This article provides a behind-the-scenes look at the disadvantages and what you should know before using a death benefit only plan instead of a traditional insurance policy. Understanding the various benefits will help you make a more educated financial decision.
- The entire payment by the corporation to the beneficiary under a DBO plan is subject to ordinary income tax.
- No deduction is allowed to the employer until the benefit is paid, and the beneficiary must include payments received in income. Even if the employer sets funds aside in advance to meet promised payments (almost always through the purchase of a life insurance contract), the employer’s deduction is deferred until benefits are paid. (But, of course, the total deductions are almost certain to significantly exceed the outlays).
- To avoid federal estate tax inclusion of payments, the employee can be given no right to name or veto the naming of the beneficiary of death benefit payments. Avoiding federal estate tax requires careful plan design, which, to some degree, limits flexibility in plan design for controlling (i.e., greater than 50 percent) shareholder-employees.
- A plan covering a large and broad group of employees may have to comply with Employee Retirement Income Security Act (ERISA) provisions for vesting, funding, reporting, and disclosure.
But, in most cases, a DBO plan will be unfunded and limited to a select group of management or highly compensated employees, and will therefore be exempt from virtually all provisions of ERISA, with the exception of a simple, one page notification of the existence of the plan, which must be filed with the Department of Labor.
- Premiums on life insurance used to finance a DBO plan must be paid with after-tax dollars.
- Formal funding of a DBO plan through a trust, escrow account, or other means by which money, mutual funds, life insurance, or any other asset is placed beyond the claims of the employer’s creditors can trigger constructive receipt of the funds, may cause estate tax inclusion, and will probably result in ERISA reporting, disclosure, and funding requirement implications.
If the employer’s obligation under a plan of deferred compensation is represented by an unsecured promise, the participants are general creditors of the employer and their claim (or the claims of their heirs) is subordinated to the claims of the employer’s secured creditors, and their interests are nontransferable, there should be no reportable income under either the constructive receipt or economic benefit doctrines. Beneficiaries are therefore dependent upon the financial ability and willingness of the employer to make payments as promised.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM