[July 2005]
In our last report1 we
discussed some of the basic components of life insurance. We
addressed general issues dealing with taxation and some of
the advantages and disadvantages of group term life
insurance. We introduced the concept of executive carve-out
plans that go beyond the limitations2 of group
term policies.
As promised, this report will focus on
other types of insurance and some of the ways they are used
to compensate executives.
Term insurance
Term insurance generally provides only
a death benefit in exchange for premiums that increase with
age. Some policies have a level premium for a set term.
Proof of insurability may be required from time to time.
Consequently, term insurance may not provide a guarantee of
continued coverage.
If a death benefit were needed for a
short time period, term insurance would be ideal. It may not
be a wise choice, however, if the executive intends to hold
the insurance for a long period or if he or she would like
to accumulate cash values on a tax favored basis to fund his
or her retirement.
To offset the temporary nature of
group-term life insurance, many executives ask to be
excluded from the employer’s plan in exchange for a plan
that better accommodates their needs. Generally, the
carve-outs are used to purchase some form of permanent
insurance.
In this regard, we will discuss whole
life insurance.
Whole life insurance
Whole life insurance is designed to
last the entire life of the insured. It combines a death
benefit with cash accumulation advantages.
The single major benefit of whole life
insurance over term insurance (beyond its permanency) is the
fact that the accumulation of cash values is on a
tax-deferred basis. For compensation purposes, while
premiums may be paid with after tax dollars, cash values
accrue without immediate taxation. Therefore, in theory,
values should grow faster than a traditional taxable
investment.
Executive owned whole
life policies
If a whole life policy is owned by the
executive, dividends from the policy can be paid to the
executive at retirement or at other times as tax-free
returns of premiums. After the executive’s basis is
exhausted, he or she can obtain tax-deferred proceeds from
the contract by borrowing from the cash values. If the loans
are outstanding at death, they would become part of the
tax-free death benefit, and are never taxed. Thus, if
structured properly the plan can provide the executive with
tax-tree income from retirement until death, and then a
tax-free death benefit to his or her survivors.
Employer-owned whole
life policies
If an employer-owned policy is used to
provide a salary continuation benefit, the policy may be
applied under different methods as outlined below.
Method A: The employer would pay
the salary continuation benefit from current business
earnings and simply use the policy to recover the costs
associated with the plan when the executive dies.
Method B: Cash values would be
kept on the corporate books to offset the present value of
the future plan benefits. The death benefit under the
arrangement would be designed to provide for recovery of the
plan’s costs at the time of the executive’s death.
Method C: The employer would
structure the insurance to generate high cash values which
would be used to provide the after tax costs of the
executive’s benefit. This method keeps the corporation’s
requirements at zero when the benefits are disbursed. In
other words, cash values of the policy provide the means to
pay benefits to the executive on an after tax basis, with no
payments coming from the employer’s then current earnings.
The employer would generally hold the policy until the
executive dies in order to recover the cost of the plan.
Tax compliance
Care should be exercised when designing
any plan as traps abound. This cautionary note holds true
regardless of the employer’s tax status3.
Congress recently enacted legislation4,
in the wake of the Enron scandal, which adds new obstacles
to the compliance course and imposes significant penalties
if one fails to conform. Moreover, if the employer is a
tax-exempt organization, additional requirements must be
addressed5.
Summary
In our next report, we will focus on
other types of life insurance policies, as well as policy
riders, and how they are used in executive compensation
arrangements.
Meanwhile, if you have any questions,
please feel free to contact Vincent Ruocco, LLC, CPA at
(203) 932-2931 or
vruocco@artcpas.com.
_____________________________________
1 Because the matter is
complex, we intend to issue a series of articles rather than
attempt to address the entire topic at once. You can read
Part 1 of our report on Using Life Insurance as Compensation
on our website at
www.artcpas.com
2 Internal Revenue Code
Section 79
3 For-profit or
not-for-profit
4 The American Jobs
Creation Act of 2004
5 Internal Revenue Code
Section 457
