Protecting Against the Loss of a Key Employee
Business owners frequently use life insurance to protect their company from many of the potential problems which may otherwise damage or destroy what has taken years to build. Life insurance is unique in that it will generally pay the pre-determined amount no matter when the death occurs.
The premiums are usually small compared to the potential death benefit. Also, if policies are used which develop cash values; they can be shown as business assets on the balance sheet, contributing to the values of the business and potentially to its borrowing power.
Borrowing against cash values may also be a lifesaving source in times of financial crisis. 1
How Key Employee Insurance Works:
- Company owns the policy
- Company pays the premiums
- After death, the company collects the policy proceeds 2
- Potential Uses for Proceeds
- Purchasing stock from the decedent’s estate
- Honoring salary continuation arrangements to surviving spouse
- Finding, recruiting, and training a new employee
- Pay any necessary bills and strengthening the credit position
- Funding expansion of the business
- Adding income-tax free corporate surplus
1 Policy loans and interest will reduce the payable death benefit of a policy. If a policy lapses or is surrendered with a loan outstanding, the loan will be treated as taxable income in the current year, to the extent of gain in the policy.
2Under the provisions of IRC Sec. 101(j), death proceeds from a life insurance policy owned by an employer on the life of an employee are generally includable in income, unless certain requirements are met. The law was effective for contracts issued after August 17, 2006, except for contracts acquired under an IRC Sec. 1035 Exchange. State or local law may vary. Professional legal and tax guidance is strongly recommended.
Deferred compensation plans allow an employee or owner to defer a portion of their current income to a specified future date, making wages earned in one period to be paid at a later date.
Life insurance is the vehicle often used to fund a deferred compensation plan. Deferred amounts can be used to pay premiums on cash value life insurance, which can then be available at retirement to supplement other income. Also, if the insured dies before retirement, their beneficiary would receive the insurance policy’s death benefit.
Qualified plans are eligible to receive tax preference under the IRS Code:
Note: Employers should obtain an IRS ruling regarding the tax status of a qualified plan.
Disadvantages of a qualified plan include:
- Nondiscrimination requirements prohibit an employer from providing benefits for highly compensated employees to the exclusion of other employees
- The amount of the employer’s contributions can be limited
- Regular reporting of the plan is required
A non-qualified plan does not receive as favorable tax treatment as a qualified plan:
- The employer is not entitled to tax deductions until the benefits are actually paid to the employee
- Under the doctrine of constructive receipt, the benefits are taxable to the employee at the time the employee has the right to receive the benefits without regard to when the benefits are actually paid, and it is not mandatory for the taxpayer to take possession of the funds.
Advantages of a non-qualified plan are:
- The employer can choose among the recipient employees without regard to years of service, salary level or any other criteria
- Allows a business to provide benefits to officers, executives and other highly paid employees without including all employees
- No limitations are placed on the employer’s contribution amounts
- A non-qualified plan is not as expensive to set up as a qualified plan
- Filing or reporting requirements are not required as with qualified plans
Agreements and insurance policies within a business must be integrated with the overall plan and objectives of the business. Careful consideration must always be given to the selection of the plan which is right for any given business and to the method of funding for the plan. This material only contains general descriptions and is not intended as any financial or tax advice.
In order to guarantee a buyer for the interest in a business (particularly a minority interest which may be of very little value to one’s heirs), consideration should be given to a lifetime agreement among the business owners as to how to dispose of the business.
Under an entity plan the corporation (or partnership) buys the interest of the deceased business owner. This type of arrangement is often used when there are several owners.
Under this plan each surviving owner agrees to buy the interest of any deceased owner.
An attorney should be consulted in deciding which plan is better.
Advantages of Buy-Sell Agreements
- Guarantees a buyer for an asset that probably will not pay dividends to one’s heirs.
- Can establish a value for federal estate tax purposes that is binding on IRS. See IRC Sec. 2703.
- Spells out the terms of payment and is easily funded with life insurance and disability insurance, if desirable. 1
- Provides a smooth transition of complete ownership, management, and control to those who are going to keep the business going.
1 Buy-sell agreements are frequently funded with life insurance. Under the provisions of IRC Sec. 101 (j), added by the Pension Protection Ave of 2006, death proceeds from a life insurance policy owned by an employer on the life of an employee are generally includable in income, unless certain requirements are met. State or local law may vary. Professional legal and tax guidance is strongly recommended.