September 26, 2007
Debbie Reiss Hardesty

I. INTRODUCTION

Insurance companies market traditional as well as innovative life insurance products as the answer to employers' objectives in providing benefits to employees.  While some benefit plans using life insurance products are fairly easy to implement and administer and have predictable tax effects, many others are complex to administer because they are subject to numerous legal requirements; and the tax results are not always clear.

No insurance product should ever be purchased without the assistance of a competent insurance agent and comparison of a number of products.  Many agents will now work on a fee-for-service basis as opposed to a commission basis and many employers feel the agent has less bias if on a fee-for-service compensation arrangement.  If the agent is not eligible to sell products of a number of insurance companies, you may want to have several agents make proposals for the type of product, and ask one or more of them to compare those proposals for you.

There are a number of independent sources that will rate the insurance companies with which you might contract.  If is imperative that these resources be reviewed, especially for policies with large premiums.  These include:  A.M. Best's Insurance Reports; Duff & Phelps, Inc.; Moody's Insurance Credit Reports; Standards & Poor's Rating Insurance Services, among others.

II. LEGAL RULES FOR AN EMPLOYER TO CONSIDER

A. State Law:
 
Most states have laws that restrict who can own a life insurance policy on another person's life; trafficking in the life or death or random persons is against public policy.  So, unless a company has an "insurable interest" at the time a policy is purchased, the policy might be void as against this public policy and no death benefit is then payable. Some state laws require specific written consent of the person to be insured, in order to show that an insurable interest exists, with exceptions for certain common situations such as family relationships. 

B. Basic Life Insurance Tax Principles:

• Death benefits under a life insurance contract are not includable in gross income for Federal income tax purposes
• Cash buildup within a life insurance policy are not taxable as it builds up
  
• Loans taken from life insurance cash buildup is not realized income
  
• Withdrawals of cash build up within life insurance (other than withdrawals taken as periodic annuity payments) are tax free, to the extent they do not exceed the amount invested in the insurance contract to the date of withdrawal
  
• Premiums on life insurance (other than group term life insurance under $50,000) are generally not deductible for tax purposes (if insured person is directly or indirectly the beneficiary).
  
• Interest paid or accrued on policy loans is generally not deductible either (although the latter rules are very complex and  have a few exceptions, including one for certain "key man" policies)
  
• Policy dividends, if any are paid directly in cash or used to purchase a different type of benefit generally  reduce premiums paid on the policy in arriving at the "amount invested"  and are therefore only taxable if the cumulative withdrawals and dividends exceed premiums paid.
• Dividends used to buy paid-up additions to insurance or to reduce premiums do not generally result in a reduction of the "amount invested" or tax basis in an insurance contract.

C. Exceptions to Basic Tax Principles:

• Modified endowment contracts—if the amount paid for a life insurance contract at any time during the first 7 years after its issuance exceeds the sum of net level premiums that would have been required in order to have some paid-up death benefit after 7 years, then there are less-generous tax rules regarding withdrawals. (adopted in 1988 to discourage use of investment-oriented life insurance as a tax shelter vehicle.)
• Alternative Minimum Tax— insurance proceeds are included in a corporation's income for purposes of alternative minimum tax, unless the corporation is an S corporations.  Code Section 56(g)(6).
• Transfer for value rules—death proceeds are only tax free to the extent of a new beneficiary's tax basis in a policy—amount paid for it plus premiums that beneficiary paid, if the policy is "transferred for value."  Consider these rules any time a policy's owner or beneficiary is changed, except if it is to the insured, a partner of the insured, a partnership in which the insured is a partner, or a corporation of which the insured is a shareholder or officer, between spouses a grantor trust or by gift.
• Pension Protection Act rules—death proceeds in excess of amount paid for life insurance are taxable to employer which owns a policy issued (or materially increased) after 8/17/06, unless (i) there is notice of and consent to the policy by the insured at time of issuance, and either (ii) the insured was either (A) an employee within 12 months before death, or (B) insured was, at time policy was issued, an HCE (defined same as for retirement plans), a director, or a Highly compensated individual (one of top 35% when ranked by pay), or (iii) proceeds are paid to a member of insured's family, the insured's named beneficiary, or used to buy the insured's equity in the employer business.  "Employer" is defined broadly to include related companies and individuals; "employee" includes directors.  The new law also adds an annual reporting  requirement.

D. ERISA:

Insurance benefits can be provided to only one employee or to several employees of the employer.  If benefits are provided to only one employee, the benefit may not be considered a "plan" under the Employee Retirement Income Security Act of 1974 (ERISA) and therefore may be exempt from the non-tax provisions of ERISA.  DOL Advisory Opinions 76-79 (5/25/76); 76-110 (9/28/76).  However, if insurance benefits are provided to more than one employee, the employer may have a welfare benefit or pension benefit plan under ERISA and therefore be subject to at least some of ERISA's requirements.

Whether the insurance arrangement is a welfare plan or a pension plan under ERISA depends on the type of policy and its intended use.  If the employer purchases only term insurance for employees, the plan will be a welfare benefit plan under ERISA Section 3(1) and therefore will be exempt from ERISA's participation, funding and vesting rules.  ERISA Sections 201 and 301.  This means that there are no ERISA discrimination tests or limitations on the employer's choice of employees who will receive insurance coverage and the terms and duration of the employer's payment of premiums is governed solely by the employer's promise to the employee. But, even welfare benefit plans are not generally exempt from ERISA's fiduciary duty or reporting and disclosure rules.  ERISA Sections 101 and 401.  If the plan is a deferred compensation plan under ERISA and does not qualify for the select management or highly compensated employee exception (see next paragraph), the plan may be subject to ERISA's participation, funding and vesting, and reporting and disclosure rules, all of which are designed to ensure that the plan does not discriminate in favor of highly compensated employees.

Whether the program is a welfare or a pension program under ERISA, if the plan is designed primarily to benefit select management or highly compensated employees, the plan can be exempted from most of ERISA's reporting and disclosure rules, by filing a notice with the DOL that promises it a copy of the plan document upon request.  DOL Reg. Section 2520.104-24.

III. TYPICAL USES OF INSURANCE IN EMPLOYMENT SITUATIONS

A. Bonus  Plan:

Employers can provide employees additional compensation in the form of insurance protection by paying life insurance premiums for employees.  This type of plan is relatively easy to implement and administer, but does not generally provide employees with tax deferral.  The entire premium paid by the employer must be included in the employee's income currently  (unless the insurance is group term life insurance under Section 79 of the Code and is provided on a non-discriminatory basis).  The employer may deduct currently the premiums it pays if:

1. The employee is the owner of the policy;

2. The payment is an ordinary and necessary business expense; and

3. The payment and all other compensation received by the employee is reasonable.
 
Different rules govern the tax treatment to partners and S corporation shareholders. Tax advice should be sought before implementing a program for partners or S corp shareholder-employees.

B. Insurance Used To "Fund" Deferred Compensation Plans:

Insurance can be used as a vehicle for an employer to set aside the funds to meet a promise to pay an employee compensation at some future date.  The term "deferred compensation plan" is generally used to describe a plan that defers not only the receipt of compensation, but also the recognition of income by employees.  Employers may not take a deduction for deferred compensation plan benefits until those benefits are included in employees' income, unless the plan is a qualified retirement plan under the Code.  Code Section 404(a).

Under an insurance-funded deferred compensation plan, the employer typically promises to pay the employee a specified pr formula amount (defined benefit) or the amount accumulated from credits of "contributions" and earnings (defined contribution).  The employer funds its promise to pay by purchasing life insurance on the employee's life.  The insurance is owned by the employer and the employer is the beneficiary.  Generally, the insurance must remain a general asset of the employer subject to its general creditors' claims in order to preserve the tax deferral to the employee.  Care should be taken to insure all incidents of ownership of the policy are in the employer's hands.

The employer can pay all insurance premiums with its own dollars, or employees can be required to forego salary in order to be eligible for benefits under the plan.  The plan must be carefully designed to ensure the desired result of deferring the recognition of income by employees under new Section 409A of the Code. Deferred compensation for employers not subject to federal income tax must also comply with Section 457 of the Code or taxation of the benefit might occur before payment.

C. Split Dollar Life Insurance:

Split dollar life insurance is a method employers can use to help employees purchase life insurance protection and defer compensation.  It is subject to different rules than described below if the policy was issued prior to and not materially changed after 2003 (with some transition rules for 2001-2003). Below is a very general description of current split dollar tax rules; entire outlines could be devoted to just these rules.
 
This type of plan divides the ownership of the death benefit and/or the cash values of a policy between the employer and the employee. Sometime the employee pays part of the premium; sometimes the employer pays the entire amount. 

Split dollar is taxed under either a "loan" regime or an "economic benefit" regime, and which applies is generally determined based on the named owner of the policy—if the employer is the policy owner, then the economic benefit regime generally applies; if the employee is the owner, then the loan regime is generally applicable. 

In the economic benefit regime, if the employer pays all premiums, the employee is taxed on the value of the death protection he is afforded (using an IRS table value) and on the cash value (if any) to which the employee has "current access." 

Under the loan regime, the employer is deemed to have loaned the employee any amount the employer pays toward premiums on the policy, and the employee will be imputed (using applicable federal rates published by IRS) with income to the extent interest is not currently paid to the employer for the premium "loan." 

Public companies are now prohibited under Sarbanes-Oxley from lending money or extending credit to executive officers or directors. How post-enactment split dollar programs fare under this restriction is still not clear in SEC guidance, but most commentators advocate that they are acceptable as long as they are taxable under the economic benefit regime.

D. To Provide Funds For Stock Buyout Arrangements:

In closely held companies, shareholders frequently enter into an agreement whereby the remaining shareholders agree to purchase the shares from a shareholder's estate in the event a shareholder dies. The estate is obligated to sell the shares to the remaining shareholders.  This type of arrangement is desirable to the shareholder to make his estate more liquid for his family and enables the remaining shareholders to retain control  over the corporation.  The shareholders frequently purchase insurance on each others' lives in order to have the funds to purchase those shares from the deceased shareholder's estate.  The corporation can help the shareholders purchase this insurance through use of an insurance bonus or split dollar arrangement.

Rather than a cross purchase of insurance, another way to structure a stock buyout arrangement is for the corporation to agree to purchase shareholders' shares upon death.  (beware of AMT).

If insurance is used to fund a stock buyout arrangement, the policies should be evaluated every few years to ensure that the proceeds will generate enough after-tax dollars to purchase the shares at the agreed upon price, which price should change from year to year depending on how that price is determined under the arrangement.

E. Disability Benefits:

Many employers wish to provide disability benefits for some or all of their employees.  These plans are especially valuable to higher-paid executives.  In some professions, individual disability policies are frequently purchased early in a professional's life, and can provide substantial assistance in covering the income needs of a disabled person; however, in those professions the originally-purchased disability insurance is not enough if it is not upgraded to pay higher benefits as the compensation of the professional increases. 

In other industries, executives frequently have never purchased their own disability insurance (it is sometimes unavailable on an individual basis) and rely quite heavily on the disability insurance (if any) provided by their employer.  Executives often do not have sufficient disability coverage through a group disability program, however, because it caps the amount of salary that will be replaced and doesn't give complete income replacement for the higher paid.

Before providing any additional funds to an executive to buy an individual disability insurance policy, an employer should look at its short and long term group disability insurance, workers' compensation benefits available, consider the social security disability benefits that would be available upon a total and permanent disability, and any disability benefits from its qualified retirement plan.  If these sources do not replace 60%-70% of an executive's income, the employer might provide an employee the funds to purchase some individual disability insurance to supplement the other sources available.

An employer might also consider disability overhead insurance (naming the company as the beneficiary), to cover the income that might be generated by that employee but for his disability and to assist the employer in meeting its overhead expenses that would otherwise have been paid by the income the employee might generate.  This is a type of “key man” coverage that provides for a disability situation as opposed to the death of a key employee. 

Another use of disability insurance is a type of policy intended to be purchased by an employer or by shareholders to fund any buy-sell arrangements that are agreed to among shareholders or the company upon the disability of an employee/shareholder.

If disability insurance is paid for with after-tax dollars, the benefits received if and when an executive becomes disabled are free from income taxes.  If the corporate employer pays the premiums on disability coverage, they can be deducted by the employer and not included in the employee's income.  If this route is taken, however, then any benefits received on the policy will be income taxed to the employee.  A policy that is partially paid by after-tax dollars and partially paid with pre-tax dollars must be prorated between taxable and non-taxable benefits. 

Under IRS Rev. Rul. 2004-55, an employer may give employees an annual election to be taxed on premiums paid for disability insurance paid for by the employer; if the employee becomes disabled in a year in which the premiums are imputed income to the employee, then the disability benefits are tax free.

F. Group Carve Out Plans:

This is an arrangement whereby the employer limits its group term insurance coverage to $50,000 (generally just for the more highly paid), and for those it wants to promise higher benefits, it purchases individual insurance policies. These arrangement generally provide some portable benefits to executives.