
- Agreement to defer must be made prior to earning the
income.
Salary Continuation Plans (Supplemental Executive Retirement Plans, SERPs)
- Employer promises to pay a retirement benefit in addition to the executive’s current salary.
- Employee’s current salary is not reduced to provide the benefit.
NONQUALIFIED DEFERRED COMPENSATION
FUNDING ARRANGEMENTS
Unfunded
Funded
NONQUALIFIED DEFERRED COMPENSATION
FUNDING ARRANGEMENTS
_____________________________________________________________________
UNFUNDED - “a promise only”
* Employer’s promise is secured by the company’s general assets.
-meets standards of “substantial risk of forfeiture “
- Tax Defferral
_____________________________________________________________________
INFORMALLY FUNDED “in acct intended to pay ,available to creditors”
“rabbi trust”
* Employer sets aside specific assets which are intended to pay the promised benefits.
* Assets remain general assets of the business and are available to general creditors of the employer.
_____________________________________________________________________
FUNDED - “ secular trust”
* Employer sets aside specified segregated assets NOT available to creditors
INFORMALLY FUNDED: RABBI TRUSTS
INFORMALLY FUNDED: RABBI TRUSTS
- Trust holds assets for the purpose of paying the promised benefits under the NQDC plan
- Springing irrevocability
- Insolvency triggers are NOT permitted
- SUBSTANTIAL RISK OF FORFEITURE IS REQUIRED in order to obtain deferral of taxation to the executive
Income generated is taxed to Employer,m then at distribution Employer gets tax deduction.
_Available to Creditors
-May be seized on liquidation of company
-Do NOT protect against bankruptcy
-AT risk of Forfeiture
-Deferral of taxes for executive
-Income generates in trust -taxes paid by Employer
-Employer tax deduction upon distribution to executive
FUNDED: SECULAR TRUSTS
*
FUNDED: SECULAR TRUSTS
- An irrevocable trust holds assets for the purpose of paying the promised benefits under the NQDC plan
- Results in immediate taxation to the employee (and deduction for the employer) unless a substantial risk of forfeiture exists
- NOT AVAILABLE TO CREDITORS
- IMMEDIATELY TAXABLE TO EMPLOYEE
if add vesting schedule, then on taxed on the amount that is fully vested each year. ( vesting schedule can help defer some taxes to the future)
income generated in the trust is generally taxed t the employee as it is earned.
TAX TREATMENT OF NONQUALIFIED
DEFERRED COMPENSATION (1 OF 3)
TAX TREATMENT OF NONQUALIFIED DEFERRED COMPENSATION
(1 OF 3)
Employer gets tax deductions as contributions are made, then at distribution to employee, ( employee pays taxes )
IRC §409A
- Imposes harsh penalties for plans that do no comply:-Tax on prior deferrals, interest, penalties, and an
additional 20% tax on deferrals- Plan must be in writing
TAX TREATMENT OF NONQUALIFIED
DEFERRED COMPENSATION (2 OF 3)
Substantial Risk of Forfeiture
*
TAX TREATMENT OF NONQUALIFIED DEFERRED COMPENSATION
(2 OF 3)
Substantial Risk of Forfeiture
exist- yes, then EE can defer taxes
exist - NO , then EE must pay taxes along the way
When has substantial risk of forfeiture, then employee can defer taxes to future
- Rights to compensation are conditioned upon future services or certain targets.
- Impacts timing of when income is subject to tax
Tax applies when there is no longer a substantial risk of forfeiture.
TAX TREATMENT OF NONQUALIFIED
DEFERRED COMPENSATION (3 OF 3)
Constructive Receipt
Economic Benefit
AX TREATMENT OF NONQUALIFIED DEFERRED COMPENSATION
(3 OF 3)
Constructive Receipt - “It’s available to me “
–if can chose to receive today or future- then taxable
–Income, although not actually in the taxpayer’s possession, is subject to TAX in the year in which it is constructively received.
Economic Benefit
* An employee is taxed on funds or property set aside for the employee if the funds or property are unrestricted and
nonforfeitable, even if the employee was not given a choice to receive the income currently
USE OF LIFE INSURANCE TO FUND NQDC PLANS
* Life insurance is a popular investment vehicle for plans that are informally funded.
USE OF LIFE INSURANCE TO FUND NQDC PLANS
- Life insurance is a popular investment vehicle for plans that are informally funded.
- NQDC agreements often include a pre-retirement death benefit.
- Employer can purchase a permanent life insurance policy to pay the promised death benefit to the employee’s beneficiary.
- If employee lives to retirement, employer can keep the policy in force. Upon the death of the employee the benefit is used to reimburse the employer for the supplemental retirement benefits paid to the employee.
SPLIT DOLLAR LIFE INSURANCE
SPLIT DOLLAR LIFE INSURANCE
- A discriminatory benefit plan where the employer and employee share the cost of a permanent life insurance policy on the employee.
- At the death of the employee the employer is reimbursed for their cost and the employee’s beneficiary receives the remainder of the death benefit.
KEY PERSON LIFE INSURANCE
KEY PERSON LIFE INSURANCE
- Protects the business on the death of a key employee
- Business owns, pays for, and is the beneficiary of the policy.
- Death benefit proceeds may be used by the business to locate, hire, and train a replacement; or may finance any number of timely business transactions
SEC. 162 BONUS PLAN
( GROUP CARVE-OUT LIFE INSURANCE)
SEC. 162 BONUS PLAN
(GROUP CARVE-OUT LIFE INSURANCE)
- A fringe benefit offered on a discriminatory basis to a select group of executives in which a salary bonus is provided for the purpose of purchasing a life insurance policy owned by the employee.-The employee is taxed, the employer deducts the salary bonus.
- The employee owns the policy and names the beneficiary.
- Since the salary bonus is taxable to the employee, a double bonus is often used to cover both the cost of the premiums and the additional taxes.
Life Settlements and Viatical Settlements are similar in that?
a. Buyers of life policies in both are subject to Transfer For Value tax rules
b. Sellers of life policies in both are subject to income taxation
c. Life Settlement seller (insured) must be terminally ill
d. Viatical Settlement sales are not taxable to chronically ill insured
Life Settlements and Viatical Settlements are similar in that?
A. Buyers of life policies in both are subject to Transfer For Value tax rules
The correct answer is A.
In both cases, the buyers are subject to Ordinary Income Tax on the Death Benefit (FMV) less the purchasers basis in the policy. Value received from a viatical or life settlement company by the insured is tax-free if the insured is terminally ill. If the insured is chronically ill, the proceeds will be tax-free when used for medical or long term care, any other use would subject the insured to income tax.
Non-qualified plans are often informally funded by the purchase of:
a. Annuities
b Life Insurance
c. Cash
d. Physical assets
Non-qualified plans are often informally funded by the purchase of:
Annuities Life Insurance Cash Physical assets
The correct answer is B.
Informally funding a non-qualified plan requires the employer sets aside specific assets which are intended to pay the promised benefits. these assets remain part of the general assets of the business and available to creditors. Life insurance has the advantage of internal build up of cash that is not taxable to the employer. Annuities owned by businesses do not have the same tax deferred status as individually owned policies. Corporate owned policies are taxable. Cash would be better used elsewhere, plus the company can only hold so much in cash without issue. Physical assets (computers, equipment, etc.) of the employer should not be used for employee benefits.
- Taxation of Life Insurance policies
- LIFO vs FIFO
- IRC Section 1035 Tax-Free Exchanges
- Non-Qualified Deferred Compensation
- Rabbi
- Secular Trusts
- IRC Section 162 – Executive Bonus Plans
- Insurance funded Buy-Sell Agreements:
- Cross-Purchase
- Entity (Stock Redemption)
1035 EXCHANGES
1035 EXCHANGES
OK
TO GO DOWN
I L
I 1035 I E TAXABLE GOING UP
I
v A
Which of the following is false regarding a deferred compensation plan that is funded utilizing a rabbi trust?
- Participants have security against the employer’s unwillingness to pay.
- Rabbi trust provide the participant with security against employer bankruptcy.
- Rabbi trusts provide tax deferral for participants.
- Rabbi trusts provide the employer with a current tax deduction.
2 AND 4
Which of the following factors are desirable when an employee is seeking deferral of a portion of current compensation by means of an informally funded nonqualified deferred-compensation plan?
- The employee’s tax bracket will be lower after retirement.
- The employee enjoys a strong personal current financial position.
- The employer is in a strong financial position.
- Assets used to fund the plan are irrevocably committed to the employee.
1, 2, and 3.
Rationale
Statement 4 is not correct. If assets are irrevocably committed to the employee, the value of these assets is included in the employee’s gross income unless there is substantial risk of forfeiture.
Statements 1, 2, and 3 are all desirable factors
Assume ARCO’s board elects to offer their three executives a split-dollar plan with a $100,000 policy owned by ARCO on each of the three executives. Under these assumptions, which of the following statements is (are) true?
- The executive will be taxed on the Table 2001 cost as additional compensation if the executive pays no portion of the annual premium.
- The employer must pay all of the premiums under a split-dollar plan.
- The executive will have to pay interest (or be taxed on this amount) on the outstanding loan balance associated with any premiums paid by the employer.
- The executive will be taxed on all premiums paid by the employer in the year paid.
1 only.
Rationale
Under a split-dollar arrangement where the employer owns the policy, the employee will either have to pay the Table 2001 costs or be taxed on this amount if the employer pays it. Thus, Statement 1 is correct and
Statement 2 is incorrect.
Statement 3 is incorrect, as these rules apply to policies owned by the employee or a trust created by the employee.
Statement 4 is incorrect, as the employee only has to be taxed on the Table 2001 amount and the change in the cash value in the policy.
A viatical settlement company purchased a $250,000 policy for $160,000. It paid additional premiums of $7,000 (in total) over the next three years before the insured died. What income must the viatical company report from the policy proceeds in the year of the insured’s death?
83,000 ordinary income.
Rationale
The viatical company must report the gain as ordinary income. The amount of the viatical settlement plus the additional premiums are costs and are deducted from the proceeds in determining the gain.
Cindy Sue has been with CS Designs, Inc. for five years. CS Designs has a deferred compensation plan to provide benefits to key executives only. CS Designs contributed $400,000 into a trust for Cindy Sue’s benefit under the company’s deferred compensation plan. The plan requires that executives must work for the company for 10 years before any benefits can be obtained from the plan. Cindy Sue has come to you to determine when she will be subject to income tax on the contribution by the employer. Which of the following is correct?
Since Cindy Sue cannot receive the benefits until she has been with the employer for 10 years, the substantial risk of forfeiture doctrine will not require inclusion in income for the current year contributions made by the employer.
Rationale
The economic benefit and constructive receipt doctrines will not cause inclusion because the assets are forfeitable if she does not stay the required length of service. Deferred compensation plans are by nature discriminatory. The contributions will be included if the employee has an economic benefit, no risk of forfeiture, or constructive receipt
In 2023, Chip, an accomplished professional race car driver, is to receive a signing bonus for agreeing to drive for Hot-Lap International, a racing team. Hot-Lap agrees to establish a NQDC agreement with Chip to defer the bonus beyond Chip’s peak income producing years. Hot-Lap transfers the bonuses to an escrow agent, subject to the risk of forfeiture to team creditors in bankruptcy, who invests the funds in securities acting as a hedge against inflation. The bonus is deferred until 2024 and is then paid to Chip in years 2024-2030. When is the income deductible by the employer and includible by Chip?
employer Deduction: 2024 - 2030 Employee Deduction: 2024 - 2030
Rationale
The income is only deductible when includible by Chip in 2024-2030
Rick has an 18% nonqualified deferred compensation plan that is funded annually by his employer. Payments are made to a separate trustee of a secular trust who was selected by Rick and his employer. The employer contributions are discontinued at Rick’s death, disability, or employment termination. When Rick retires or terminates employment, he will receive the proceeds from the trust.
Which of the following is/are correct regarding the deferred compensation plan?
- The contributions are not currently taxable to Rick because they are subject to a substantial risk of forfeiture.
- The contributions to the plan are currently subject to payroll taxes.
- The employer can deduct the contributions to the plan at the time of the contribution
2 and 3.
Rationale
Because this arrangement is a secular trust and there is not vesting schedule associated with it, there is no substantial risk of forfeiture to Rick. Thus, Statement 1 is false. Because the trust is not subject to the general creditors of the employer, this is straight compensation. Rick must treat the payments as constructively received, and the employer may deduct the payments as compensation immediately. The payments are subject to payroll tax since the compensation is currently earned.
not constructive receipt of funds
NOT considered constructive receipts of deferred comp
– unsecured promise to pay
—subject to substantial limitations or restrictions
—triggering event is beyond employees control
economic benefit doctrine provides
Economic benefit doctrine
Employee will be TAXED
on funds or property set aside for the employee if the funds or property are
UNRESTRICTED and nonforfeitable,
even if the employee was not given a choice to receive the income currently.
In other words, if an employer sets aside funds for an employee and there is no risk that the employee will not receive the funds, then the funds are taxable
Which of the following is true regarding employer contributions to secular trusts for employee-participants of a nonqualified deferred compensation agreement?
- Participants have security against an employer’s unwillingness to pay at termination.
- Participants have security against an employer’s bankruptcy.
- Secular trusts provide tax deferral for employees until distribution.
- Secular trusts provide employers with a current income tax deduction
1, 2, and 4.
Rationale
Secular trusts are similar to rabbi trusts except that participants do not have a substantial risk of forfeiture (unless there is a vesting schedule associated with the contributions) and thus, do not provide the employee with tax deferral. Secular trusts provide the employer with a current income tax deduction for contributions. Secular trusts protect the participant from employer unwillingness to pay because they are funded and they protect from bankruptcy because there is no risk of forfeiture
