There are questions surrounding group insurance. Life insurance is a big deal in any household. Without it, you’d have to worry about your loved ones. There are many options to choose from when it comes to buying life insurance. Our experts answer some questions revolving around this topic.
Question – Can group insurance be used to fund a buy-sell agreement?
Answer – The use of group insurance to fund a buy-sell is generally not a sound idea. First, if the buyout price is artificially reduced in return for a corresponding increase in the group term coverage (under the pretext that “This makes your buy-sell partially tax deductible. What’s the difference where the family gets the money as long as they get the same number of dollars?”). The difference is that the family is cheated because it does not receive a fair price for the business interest held by the estate plus the group insurance to which it is entitled. Furthermore, since the IRS is likely to claim that the corporation is an indirect beneficiary of the group term insurance (by virtue of the reduction in the buy-sell price) the premium for the additional life insurance may not be deductible. Moreover, the price set in the agreement will not be binding on the IRS or on the courts, and the estate could conceivably pay an estate tax greater than the money it receives for the stock.
Another ploy that will be unsuccessful (and that is dangerous from a tax viewpoint as well) is for two shareholders to sign a cross purchase buy-sell agreement and name each other the beneficiary of the coverage on their respective lives. In return, they lower the price of a decedent’s interest in a buy-sell. Under these circumstances, there has been a transfer of an interest in a policy (i.e., when one shareholder named the other as beneficiary), and that transfer of interest has been made for valuable consideration (i.e., reciprocity of the other’s action). This is clearly a “transfer for value” and it will cause the proceeds to be income taxable.27
Yet another trick that is periodically suggested is to name one’s own family as the beneficiary of an increased amount of group term life, but agree that the increase will in turn be considered payment made to the family of the deceased insured in return for full or partial payment for his or her stock. Mechanically, it is almost impossible to match insurance needs with the group schedules of benefits because of the nondiscrimination rules. Furthermore, once the family has received the proceeds, but still holds the stock, if they decide not to transfer the shares, how (aside from an expensive and aggravating lawsuit) will the surviving shareholder obtain the stock?
Question – When an employee becomes older, the reportable income tax cost of very large amounts of group term life insurance tends to increase very rapidly. What are the techniques available to solve this problem?
Answer – It is true that a very substantial amount of income can be generated by group term life as the employee ages. For ages sixty-five to sixty-nine, the reportable cost per thousand per month is $1.27, while for ages seventy and over, the reportable cost per thousand per month is $2.06.
One solution is the executive bonus carve-out, a simple arrangement that provides up to $50,000 of coverage for all employees (including retired employees) through the group insurance plan, but carves out selected employees for special treatment.
Specifically, the chosen individuals are provided with amounts of individual term and/or whole life insurance by the employer. Premiums are paid by the employer, but reportable by the employee as income. To make up for the income tax burden, an additional bonus is paid in cash to the employee. This is particularly appealing when the corporation is in a higher bracket than the executive.
Permanent insurance is often preferable in a group carve-out since the goal is to reduce or eliminate the out-of-pocket cost and reportable income of retired executives. This can be accomplished by using a limited-pay policy along with applying dividends to pay premiums so that the policyowner’s out-of-pocket premium payments diminish over time, usually to zero in seven to ten years. Because the shareholder-employees and other key executives generally want substantial and permanent coverage, one solution is the executive bonus carve-out life insurance plan. The characteristics that make this approach appealing include:
The plan is simple and easy to present to corporate officers.
They can use the corporation as a vehicle to provide individually-owned permanent life insurance for shareholder-employees and key executives.
The plan avoids the complex and costly nondiscrimination rules for excess coverage.
The plan is flexible and the company can provide additional insurance amounts through Code Section 162 bonus or split-dollar coverage.
Leveraging may be possible because the corporate deduction may be greater than the taxable income incurred by the participants in the plan.
Question – Does the substantial individual insurance benefit available under a Section 162 plan render the Section 79 group term plan obsolete?
Answer – The answer to this question depends on many factors:
Does the corporation already have a group insurance plan in place that benefits employees?
Does the current plan meet the nondiscrimination rules?
Does the corporation wish to continue to provide group term life insurance coverage to nonhighly compensated rank-and-file employees?
Generally the group term life insurance plan is still favorable on a nondiscriminatory basis. The corporation is allowed an ordinary business expense deduction for contributions to the plan. Employees, including the shareholder-employees and other key executives, receive the first $50,000 of coverage income tax-free.
Therefore, there are many reasons to continue an existing group term plan. The corporation may also want to avoid the adverse morale consequences of terminating a popular fringe benefit plan covering a broad cross-section of employees and replacing it with a highly discriminatory life insurance plan covering only a few key employees.
What is generally recommended is that the shareholder-employees and other key executives who require (and for whom the corporation wishes to provide) more substantial life insurance coverage participate in either a Code Section 162 bonus or split-dollar life insurance plan to supplement a Section 79 plan. The group term plan can still provide key employees with the $50,000 of tax-free coverage. Excess coverage can instead be carved out of the group term life insurance plan and provided through a discriminatory arrangement.
Generally, the Section 162 bonus plan makes more sense when the corporation is in a higher bracket than the participant and the plan is limited to shareholder-employees. Under the Section 162 plan, the corporation pays the entire cost as deductible compensation and the participant is taxed on the full amount of the premium bonus. No reimbursement of corporate contributions will be available.
The split-dollar approach is favored when the size and permanency of the corporation’s outlay is a concern and the corporation is in a lower bracket than the participant. Split-dollar becomes more favorable if coverage extends beyond the shareholders. Since the employer’s share of the premium is nondeductible, the higher bracket corporation should generally avoid the substantial non-deductible outlays in a split dollar plan and instead provide deductible bonuses through a Section 162 bonus life insurance plan.
Question – Can a group plan include an owner-employee?
Answer – Yes. The employer may be a sole proprietorship, partnership, or close corporation. Employees eligible for coverage may include sole proprietors, partners, and employee-shareholders. (Note, however, that tax rules are different for self-employed individuals and partners than for common law employees.) Some group contracts also cover employees of an employer’s subsidiary. Retired employees may also be included.
Question – Can a trade association offer life insurance to its members?
Answer – Yes. Employers in the same type of business or industry can sponsor voluntary insurance plans for their members. For instance, a national association or state association of teachers, doctors, lawyers, or CPAs might sponsor such a plan. Generally, a trust acts as the master policyholder for trade association plans.
Question – What is group creditor life?
Answer – Banks, finance companies, credit unions, retailers, and others may qualify for group life insurance on the lives of individuals who borrow money from the creditor. Although one purpose of group creditor life is to protect lenders against possible financial loss due to the death of a debtor, these companies are often in the business of selling the insurance and, therefore, profit from the sales directly.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM