This chapter presents other uses for insurance products to provide business executives with special benefits and protection with particular attention to Section 162 executive bonus plans covering life insurance needs and Indemnification insurance as a third party guarantee for executives in unfunded deferred compensation plans.
A Section 162 executive bonus plan is yet another means available to employers who want to provide nonqualified benefits to selected employees on a legally discriminatory basis. Section 162 refers to the part of the tax code allowing employers to take a tax deduction for their contributions to the plan. These plans can be used to provide bonuses in the form of funds to pay for life insurance and/or disability income insurance for executives. Under this type of agreement, the employee purchases a cash rich life insurance policy and names himself as owner. This may be a single insured or a joint insured policy.
It must be noted that large compensation packages in the form of a bonus have come under fire from the government with the result that there has been recent (Feb. 2008) Revenue rulings covering the amount of the bonus and the drafting of compensation arrangements with senior officers. The general principle is still effective, so it will be discussed first, with the recent restrictions following.
The employer pays the premiums to the life insurance company which is fully deductible by the employer and considered compensation to the employee. The premiums are considered taxable income to the employee, so often the corporation with "double bonus" the employee.
The tax advantages under these rules include tax-free accumulation of funds, tax-free income through loans and withdrawals and tax-free transfer at death.
If the employee is a stockholder of the company and is/her tax bracket is less than the corporate tax bracket, this plan is very attractive to the employee-stockholder who wishes to withdraw profits from the corporation. There are many producers who insist that this plan works best with stockholders of "C" or "S" corporations.
The benefits usually include the life insurance policy death benefits as well as cash value accumulations that can be used as a retirement income supplement. With this type of executive bonus plan, the business can use tax deductible company funds to selectively provide valued benefits to key people. These plans can be effective tools to attract and keep key executives.
The bonus plans are rather simple in design, although they should always either be prepared by an attorney, or reviewed by an attorney or tax advisor. Basically, the company provides the key executive with a bonus that is taxable as income to the recipient. Usually, the bonus is a deductible business expense for the company.
The key employee may choose to use the bonus to purchase a whole life or universal life insurance policy (some producers prefer the newer interest-sensitive universal life policies) that builds cash value that grows on a tax deferred basis. Any cash value accumulation will grow tax deferred and may be accessed by the employee income tax-free through withdrawals and policy loans. (See new restrictions below) The cash value of the policy can be used to supplement retirement income or for most other financial need.
If the key executive dies, in most cases the heirs will receive the death benefit proceeds from the life insurance policy, tax free.
There are some variations such as the double bonus plan where in the company will provide the key executive with a large enough bonus to cover the life insurance premiums as well as the income taxes incurred by the executive on the bonus, and which can be used to eliminate any expense for the key executive.
There is also a "controlled" bonus where the company wants to retain some measure of control over the bonus. The company and the executive enter into an agreement which includes a vesting schedule on the cash value growth of the policy. This can be considered as "golden handcuffs" as it allows a company to limit the availability of the cash value benefits until the executive has fulfilled the terms of the agreement, whereupon the executive is "vested." Once the executive is vested, he gains total control of the policy's cash value.
This plan has several advantages; in particular, the company can choose the key employees they wish to reward. These payments can be a fully deductible expense to the company. The key employee may name the beneficiary of the entire death benefit of the life insurance policy.
Unless there is some sort of restricted or controlled executive bonus, the key executive will have immediate access to policy cash value and may access that cash value without income tax through policy loans and withdrawals. Executive bonus plans are not usually subject to "qualified plan limits." (Again, please refer to recent IRS rulings.)
There is a disadvantage to the company inasmuch as they are unable to fully recover its costs from the death benefit since the key executive names the policy beneficiary.
The company has very little control of the policy. Even if the controlled executive bonus is utilized, it only restricts the key employee's access to the policy's cash value. And, obviously, one of the disadvantages is that the bonus is never recovered by the company even if the key employee leaves the company prior to vesting.
For the key employee, he must include any bonus in his taxable income, plus, without proper estate and/or financial planning, the insurance policy's death benefit will be includable in his taxable estate.
And perhaps the most practical disadvantage is that establishing such a plan is not as easy as taking a life insurance application. Just to mention a few of the tasks that might appear:
The process of a Board Resolution would include a bonus check being issued to each of the stockholders (if that is what is needed) and then each involved stockholder writing a check for the respective insurance premium.
This is not insurmountable but it is a lot of work if the policy is going to be for a small amount. In those situations where the client is a large company and the policy is large, it works well, thank you.
By including a restricted access provision in the agreement, the employer can limit the conditions under which the employee may use the policy's cash values. These conditions would also become part of the life insurance policy itself by means of an endorsement. The restrictions tend to make an executive bonus plan resemble split-dollar and deferred compensation plans, under which the employer retains certain rights by virtue of limiting the employee's rights. A major difference remains in that the employer's contributions in the form of bonuses are still currently deductible and the employee is still currently taxable on the bonuses.
Restricted access can be accomplished by various means. The employer might include a vesting schedule that requires the executive to remain employed for a certain period before any cash values become available. The longer the employee remains, the greater the amount vested until the employee eventually has access to 100% of cash values. The restriction may either require the employee to completely forfeit unvested amounts or allow these amounts to be paid after a period of time has passed.
For example, suppose an executive who is only 70% vested leaves the employer, whereas five more years of employment would have resulted in 100% vesting. The employer may require five years to pass, and then release the remainder of the cash values to become the employee's unrestricted property. On the other hand, the agreement might require the employee to use the cash values to pay back the bonuses if the employee leaves prior to a stipulated date.
In Revenue Ruling 2008-13 (Feb. 21, 2008), the Internal Revenue Service (IRS) added an additional layer of complexity to drafting compensation arrangements for senior executives - an area of the law that already has been subjected to unprecedented changes as the result of Internal Revenue Code (IRC) Section 409A. The ruling adopts a new interpretation of IRC Section 162(m), which Congress enacted in 1993 to limit the amount publicly-traded companies and their affiliates can deduct for compensation paid to their highest-ranking executives. Rev. Rul. 2008-13 expands the scope of Section 162(m) so that an executive's performance-based compensation under a performance plan that: satisfies all the criteria of Section 162(m) will be non-deductible solely because the executive also is covered by a severance provision that takes his or her targeted performance bonus into account in calculating severance pay.
Section I62(m) denies a deduction to any publicly held corporation for compensation in excess of $1 million per year paid to a "covered employee," A "covered employee" is the chief executive officer of the corporation and any other employee whose compensation must be disclosed because he or she is one of the four highest compensated employees of the registrant (not counting the CEO).
Some types of compensation do not count against the $1 million limit, including compensation payable "solely on account of the attainment of one or more performance goals," provided that the adoption and implementation of the performance bonus plan satisfy certain requirements related to corporate governance and shareholder consent. These goals are set forth in Treasury Regulation § 1.162-27:
"Compensation does not satisfy [this requirement] if the facts and circumstances indicate that, the employee would receive all or part of the compensation regardless of whether the performance goal is attained [including circumstances where] the payment of compensation under a grant or award is only nominally or partially contingent on attaining a performance goal... Compensation does not fail to be qualified performance-based compensation merely because the plan allows the compensation to be payable upon death, disability, or change of ownership or control, although compensation actually paid on account of those events prior to the attainment of the performance goal would not satisfy the requirements of this paragraph (e)(2)."
On January 25, 2008, the IRS issued a Private Letter Ruling that relied in part on this regulation to hold that a corporation could not deduct a performance bonus paid to an executive after the attainment of the pre-established performance criteria because the executive's employment agreement provided that if he were terminated without cause or even for good reason, pending performance bonus targets would be deemed satisfied and the executive would be paid the target bonus, Priv. Ltr. Rul. 200804004 (Jan. 25, 2008).
The Private Letter Ruling came as a surprise to many, and there were almost immediate calls for its withdrawal and clarification. Rev. Rul. 2008-13 was in part a response to these requests. However, the Revenue Ruling neither withdrew nor clarified the reasoning of the Private Letter Ruling. Instead, it adopted the holding of the Private Letter Ruling, and further expanded the circumstances under which compensation will not be considered performance-based compensation to which the $1 million limit under Section 162(m) does not apply. Under this ruling, compensation payable to a covered employee following the attainment of properly established performance criteria will count against the $1 million deduction limit if compensation would otherwise be paid upon the executive's involuntary termination without cause, voluntary termination for good reason, or retirement, whether or not the goal had been attained.
This establishes unequivocally that compensation counts against the $1 million deduction limit, even if it is paid because of the attainment of a properly-established performance goal to an executive who has not terminated employment, if the compensation is otherwise payable either in the event of attaining performance criteria or under any alternative scenario when the performance criteria is not met other than the alternatives specifically mentioned in the Treas. Reg. § I.162-27(e)(2)(v), i.e., death, disability, or a change in control.
It is important to note that this regulations provides for a facts-and-circumstances determination of whether compensation is payable for a reason other than attainment of a performance goal. The regulation instructs that this facts-and-circumstances determination "is made taking into account all plans, arrangements, and agreements that provide for compensation to the employee." It seems to follow that (as in Priv. Ltr, Rul. 200804004), if an executive employment agreement or senior executive severance plan provides for payment of a performance-based bonus target upon a voluntary or involuntary termination of employment, the holdings in Rev. Rul. 2008-13 would be applicable to any compensation paid under the performance plan, even if the performance plan itself complied in all respects with Section 162(m).
Thus the practical implications of Rev. Rul. 2008-13 are even more far-reaching than its holdings suggest. Rev, Rul, 2008-13 should be taken into account in drafting any executive employment agreement or executive severance arrangement for a public company or for any company that might become a public company at any time during the term of the employment agreement or severance plan. Similarly, in the context of an acquisition by a publicly-traded company, the prospective new owner may need to consider whether any of the target's surviving employment agreements or other executive arrangements unexpectedly might trigger the disallowance of deductions for performance-based pay to senior executives of the combined enterprise.
Perhaps in recognition that many existing performance bonus plans and executive deferred compensation arrangements unexpectedly would trigger disallowance of deductions under Section 162(rn) if Rev. Rul. 2008-13 were applicable immediately, the ruling provides some limited transition relief, including a "grandfathering" exception. The holdings in Rev. Rul. 2008-13 will not be applied to disallow an otherwise allowable deduction for compensation payable under a plan with a performance period that begins on or before January 1, 2009. In addition, the holdings in Rev. Rul. 2008-13 will not be applied to compensation payable under the terms of an employment: contract as in effect on February 21, 2008, without regard to any future renewals or extensions (including renewals or extensions that occur automatically under the terms of the contract without: action on the part of the employer or employee).
One way to restrict access is through a secular trust, which we discussed briefly in the previous chapter. This irrevocable trust, which in this case is established by the employee, not the employer, owns the life insurance policy. The IRS has not issued any specific rulings on the use of life insurance policies in secular trusts, but so far the use of the trust has not allowed the employee to escape current taxation on the bonuses that fund the insurance that makes up the trust. Likewise, the employer has been allowed to take the deduction for bonuses as compensation even when the trust is used.
One concern with a secular trust-and possibly with any other severe restrictions on the employee's access to the cash values is that the IRS could decide this represents a substantial risk of forfeiture as described earlier. In this case, the employer would not be allowed to take the tax deduction. The employee would not be currently taxed on the bonus in this case either.
The previous chapter briefly mentioned insurance used to provide a third-party guarantee or protection for an executive who has forgone current compensation under an unfunded deferred compensation plan. This coverage is called indemnification insurance or executive indemnification insurance.
The policy pays a benefit to the insured executive in the event the employer either refuses or is financially unable to pay the deferred compensation benefits when due. The policy benefits are intended toequal the deferred compensation benefits the employee would have received had the employer not defaulted. These benefits are taxable income, just as the deferred compensation benefits would be taxable if they had been paid as agreed.
An IRS ruling indicates that the existence of such insurance does not cause a deferred compensation plan to become taxable currently as long as the other requirements for these plans (as discussed in earlier) are met. The employee must own the indemnification insurance and be the person who benefits from it. The employee pays the premiums, which are not tax deductible-the general rule for insurance premiums paid by individuals.
The IRS even allows the employer to reimburse the employee for the insurance premiums as long as the employer receives no benefit from the policy and has no other legal interest in the insurance. If the employer does pay the premiums, their value is taxable income on which the employee must pay current taxes.
One drawback to executive indemnification insurance is that employees who need the coverage the most are probably the least likely to be able to get it. That is, if the financial soundness of a business is in question, the insurance company is not likely to take the risk. Of course, an executive who believes the employer's financial future is uncertain should probably not agree to a deferred compensation arrangement in any event. Executives will find the insurance a more viable purchase to protect against the more remote risks, such as unforeseeable economic downturns or an unpredictable decision by the employer to refuse to pay the deferred compensation benefits.
The business insurance issues and product solutions you've learned about in this text have addressed two key areas:
1. Business continuation in the event of an owner's death or disability.
2. Benefits that may be provided for selected employees rather than to all employees, avoiding the costs and administrative headaches associated with benefits that must meet nondiscrimination standards.
One must be very much aware, of course, that tax-qualified employee benefits are also a significant issue for many businesses. Employers often provide group life and health insurance for all employees, as well as pension, profit sharing or other retirement programs.
1. A Section 162 executive bonus plan is a means available to employers to provide nonqualified benefits to employees on:
A. a discriminatory basis.
B. a nondiscriminatory basis.
C. an all inclusive basis.
D. a tax free basis.
2. With a traditional executive bonus life insurance plan the ______ owns the policy.
A. employer.
B. employee.
C. employee’s estate.
D. employer’s general creditors.
3. The death benefit’s proceeds of policies provided under Section 162 are paid to the ______ beneficiaries’ income ________.
A. employer’s, taxable.
B. employer’s, tax-free.
C. employee’s, taxable.
D. employee’s, tax-free.
4. Who is entitled to a tax deduction for a Section 162 bonus paid for life insurance? The
A. employer.
B. employee.
C. trustee.
D. rabbi.
5. With a section 162 executive bonus life insurance plan the _____ is the insured and the
_____ is the beneficiary.
A. employer, employer.
B. employer, employee.
C. employee, someone other than the employee.
D. employee, someone other than the employer.
6. The death benefits paid under a Section 162 executive bonus life insurance plan are included in the estate because the
A. employer paid the premiums.
B. employer owned the policy.
C. employee had incidents of ownership.
D. employer was the beneficiary.
7. If the employer pays the premiums under an executive bonus life insurance plan the value is
A. non-deductible by the employee.
B. non-deductible by the employer.
C. not taxable to the employee.
D. taxable to the employee.
8. With a traditional executive bonus life insurance plan the employer
A. owns the policy.
B. can barrow from the policy.
C. can surrender the policy for its cash value.
D. pays the employee a bonus intended to fund life insurance premiums.
9. Tax treatment of restricted access plans remain open to ________ interpretation.
A. the insurance commissioner
B. I.R.S.
C. the employer’s
D. SEC
10. A secular trust
A. is an irrevocable trust.
B. leaves unlimited access to the employee.
C. is established by the employer.
D. prevents the employer from receiving a tax deduction.
Answers
1A 2B 3D 4A 5D 6C 7D 8D 9B 10A