Even though life insurance is generally purchased for personal or family purposes, it also fills a very important need of the business and industry community. This is an area requiring considerable expertise and there are very successful agents, brokers and insurance companies that specialize in this market. It is not an easy market to penetrate, as accountants and attorneys, in addition to senior officers of corporations, become involved in this process. Using life insurance for business purposes is technical and requires expertise, but those who are seriously involved in this important market started “small”, such as with small businesses, and then as confidence and expertise grew, expanded into the larger firms.
Business uses of life insurance can be categorized into three areas:
Almost 20% of the assets of the households in the U.S. are held in businesses that are privately held, and in most cases, family businesses. These are considered as closely held businesses. These businesses have unique characteristics, such as that the owners usually manage the firm and are usually owned by less than 10 individuals.
For purposes of this discussion, the most important characteristic is that the ownership of the closely held business is usually not marketable. Therefore, the only ones who would be interested in purchasing the business upon the death of the principal would be other owners, employees, or competitors. In any event, the successor(s) could have a difficult time keeping the business going as lines of credit would have to be re-established, and the ‘very important but difficult-to-measure asset’ of “good will” may be dissolved or decreased by the death of the original owner.
The business stability and the continuation of the business following the death of the owner, or one of the owners, of a closely held corporation are highly important to the family of the deceased owner and the surviving owners, not to mention the employees.
The principal types of closely held firms are
As the name implies, a Sole Proprietorship is an (unincorporated) business owned by a single person; typically the owner also manages the business. The fact that it is owned and operated by a single person makes it a particularly “fragile” business because everything revolves around the owner.
When a proprietor dies, the debts of the business become the debts of the estate as the law recognizes business and personal assets as one and the same in a sole proprietorship. The personal representative, or executor, of the proprietor is required to dispose of the business as quickly as possible.
Life insurance can fund the disposition in several ways:
A partnership is a voluntary association of two or more individuals for the purpose of conducting a business for profit as co-owners. There are two basic kinds of partnerships, (1) General partnership, where each partner is actively involved in the business and each are liable for the partnership obligations; and (2) Limited partnership has one (or more) general partners, and one or more limited partners who are not involved in the management and are liable for obligations of the partnership only to the extent of their investment in the partnership.
The most important rule of partnership law affecting the area of life insurance, is:
F Upon the death of a general partner, the partnership is dissolved, and in the absence of contrary arrangements, the surviving partners become liquidating trustees.
The surviving partners must not only liquidate the business; they also must pay to the estate of the deceased, a “fair” share of the liquidated business. Unfortunately, liquidation of a business nearly always results in the assets of the business shrinking as most of the assets will only bring a portion of the actual value. Most importantly to the survivors, is the method of making a living has just disappeared.
CONSUMER APPLICATION
Olivia Kern and Elaine O'Connell were co-owners of a successful 10-year-old retail business. When Elaine was tragically killed in a car accident, Olivia suffered a double loss: first, the death of her dear friend and second, the loss of her business. Why her business? While Elaine's husband and daughter both wanted Elaine's business to continue after her death, they were forced, for financial reasons, to use Elaine's share of the business income, causing the store to close.
Neither of Elaine's survivors were equipped to contribute financially to the business nor were they equipped by training or personality to help run the business. Seeing the financial problems her friend's family was having, Olivia immediately began sharing profits with them and attempting to add to that amount to buy Elaine's half of the business from her heirs. These kind and thoughtful actions unfortunately resulted in cash flow problems for the business and finally, the financial burden forced Olivia to go out of business altogether. Olivia's loss was rooted in the lack of capital to purchase Elaine's half ownership from the survivors when Elaine died
Often, partners believe that if one partner dies, the surviving partner will simply buy out the interests of the estate. This is overly-simplistic because the surviving partner will have to come up with the money, and even if that is possible, they must pay a fair price. This brings up another problem, which is that the surviving partner has a fiduciary relationship with the estate of the deceased and other surviving partners (if any), and in some states, they are not allowed to purchase the property because it amounts to a “trustee purchasing trust property.”
Because of the reasons as listed above, it is very common for partnerships to enter into a buy-and-sell agreement. This type of arrangement has been mentioned earlier, and can be used for sole partnerships, partnerships and close corporations in which the business interests of a deceased or disabled proprietor, partner or shareholder are sold, according to a predetermined formula to the remaining members of the business.
As an example, for a business with three partners, the agreement could be that upon the death of one partner, the two survivors agree to purchase, and the deceased’s partner’s estate has agreed to sell the interest of that partner, according to a predetermined formula for valuing the partnership, to the survivors. The funds for buying out the deceased partner’s interest are usually provided by life insurance policies, with each partner purchasing a policy on the other partner(s). Each is the owner and beneficiary of the policies purchased on the other person.
For a “professional partnership” – usually for attorneys and physicians – the business continuation agreement is a little different. There is usually a provision whereby the income to the deceased partner’s estate or heirs continue for a specified period of time, and with the amount of the income based on a profit-sharing agreement. Frequently, there is also a separate agreement providing for the sale of the deceased partner’s business assets.
There are two types of buy-and-sell agreements, entity and cross purchase.
Under the entity type of buy-and-sell agreement, the business itself is obligated to buy out the ownership of a deceased (or disabled) partner, with each partner binding his/her estate to sell if the partner is the first to die.
Under the cross-purchase agreement, the agreement is between the business owners themselves as each owner binds his/her estate to sell his/her business interests to the surviving owners; and each surviving owner binds himself/herself to buy the interest of the deceased owner.
As indicated above, life insurance is commonly used to fund these arrangements.
Under the entity approach, the partnership itself applies for, owns and is the beneficiary on each partner’s life. The death benefit of the policy should, in most cases, equal the value of the insured partner’s interest in the business.
Under the cross-purchase approach, each partner applies for, owns and is beneficiary of a life insurance policy on each of the other business partners. The death benefits generally equals the agreed-upon value of the other partners’ interest in the business.
The taxation of life insurance proceeds used for partnership buy-and-sell agreements, is the same as individual personal insurance. Premiums are not deductible as a business expense, whether it was paid by the business or a partner. Death proceeds are normally income tax free.
F The cost basis for each surviving partner is increased by the proceeds received by the partnership in the case of the entity plan; and by the amount paid for the deceased partner’s interest under the cross-purchase plan.
Life insurance death proceeds are not included in the gross estate of the insured unless the insured possesses any incidents of ownership in the policy, or the proceeds are payable, to or for the benefit of, the insured’s estate. Any death proceeds payable to the partnership normally would increase the value of the partnership for estate tax purposes.
The question of valuation of the business for estate tax purposes must be addressed if the value of the business is less than fair market value even if there is a value stated in the agreement. A value stated in the agreement will control if the agreement is a bona fide business transaction performed at “arm’s length” and is not a method of transferring property to the deceased’s family for less than adequate compensation.
A closely held corporation is usually held by a small number of people active in the business, and usually is not sold or transferred except for death or disability, or in case of major corporate restructuring. The difficulties involved when a shareholder dies are caused because of the very structure, i.e., the shareholders are usually its officers, they have an incentive to pay themselves salaries (salaries are tax deductible, dividends are not), and the BIG problem: there is no market for their stock.
It will be noted that there is a significant similarity to a partnership situation, therefore a plan to retire a stockholder’s shares in case of death can be as important to shareholders, as for the owners of a sole proprietorship or partnership.
Death of a Majority Stockholder
A unique situation arises when the majority stockholder in a closely-held corporation dies (or is disabled). Many closed corporations (synonymous with closely-held corporation) are family owned with a principal stockholder, or the founder of the company, etc., is a majority stockholder. When this stockholder dies, the other stockholders may have to accept an adult heir into the company (everyone is aware of the hazards involved in a new majority stockholder), or perhaps they may have to pay dividends to the heir(s) which would be approximately the same as the salary of the majority stockholder had been receiving. If the stock of the deceased stockholder has been sold to an outside interest, the remaining stockholders may be forced to accept active management of someone they, at the very least, did not know.
The only other alternative would be for the remaining stockholders to purchase the stock from the estate of the deceased stockholder. This may be impractical as the remaining stockholders may not have sufficient funds to purchase the stock, they may not be able to agree on a fair price, and sometimes the heirs will refuse to sell.
The alternatives to the heirs are not encouraging, and as a practical matter, the best they can hope for in most cases, is a reasonable percentage of the worth of the business. The remaining stockholders could possibly get what they can from their stock, and then take their talent and customers and start up a new business.
Death of a Minority Stockholder
The death of a minority stockholder, or an equal stockholder (where everyone has the same percentage of shares) have serious problems also. The majority stockholders can force their will on the new minority stockholders, and at the very best, lawsuits can start flying all over the place – there are a lot of laws protecting minority stockholders.
All this being said, the fact still remains that the minority stockholder’s heirs are not in a good situation as they own stock which was possibly subject to rather substantial state and federal estate taxes, but the stock has little, if any, marketability, as who would buy a minority interest in a closely-held corporation? Further, they will not receive any income from the stock as closed corporations rarely pay dividends (stockholders prefer salary).
The entity (usually stock-redemption) or the cross-purchase agreements will work as well for close corporations as for partnerships. It would be repetitious to go through the procedures again, but it would be more important to have a frequent valuation of the stock and the agreement reviewed and changed when necessary.
Using life insurance, each stockholder is insured for the value of the stock that they own, and the insurance is either owned by the stockholders or the corporation. Upon the death of the stockholder, benefits are used by either the stockholders or the corporation, and the business future of the survivors continues and the beneficiaries of the estate receive cash for their interest.
Taxation of Corporate Buy-and-Sell Agreements
Life insurance premiums are not tax deductible with the stock redemption or the cross-purchase approach and proceeds are not taxable (except in some Minimum Tax situations). Increase in cash values are usually not taxable.
If life insurance is owned by a corporation to fund an entity buy-out agreement and then at a later date it is decided to change to a cross-purchase agreement, the policies that are owned by the corporation can not be transferred directly to the shareholder (someone other than the insured) or the “transfer-for-value” rule may apply. This rule allows exceptions for transfers between partners and partnerships, but not between corporations to stockholders. It has sometimes been suggested that the stockholders also enter into a (side) partnership agreement because a transfer for value does not apply to partnerships.
As with the partnership entity buy-and-sell agreements, the life insurance death benefits will not be included in the estate of a deceased stockholder (unless the stockholder had an incident of ownership in the policy or if the benefits were paid to or for the stockholder’s estate).
A full discussion of the Alternative minimum Tax (AMT) is outside the scope of this text, but it should be mentioned that with most modern cash-value policies, after a few years the annual increase in the cash value exceeds the net annual premium. In some cases this would trigger the AMT tax. If there is a possibility of this, the cross-purchase approach should be considered as the corporation is neither the owner or the beneficiary of the policies and the AMT tax could be avoided.
NOTE: At the time this text was being prepared, Congress was seriously debating the repeal of the alternative minimum tax and while it will probably be passed in the House, the Senate may or may not pass it at this time. If this tax is repealed, references to this tax should just be ignored as a factor in this discussion.
In determining the best type of agreement for tax purposes, it would depend upon the tax status of the corporation and the shareholders. If the corporation is in a lower tax bracket, the redemption plan would be best in most cases as the premium payments for the policies would take a smaller share of the corporation’s after-tax income, than it would take of the shareholders’ after-tax income.
However, if the shareholders are in a lower tax bracket, the cross-purchase plan may be better because the premium payments would take less of the after-tax income of the shareholder than that of the corporation.
With only two shareholders, there is little administrative difference in the two plans. However, if there are several shareholders, each shareholder would have to purchase a policy on each of the other shareholder’s lives. (To determine the number of policies that would be required, the formula is n(n-1) where “n” is the number of stockholders. If there were 6 stockholders, then 6(5) – or six, times [six less one =, or five] – would be 30 policies that would be needed).
For tax purposes, with a stock-redemption plan, when the corporation buys the stock from the heir or estate of the deceased stockholder, the stock then becomes treasury stock and is no longer outstanding. The other stockholders now own a larger percentage of the shares outstanding, even though they maintain their original stock with no increase in cost basis – and even though they now each own a larger share of the corporation. However, as the ownership has increased and the cost basis remained the same, upon a subsequent sale, their taxable gain will have been increased.
Under a cross-purchase plan, the remaining stockholders purchase the stock with their own money so they acquire an increase in basis that is equal to the purchase price of the new shares. Upon a subsequent sale, this new basis reduces the amount of any taxable gain realized by the selling shareholder.
These differences are important only if the stock is to be sold during their lifetime. Otherwise, at death the stock will have a stepped-up cost basis, so the net effect would be the same whether the ownership interest had increased by cross-purchase or entity agreements.
CONSUMER APPLICATION
COMPARISON OF TAX CONSEQUENCES OF
CROSS-PURCHASE AND STOCK-REDEMPTION PLANS
SITUATION: The Handi Corporation is owned by Jim, Bob and Ray in equal shares.
Each stockholder originally put in $100,000 – their cost basis.
The fair market value of Handi Corp. is $1,500,000.
Each owner is insured under a life insurance policy for the value of their interest, $500,000.
Jim is the first to die, and under the business continuation agreement, Bob and Ray each now own
½ of the corporation ($750,000 each).
Bob retires, and sells his shares to Ray.
EFFECTS OF THE STOCK-REDEMPTION PLAN
Jim’s death:
The corporation collects $500,000 and redeems his stock.
The value of the business remains at $1,500,000.
Bob and Ray’s ownership value now is $750,000 each, each cost basis remains at $100,000.
Bob retires:
Bob has a living buyout when he sells his ownership to Ray.
Bob has a capital gain of $650,000 ($750,000 less cost $100,000)
If capital gains tax is 20%, taxes of $130,000 would be due on $650,000 gain
Bob would realize net of $520,000.
EFFECTS OF CROSS-PURCHASE PLAN
Jim’s death:
Bob and Ray each collect $250,000 from life insurance policy, and buy Jim’s stock from his estate.
The value of the business remains at $1,500,000.
Bob’s and Ray’s interest (each) in ownership is $750,000.
Bob’s and Ray’s cost basis is $250,000 (insurance proceeds) plus original base $100,000 = $350,000 each.
Bob retires:
Bob has a living buyout when he sells his ownership to Ray.
Bob has a capital gain of $400,000 ($750,000 (sale price) less $350,000 cost basis)
If capital gains tax is 20%, taxes of $80,000 would be due on gain of $400,000.
Bob would realize net of $320,000.
(Note: If Bob retained stock until his death, the stock would then have a stepped-up basis to its then fair market value on the death of the stockholder, therefore, the result would have been the same under either method,)
Because many estates have large percentages in closely held businesses, they have liquidity problems resulting many times in forced sales and in some cases, liquidation of the business. The Internal Revenue Code 303 was created to alleviate this problem. It allows qualifying estates income-tax free stock redemption, in an amount to cover federal and state estate taxes, funeral expenses and estate administration expenses. Since a partial redemption of stock is treated as a taxable dividend to the shareholder that redeems the stock (or his heirs), this is very important in these situations. To qualify, the stock value must be included in the gross estate of the decedent and the value must represent more than 35% of the adjusted gross estate. The redemption must be made within 3 years and 90 days of filing the estate tax return.
Life insurance is an excellent funding vehicle for these situations. The business applies for and pays the premiums on the policies insuring the owner’s life. The insured is the shareholder; both the policyowner and beneficiary is the business. At death of the shareholder, proceeds are paid to the business. The results are very much like that of key employee insurance.
A “key employee” is an individual who possesses a unique ability essential to the continued success of a business. This uniqueness may include the capital they control, or the energy, technical knowledge, experience, management ability or other areas that makes this person a valuable asset to the company. To determine whether a person is a key employee, the question is whether the death of this individual could severely handicap the company.
The answer to any such question, if positive, would indicate a problem that can be solved, at least partially, by life insurance. Obviously some individuals are so “unique” in their ability that they cannot be replaced, however in most situations, an individual can be replaced provided there is sufficient time and expertise available. In any event, an infusion of funds can, at the very least, alleviate the problem.
The amount of life insurance is essentially “informed guesswork.” If the services of the key employee were to be lost suddenly, the financial loss to the company must be estimated. The life insurance benefits should equal the present value of the projected lost earnings, plus, there should be sufficient funds to pay the salary of the replacement. But in actual practice, the company would generally have to pay more to the replacement thant what they paid to the key employee. If an experienced and competent individual were hired, they would be “starting at the bottom” and would therefore demand a higher income.
Key man insurance can be furnished by nonqualified plans such as those discussed below. In addition, there can be other plans adapted to meet the particular situation that might arise upon the premature death of a key employee.
On a typical key employee plan using permanent life insurance, the employer pays the premiums on the policy. Dividends generated by the policy are used to pay the income tax of the key employee (caused by the employer paying the premiums, as under federal tax laws, employer-paid premiums are taxed as additional earned income for the employee). Under many of the permanent policies, after the policy has been in force for a few years, the dividends could exceed the taxable premium income to the employee.
The advantages of permanent life insurance to the key employee include life insurance coverage for life, increasing cash values, increasing dividends, selection of beneficiary and ownership of the policy.
Key employee insurance may only be purchased by non-deductible dollars, however the death proceeds are generally received income-tax-free by the corporate beneficiary under IRC Section 101.
NOTE: Corporate beneficiaries may be subject to the Alternative minimum Tax, as discussed earlier. For corporations, this brings insurance policy gains in excess of premium and death benefits in excess of cash value, into the AMT as these gains are added to a corporations book income. (See earlier note regarding possible repeal of the AMT.)
When Term life insurance is used for key man insurance, the premiums that are paid by the employer are considered federal taxable income to the employee. The employee selects the beneficiary and owns the policy. Generally, these policies will not remain in force after retirement as premiums continue to increase with age and become prohibitive (unless the employee is in very bad health, in which case they may wish to pay the extra premium under a separate arrangement with the employer).
As with the other key-man insurance plans, under the salary continuation plan the employer purchases (usually) permanent life insurance on the life of the employee. The employer is the beneficiary of the insurance policy, and owns the policy.
If the employee dies before receiving all promised supplemental pension benefits, the employer pays the remaining supplemental pension benefits to the beneficiary of the deceased employee. Funds for payments are provided from the life insurance proceeds.
Life insurance is used as an investment vehicle because employers promise employees not only supplemental employee retirement benefits (private pensions), but also benefits in the event of the employee’s premature death.
The employer usually purchases permanent life insurance on the life of the employee, is the beneficiary of the policy, and owns the policy. The premiums paid by the employer are not considered federal taxable income to the employee. Upon the death of the employee, the employer will use the life insurance proceeds to pay death benefits for several years to the employee’s beneficiary. The employer receives the life insurance proceeds tax free; however, the death payments to the employee’s beneficiary are federal taxable income to that beneficiary. This plan can also be utilized to supplement the employee’s pension plan at retirement.
The split-dollar plans are not technically “key man” insurance, but can be used for that purpose, as the employer still receives the death benefits in case of premature death of the employee. This plan, and those that are described below, are actually non-qualified executive benefits.
The “split-dollar” plan is a different approach as the premiums are “split” between the employer and the employee. It is also called an Endorsement plan because the employee’s rights are protected by an endorsement on the policy that provides that the beneficiary designation of the employee which allows the beneficiary to receive the excess cash value, cannot be changed without the insured employee’s consent.
Permanent life insurance is purchased on the employee, and the employer has an equity interest in the cash value of the policy into which the employer paid premiums. The employee has an equity interest in the cash value of the policy to the extent that the cash value exceeds the premiums paid in by the employer.
Some insurers permit the ownership of the policy rights to be split, the insured/employee being designated as the owner of the portion of the death benefit in excess of the cash value, and the employer is designated as owner of all the other policy rights and benefits.
Under many permanent policies, the cash values will accumulate to a substantial sum, whereupon the employer can withdraw from the cash value an amount equal to the amount of premiums that the employer has paid into the policy.
At this point, the split-dollar plan terminates, and the employee has the sole possession of the insurance policy. The cash values remaining should be sufficient so that no further premium payments are required by the employee to keep the policy in force.
There are actually many ways to design a split-dollar contract. An employee may notice that the initial contribution to the contract is substantial, but in later years, it becomes zero. Therefore, they may ask the employer to average these charges over a number of years to make it easier to start the plan. Also, an employer may do a variation (a “no-split” split dollar plan) in which the beneficiary provisions are set up as with the split-dollar plan, but the employee does not contribute.
The measure of taxability for split-dollar plans can be found in “PS-58” tax tables which are IRS tables used in computing the cost of pure life insurance protection taxable to the employee under qualified pension and profit sharing plans, split-dollar plans, and tax-sheltered annuities (See table on page 148). The actual cost of standard issue life insurance offered by the insurance company providing the coverage may also be used.
A “Second-to-Die” or survivorship life policy can be used for split-dollar plans. It is important that the plans terminate the split-dollar arrangement at the death of the first party, otherwise it can cause tax problems to the survivor in the form of imputed income to non-employee insureds.
A variation of this plan, often called “Reverse Split-Dollar” plan is created by changing who typically gets and pays for the account value of the policy. In effect, the employee’s primary objective is not a substantial amount of life insurance, but rather a substantial build-up of assets. Therefore, the corporation would pay the expenses and the mortality cost, and the investment account would become the property of the employee, i.e., the employer gets the death benefit and the employee gets the cash value which has been growing on a tax-free basis.
The “reverse” split-dollar plan was not particularly attractive in the past, however with the recent surge in the stock market and with the introduction of interest-sensitive insurance products, particularly variable universal life, there is much more interest in this approach.
This approach has definite tax advantages, and therefore any such arrangement should be structured with legal and professional accounting advice, as tax laws have been known to change frequently and sometimes drastically.
CONSUMER APPLICATION
Ajax Corp. wants to purchase key man insurance on Bill, age 50, non-smoker, for $200,000. Ajax agrees to use the reverse split-dollar approach. Using a variable universal life insurance policy, a relatively conservative funding level would be about $4,000 per year. Of this amount, Ajax would pay the PS-58 costs for Bill, which is $9.22 per $1,000 for the year (age 50), or $1,844 (200x$9.22). Bill would then be responsible for paying $2,156 per year.
When the policy is examined, it could easily show that the total expenses only amount to $1,200 (for which Ajax has paid $1,844). The extra money ($644) goes into the employees investment account.
The $644 is an extra “bonus” caused by using the PS-58 tables. (How long this tax break will continue is anybody’s guess.) However, this reverse split-dollar arrangement is a “good deal” for the company and for Bill, regardless of the “bonus.”
Under the Collateral Assignment plan, the insured employee applies for the policy and is the owner of the policy, and therefore designates the beneficiary. The employee is primarily liable for the premium payment also. This sounds like a typical individual life insurance purchase, which it is up to this point.
The employer and the employee enter a separate agreement, wherein the employer agrees to loan (usually interest-free) the employee an amount equal to the annual increase in the cash value. Therefore, the employee has an actual cost of the portion of premium of each annual premium that exceeds the annual cash value increase.
Because there is a loan involved, the policy is assigned by the employee to the employer as collateral (hence the name) for the loan.
At the death of the employee, the employer receives the amount of the loan from the death proceeds (not as a beneficiary, but as a collateral assignee).
P.S. No. 58 Rates
The following rates are used in computing the “cost” of pure life insurance protection that is taxable to
the employee under qualified pension and profit sharing plans, split-dollar plans, and tax-sheltered
annuities. Rev. Rul. 55-747. 1955-2 CB 228: Rev. Rul. 66-110. 1966-1 CB 12
One Year Term Premium for $1,000 of Life Insurance Protection
(Premiums are dollar amounts)
Age |
Premium |
|
Age |
Premium |
|
Age |
Premium |
15 |
1.27 |
|
37 |
3.63 |
|
59 |
19.08 |
16 |
1.38 |
|
38 |
3.87 |
|
60 |
20.73 |
17 |
1.48 |
|
39 |
4.14 |
|
61 |
22.53 |
18 |
1.52 |
|
40 |
4.42 |
|
62 |
24.50 |
19 |
1.56 |
|
41 |
4.73 |
|
63 |
26.63 |
20 |
1.61 |
|
42 |
5.07 |
|
64 |
28.98 |
21 |
1.67 |
|
43 |
5.44 |
|
65 |
31.51 |
22 |
1.73 |
|
44 |
5.85 |
|
66 |
34.28 |
23 |
1.79 |
|
45 |
6.30 |
|
67 |
37.31 |
24 |
1.86 |
|
46 |
6.78 |
|
68 |
40.59 |
25 |
1.93 |
|
47 |
7.32 |
|
69 |
44.17 |
26 |
2.02 |
|
48 |
7.89 |
|
70 |
48.06 |
27 |
2.11 |
|
49 |
8.53 |
|
71 |
52.29 |
28 |
2.20 |
|
50 |
9.22 |
|
72 |
56.89 |
29 |
2.31 |
|
51 |
9.97 |
|
73 |
61.89 |
30 |
2.43 |
|
52 |
10.79 |
|
74 |
67.33 |
31 |
2.57 |
|
53 |
11.69 |
|
75 |
73.23 |
32 |
2.70 |
|
54 |
12.67 |
|
76 |
79.63 |
33 |
2.86 |
|
55 |
13.74 |
|
77 |
86.57 |
34 |
3.02 |
|
56 |
14.91 |
|
78 |
94.09 |
35 |
3.21 |
|
57 |
16.18 |
|
79 |
102.23 |
36 |
3.41 |
|
58 |
17.56 |
|
80 |
111.04 |
|
|
|
|
|
|
81 |
120.57 |
The rate at insurer’s attained age is applied to the excess of the amount payable at death
over the cash value of the policy at the end of the year.
Choosing the Best Method of Split-Dollar Plan
In determining the best split-dollar system to be used, the first consideration should be whether the employer wants the cash value to be available for business use during the time the split-dollar plan is in force. If this is the case, the endorsement system or split ownership system is best, as under the collateral assignment system, the employer generally cannot receive any of the cash value.
Under the endorsement system, the employer can borrow from the policy at any time and for any reason (the employer is the policyowner). If the employee is not a stockholder or an officer, this method might be better as the policy and the protection it affords would be lost in the event of employment termination.
If the policy is going to be used to fund a retirement arrangement (nonqualified) the endorsement method would be best because at the employee’s retirement, the employer can take out a policy loan, receive the cash value under a settlement option, or continue to pay the premium until the employee’s death.
If the collateral method is used, since the employee owns the policy, it will have to be transferred to the corporation if it is to be used to fund a (nonqualified) retirement plan. This could subject part of the death proceeds to income taxation if the insured employee was not an officer or shareholder.
If an in-force policy is to be used, and owned by the employee, it is easier to use the collateral assignment system. Conversely, if the policy is owned by the employer, it is easier to use the endorsement method.
If a major purpose is to allow the employee to accumulate savings under the policy, then the collateral assignment method is best.
In certain, and rare, situations, the sole proprietor may not have anyone to whom they wish to leave their business. If such is the case, then the business owner may wish to sell to an employee that would like to have the business if the owner should die. Usually the employee does not have the funds to purchase the business, so the employee and the employer could enter into a split-dollar situation, but in this case, the insurance is on the life of the employer instead of the employee.
Cross-Purchase Buy-and-Sell Agreement
The major disadvantage on this type of arrangement is that the shareholders are personally responsible for the payment of the premiums on the insurance policy used to fund the plan. The corporation can help fund the plan by using the split-dollar arrangement, and the collateral assignment method is usually used. In effect, each shareholder applies for and owns a policy on the life of the other shareholders. Each shareholder then collaterally assigns the policy the shareholder owns on the other shareholder’s life, to the corporation as security for the corporation’s premium payments.
However, if a split-dollar plan is used to fund this cross-purchase plan and it uses the collateral endorsement system, it could be considered as a “transfer for value” to the other shareholders of the insured. One approach to eliminate this problem, is to set up the ownership and beneficiary arrangement when the policy is first issued, and thus, the transfer is avoided.
Also, if one of the parties to the cross-purchase agreement is a majority shareholder, using a split-dollar plan to fund the agreement could possibly create estate tax difficulties. Because of tax laws regarding incidents of ownership (without going into lengthy details) the value of the stock in the corporation and the insurance proceeds received by the co-shareholder and used to purchase stock, will both be included in his/her gross estate.
A split-dollar plan can also be used for family matters such as providing insurance protection for a married child, but they do not want to reduce the estate so that all of the children (or other heirs) will have their full share. The parents pay the premiums on the policy, typically with the spouse of their child as beneficiary, with the agreement that at the death of the insured child, the parents will receive the total amount of premiums they have paid. They have provided protection at a minimum outlay, and there are no tax implications, even gift taxation would not come into play as the $10,000 annual exclusion would apply.
CONSUMER APPLICATION
The Bradleys have five children, the oldest is Ben, a schoolteacher, married with two children. The Bradley’s are concerned that if something happens to Ben, they would have to take funds from the estate that they feel also belongs to the other four children, in order to help Ben’s family.
The parents purchase a life insurance policy on Ben’s life, with Ben’s wife named as beneficiary and children as contingent beneficiaries. Since Ben is still relatively young, they are able to purchase a policy with enough death benefit so that Ben’s family will be well cared for. They have an agreement with Ben so that in case of Ben’s death, the total amount of premium that they have paid will be returned to the parents from Ben’s estate. The agreement is also signed by Ben’s wife.
The Bradley’s have created a trust for their children, and if his parents die before Ben, the trust will continue making premium payments on the policy, with the amount of the premiums subtracted from Ben’s share of his parent’s estate.
The executive bonus plan is quite simple. The employer purchases life insurance policies on selected employees and since the employer is paying the premium, it is free to discriminate among employees benefited by this plan.
Since it is nonqualified, the premiums are considered as taxable income to the employee and are tax deductible to the employer (unless the IRS finds that the payments are “unreasonable”).
The employee owns the policy, names the beneficiary and has all other policy rights. However, the death benefits will appear in the employee’s gross estate if the employer retains any ownership interest, or the proceeds are payable to or for the benefits of the estate.
STUDY QUESTIONS
Chapter 8
1. An important characteristic of a closely held business is
A. numerous stockholders.
B. it is usually not marketable.
C. when an owner dies the business is liquidated and it is not considered important.
2. When a sole proprietor dies
A. the personal representative of the estate can run the business.
B. it does not signifially effect the business.
C. the debts of the business become the debts of the estate.
3. The type of closely held firm that continues when an owner dies is a
A. sole proprietorship.
B. closely-held corporation.
C. general partnerships.
4. An agreement whereby the business is obligated to buy out the ownership of a deceased partner is
A. a cross-purchase buy-sell agreement.
B. redemption plan.
C. entity buy-sell agreement.
5. If life insurance is used to fund a partnership buy-sell agreement the
A. premiums paid are not deductible.
B. proceeds are usually taxable.
C. proceeds are included in the insured’s estate.
6. A closely-held corporation is usually
A. owned by a professional partnership.
B. owned by a small number of people.
C. openly traded on a national stock exchange.
7. A “key employee” is
A. an individual that posses a unique ability essential to the success of a business.
B. usually a stockholder.
C. always an officer in the company.
8. With “key employee” insurance
A. the employee pays the premium.
B. the premiums are deductible as a business expense.
C. there are advantages to use permanent life insurance.
9. With “key employee” insurance the premium is paid by the _______________ and the _____________ is the beneficiary.
A. business/business.
B. employee/business.
C. employee/employee.
10. With a split-dollar life insurance policy
A. the premiums are split between the employer and the employee.
B. term life insurance is purchased on the life of the employee.
C. the employee is the insured but has no interest in the policy.
Answers to Chapter Eight Study Questions
1B 2C 3B 4C 5A 6B 7A 8C 9A 10A