Requirements of Using a Death Benefit Only Plan

The employer installs a nonvoluntary DBO plan by a written contract between the employer and the selected employee stating the terms of the contract. The employee should have no choice with respect to whether to elect coverage.

The agreement should specify:

  • the amount of the benefit, or the formula upon which the benefit is based;
  • the employee (or employees) covered by the plan;
  • the class of beneficiaries entitled to the benefit;
  • the terms upon which the benefit can be forfeited; and
  • collection procedures.

There is no IRS or Department of Labor guidance or requirement with respect to the formula for determining how much survivors will be paid—the amount is entirely up to the employer. Most will want to keep the formula simple. A common formula uses multiples of $10,000 (such as $30,000, $40,000, $50,000 per year) and combines that with a specified number of years ranging from two to fifteen. An alternative is to make payments based upon either a percentage of the employee’s final salary or an average of the top three or five years of salary prior to death. Some use the same formula as is used in the firm’s qualified pension or profit-sharing plan.

It is suggested that, instead of specifying the name of the employee’s spouse and children, the contract should be drafted to state that benefits are payable to “the covered employee’s surviving spouse, if living, otherwise the children of the covered employee, in equal shares.” (Some plans also provide benefits to parents of covered employees). No benefit should be payable if the employee is not survived by an eligible beneficiary.

A corporate resolution by the company’s board of directors should be adopted in writing well in advance of the time payments are to be made (and preferably before the contract with the employee is signed). Note that:

  • no amounts are set aside beyond the claims of the corporation’s creditors in a trust, escrow account, or annuity to meet the employer’s obligation (since benefits are unfunded, survivors are general unsecured creditors of the employer); and
  • the obligation of the corporation to make payments is contingent upon both: (a) the employee’s continued employment with the employer as of his date of death; and (b) survival of a beneficiary from among the employer specified eligible class.

Life insurance is almost always used to finance the employer’s obligation under a DBO. Although, in most cases, a form of whole life insurance is used, term coverage could be used to minimize employer outlays, if coverage will cease under the DBO contract by age sixty or sixty-five. Life insurance guarantees that adequate amounts will be available to make promised payments, even if the eligible employee dies immediately after being insured (in fact, the employer may want to wait until the employee’s insurability is assured and actual coverage is in force before executing the DBO contract).

This life insurance should not be mentioned in the contract with the employee. A linking of the life insurance with the promised benefits could cause unnecessary estate tax inclusion, income taxation on premium payments, and Department of Labor intrusion.

Under a separate corporate resolution, the board of directors should authorize the purchase of the life insurance as key employee insurance.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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