This article provides a behind-the-scenes look at tax implications that should be considered about using a death benefit only plan instead of a traditional insurance policy. Understanding the various taxes will help you make a more educated financial decision.
- No income tax is payable by the covered employee on the premiums that the employer pays for key-person insurance, which is used to finance the employer’s obligation under a DBO plan. To obtain this result, the promises made by an employer under a DBO plan should not be, and should not appear to be, dependent upon and funded directly by an insurance policy. The facts should indicate that if and when a liability to make payments occurs, the employer is always directly responsible for those payments and has not, at any time, shifted that obligation to an insurer.
- Premiums on the policy, of which the corporation is both the owner and beneficiary, are not deductible.
- Proceeds of the key-person life insurance policy used to finance the employer’s obligation under the plan are received income tax free.
- Corporate earnings and profits are decreased by the amount of premium payments, but increased by the sum of: (a) cash surrender value increases; and (b) the excess of death proceeds over cash values in the year received.
- Cash values should not, per se, trigger an accumulated earnings tax.
- Benefits paid by a corporation to the employee’s beneficiary are taxable in full as ordinary income to the beneficiary, just as if the payments were a continuation of the deceased employee’s salary. Even though the employer generally receives the insurance proceeds income tax free, that characterization is lost once the employer pays out the promised continued salary to the beneficiary. So whether the DBO payments are made for a period of years or in the form of a lump sum, payments are taxable to the beneficiary at ordinary income tax rates.
Death benefit payments are considered income in respect of a decedent (IRD, also known as “Section 691 income”). No stepped-up basis is allowed for IRD. However, the beneficiary is allowed to take an income tax deduction for any federal estate taxes paid on that income. In other words, to prevent the beneficiary from paying a tax on a tax (i.e., income taxation on the portion of the death benefit depleted by estate tax), an income tax deduction is allowed on estate taxes paid.
- When benefits are paid, they are deductible as deferred salary by the employer corporation, to the extent that amounts represent reasonable compensation (in amount and duration) for the services actually rendered by the deceased employee. In addition, the plan must serve a valid business purpose. One article has suggested that if an employer purchases key employee life insurance to recover a portion of the costs associated with the plan, payments made by the employer to the beneficiary would not be deductible, on the grounds that no deduction is allowed for a business expense which is reimbursed by insurance or otherwise.6 But this reasoning appears flawed because there is no nexus between the life insurance and the employer expenses, a connection essential to operation of Code section 265(a)(1), which would then block the deduction.
As a practical matter, the issue of nondeductibility seldom arises except when: (a) the decedent was a controlling or major shareholder employee; (b) the beneficiary is a stockholder; (c) there was no written agreement to pay the benefit prior to the employee’s death; or (d) the facts indicate a lack of arm’s length bargaining. In such cases, the IRS may attempt to disallow the corporation’s deduction and treat payments as a dividend, rather than as a form of deferred compensation. Careful documentation of the bargaining process and of the employer’s need to recruit, retain, or reward a true key employee will minimize the chance for an IRS success.
- Payments from the corporation to the beneficiaries of the covered employee may be excludable from the employee’s gross estate. For instance, if the payment is purely and truly voluntary on the part of the business and is not made under a contract or plan, it should be excludable from the employee’s estate because, at death, the covered employee never had a right subject to transfer. But even if the DBO payments are made under a formal and binding contract or plan, estate tax exclusion is possible. To assure estate tax exclusion:
- Give the employer (rather than the covered employee) sole discretion as to the class of beneficiary to receive the death proceeds (preferably by stating a class of beneficiary such as “the employee’s spouse, if living, otherwise the employee’s children in equal shares”). No rights over the life insurance policy used to finance the employer’s obligation should be given to the employee. If the agreement gives the employee the right to name, change, or veto an employer change of beneficiary, payments will be includable in the employee’s estate. The employee’s estate should not be named as beneficiary.
- Give the employee no lifetime postretirement benefit or plan (other than a qualified pension or profit sharing plan). Be sure that the DBO plan provides only death benefits and provides no postretirement lifetime payments to the employee. (Keep in mind that the IRS can also link lifetime payments under other plans to the DBO plan and consider the two as a single plan, even if they are separate plans. So estate tax inclusion cannot be avoided by providing death benefits under the DBO and lifetime postretirement payments under a separate plan.)
- Give the employee (and the employee’s estate) no right to dispose of the payments, should one or more specified beneficiaries die. If the employee is found to hold a reversionary interest (one which could revert back to his estate) and that interest has an actuarial value exceeding 5 percent of the benefit, the IRS will include the payments in his estate.
- The employee should be given no right to alter, amend, revoke, or terminate the agreement or change its terms. If the employee had any of these rights (either alone or in conjunction with any other person), the IRS would require inclusion. This inclusion by virtue of the employee’s right to make changes to the agreement spurs a number of issues. For instance:
- Will the mere possibility of exerting influence upon an employer to make changes to the agreement cause inclusion? What if the covered employee were an officer, director, or shareholder? Can the employee, by terminating employment, terminate the plan? To each of these questions, the courts have held that no inclusion was required.
- Will a controlling (more than 50 percent) shareholder, merely by virtue of such control, have the power to unilaterally make a change to the agreement that would cause estate tax inclusion? It is likely that the IRS will attack any situation where the covered individual owns more than a 50 percent interest, although, in the authors’ opinion, the fiduciary responsibility one owner owes to another, regardless of the size of the other’s interest, negates the ability to make unilateral decisions that affect others.
If there is estate tax inclusion and the DBO benefit is paid in a lump sum, the entire lump sum will be taxable. If there is estate tax inclusion and benefits are payable in installments, the present value of payments to be made at the covered employee’s death would be includable in his gross estate. For instance, assuming a 5 percent federal discount rate, payments of $100,000 per year for ten years would have a commuted (present) value of about $772,170 ($100,000 × 7.7217).7
Payments under a DBO plan, if paid to a surviving spouse outright or to the estate of a surviving spouse or to a general power of appointment or QTIP trust, could qualify for the federal estate tax marital deduction. This would eliminate the federal estate tax at the death of the first spouse.
Planners should note, however, that if payments are subject to contingencies, such as a reduction or cessation of payments upon remarriage, there will be both positive and negative results. A contingency typically reduces the value of the amount includable in the decedent employee’s estate. But that same contingency could also cause a forfeiture of the estate tax marital deduction. If the contract provides that after the surviving spouse’s interest ends, payments will be made to another beneficiary (other then the surviving spouse’s estate), the spouse’s interest is terminable (i.e., one which may end or fail upon the lapse of time or on the occurrence or failure to occur of some contingency). Annuities are, by definition, a systematic liquidation of principal and interest over a period of time, and are therefore terminable interests.8 Since payments to the employee’s beneficiary take the form of an annuity from the employer for a given term of time, DBO payments that pass to someone other than the surviving spouse at the employee’s death (or for any other reason) are terminable interests.
Some terminable interests are still deductible for federal estate tax purposes. For instance, if payments were for the shorter of ten years or the life of the employee’s surviving spouse, the interest would be deductible. Furthermore, a Qualified Terminable Interest Property (QTIP) election could obtain an estate tax deduction for what might otherwise be a nondeductible interest.
- The IRS will no longer claim that the payment of the death benefit at the employee’s death constituted a completed gift at the time of death.
- Death benefits paid to beneficiaries are not considered wages subject to income tax withholding.
- If a DBO plan covers only a single employee (as opposed to a class or classes of employees), then, for FICA purposes, only the benefits paid to the beneficiaries in the calendar year of the employee’s death will be subject to FICA taxes. Benefits paid after that calendar year should escape FICA taxes. If an entire class or classes of employees are covered under a DBO plan, benefits paid to beneficiaries should be totally exempt from FICA taxes.
Code Section 2033
Code section 2033 requires that property in which the decedent has an interest at the time of death be included in his estate. Inclusion is required to the extent of the decedent’s interest. The courts have uniformly held that under a properly structured DBO plan, the decedent has completely and irrevocably transferred any interest he may have had to the named recipient and thus, at the time of death, has no interest under Code section 2033.
The key to avoiding inclusion under Section 2033 is to avoid giving the employee (and the employee’s estate) any vesting or reversion rights. Language specifically stating that neither the employee nor his estate has any interest or rights in the payments to be made to the beneficiary after the employee’s death should be included in the plan documents, as well as a statement that under no circumstances will payments be made to the decedent’s executor.
Code Section 2036
Section 2036 applies to transfers with a retained life estate and requires that gratuitous transfers, in which the decedent retained the right to the income or property from the gift or the right to say who will possess or enjoy that property or its income, be included in the decedent’s estate. Courts have held that the beneficiary’s right to receive a death benefit can be considered an indirect gratuitous lifetime transfer by the covered employee. So if the employee is given and retains the right to name or change the beneficiary of the DBO plan benefit, the IRS could argue that the employee has retained a Section 2036 right. The solution is to state in the DBO plan or agreement that the employee has no right to name or change the beneficiary and that the right to do so vests solely in the employer.
The mere possibility that the employee could negotiate a new contract with the employer or terminate the plan by terminating employment is not considered a retention of Section 2036 powers. Close family relationships or stock holdings are not, in and of themselves, enough to be considered a Section 2036 retained power. However, DBO plan payments could be included in the estate of a controlling shareholder.
Code Section 2037
Code Section 2037 requires inclusion in the decedent’s gross estate only if there is a reversion (i.e., the property given away comes back), either to the decedent or to the decedent’s estate and the actuarial value of that reversion right is greater than 5 percent of the value of the property in question. For instance, if the attorney who drafted the agreement did not specify a contingent beneficiary, then, should the first named beneficiary predecease the covered employee, there could be a Section 2037 inclusion.
For example, if the death benefit is payable to the employee’s child, but the child did not survive the employee, payments would revert to the deceased employee’s legal representative (in other words, the employee’s estate). If the relative ages of the parties were such that the potential payment to the employee’s estate (the value of the reversionary interest) was worth more than 5 percent, the death benefit payable by the corporation would be includable in his taxable estate. So, naming the covered employee’s executor or making the benefit payable to the employee’s revocable living trust (or testamentary trust) would result in inclusion.1 If an employer agrees to pay benefits either to the surviving spouse or to the employee’s estate, this may create a reversionary interest that, if valued in excess of 5 percent of the estate, will result in inclusion of the present value of the benefit.
The solution to the potential section 2037 problem is for the employer to create several levels of beneficiaries, in order to provide for the contingency of one or more beneficiaries predeceasing the covered employee. For example, the DBO contract might provide words to the effect that payments were to be made “to the employee’s surviving spouse, if living, otherwise to the employee’s surviving children in equal shares, or to the survivor of them, but if no such children survive the employee, then all liability under this agreement ceases.” Clearly, the estate of the employee should not be named contingent beneficiary.
Code Section 2038
Code Section 2038 provides that if a gratuitous transfer is made coupled with the retention of the right to alter, amend, revoke, or terminate the gift, the value of the property interest given away is brought back into the donor’s estate. So, if the covered employee is given any right to change the amounts or terms of the coverage under the plan or the identity of the beneficiaries, inclusion will result under Section 2038. The clearest example of this is where the contract gives the employee a continuing right during employment to change the beneficiary of the death benefit under the DBO plan. Likewise, if a revocable trust established by the employee is named as beneficiary, payments will be included in the beneficiary’s estate since, by definition, the employee reserved the right to alter, amend, revoke, and terminate the revocable trust and can therefore change the identity of the DBO plan’s beneficiaries.
One solution is to make the designation of the beneficiary irrevocable. But that would involve gift tax implications and loss of control (and create the implication that the employee had the right to make changes up until that time). The preferred solution is for the employer to state in the agreement that the employer reserves total, sole, and unlimited right to name or change the beneficiary. The agreement should specifically provide that the employee has absolutely no power to “alter, amend, revoke, or terminate” the plan or the identity of beneficiaries under the plan in any way, either alone or in conjunction with any other party. It is important not to make the mistake of drafting the DBO contract to provide that the employee can, with the mutual consent of his employer, modify the beneficiary’s rights. If such an express power to modify or change the beneficiary’s rights should exceed those rights allowable under applicable state law, estate inclusion will result. This adverse impact occurs even though the employer’s consent is required to change the DBO beneficiary.
Code section 2038 poses a more insidious problem: the more than 50 percent shareholder. Specifically, the question posed is, “Does an individual who owns the controlling voting power in a corporation have, as the mere result of that power over corporate actions, the right to alter, amend, revoke, or terminate the DBO agreement or change the designation of its beneficiary?” In a private letter ruling, payments under a DBO plan escaped estate tax inclusion, even though the decedent owned 85 percent of the corporation’s voting stock. The IRS held that the deceased owner’s fiduciary duty and responsibility to the other shareholder (his wife) was enough to prevent his control from resulting in inclusion.2 However, in facts almost indistinguishable from those in the letter ruling, the IRS successfully argued that if the employee-decedent controlled the corporation, the DBO payments would be includable.3 This same case seems to confirm that a properly drafted DBO plan covering employees of a publicly held corporation or of a noncontrolling (50 percent or less) shareholder should not be subject to either estate or gift taxation. The outcome where the covered shareholder owns 51 percent or more is uncertain.
Code Section 2039
Code Section 2039 deals with annuities and other payments. The annuity or other payment requirement is satisfied if one or more payments are made over any period of time, regardless of whether those payments are equal or unequal, conditional or unconditional, periodic or sporadic, fixed, or variable. Essentially, it requires estate tax inclusion of amounts received at an individual’s death under any form of contract or agreement that provides both an annuity or similar payment during lifetime and a death benefit.
A pure DBO plan, as its name implies, provides only death benefits and no payments while the employee lives. So standing alone, the properly drafted pure DBO plan should not require inclusion under section 2039.
Where both postdeath and lifetime postretirement benefits exist in a single plan (or the IRS treats two separate plans that provide such benefits to the same employee as one plan), Section 2039 will require estate tax inclusion of the death benefit. Payments would be treated as though received by the survivor from a joint and survivor annuity (which, in essence, they would be). In such a case, the lump sum paid to the beneficiary or the present value of the stream of payments would be subject to estate tax.
For example, suppose a client has the right to $60,000 per year for ten years after retirement in one plan. In an entirely separate agreement, executed five years later, the client’s employer promises to pay $100,000 per year for ten years to the client’s children. The present value of the children’s rights to the stream of income will be includable in the client’s estate.
Just what sort of postretirement lifetime payments will be linked to death benefit payments under section 2039? Does the mere acceptance of wages constitute postretirement lifetime payments? The answer is no.4 What if an employee signs an agreement with his former employer to serve as a consultant for life? Will this be considered an annuity? Again, the answer is negative. Assuming payments are made for services actually rendered after retirement, those salary payments will not be linked to payments under the DBO plan.5 Likewise, if substantial services are necessary to receive payments, such amounts will be considered salary, rather than retirement benefits. Benefits payable under a short-term sickness and accident income plan or wages paid for a period of illness or other temporary incapacities, after which the employee is expected to return to work, are considered compensation.6
On the other hand, if the agreement calls for payments to be made to the employee after he becomes too incapacitated to perform services, or requires only nominal services after the employee reaches a certain age, payments will be treated as postretirement benefits. Also, payments made if an employee becomes totally incapacitated before retirement are considered an annuity or other payment. Benefits payable under a long-term disability plan that, in essence, assumes that the employee will never return to work and retires the employee on disability payments are not considered compensation, and will be treated as postretirement payments. Linked constructively with a DBO plan, the result will be inclusion of the annuity under section 2039.
Note that for linkage to be made, the employee must be receiving (or have the right to receive at the date of death) an annuity or other payment for life (or for a stipulated term that does not end before the employee’s death). For inclusion to be warranted, payments must continue to a survivor as they do in a normal joint and survivor annuity. For instance, if payments were being made to the disabled employee and the employee died before exhausting the fund, and the remaining payments were made to the next class of beneficiary, the long-term disability plan would be coupled with payments under a DBO plan.
Another key issue in determining whether a deceased employee had the right under the plan to any postretirement lifetime payments is, “What is meant by a plan?” The answer is that all rights and benefits that the employee had by virtue of employment (except those under qualified retirement plans) are considered part of one contract or plan in determining whether section 2039 applies. So it is not possible to avoid inclusion by providing death benefit payments under one contract and lifetime retirement benefits under another.
What is meant by the term contract? The term is applied broadly and includes not only contracts enforceable under state law but also payments made under an agreement, understanding, or plan. For example, a corporate resolution may constitute such an understanding.7
Code section 2041
Code section 2041 is concerned with general powers of appointment—the ability to determine who is to receive someone else’s property. If a decedent has a general power (i.e., the unlimited ability to reduce property to the possession of himself, his creditors, his estate, or the creditors of his estate), the entire amount subject to that power will be included in the decedent’s estate.
Suppose the death benefit was payable to a trust, over which the decedent retained or was given a general power of appointment. If the payments from a DBO plan are made to that trust, they will be includable under Code section 2041.
Code Section 2042
Code section 2042 requires inclusion where the insured decedent held any significant incident of ownership over the policy or (even where no incident of ownership was held at death or given up within three years of death by the insured) where the proceeds are paid to or for the benefit of the insured’s estate. Where life insurance is used as the financing mechanism for the employer to meet its potential obligations under the DBO plan, the IRS would probably claim inclusion under Code section 2042 where the employee either owns the policy or is given any right of substance with respect to the policy. For example, if the employee is given veto rights over a change of beneficiary, the IRS would likely argue that this is an incident of ownership, causing inclusion.
It is possible that the IRS would also claim inclusion where the DBO plan or some other employment related agreement gave the covered employee the right to prevent the cancellation of the policy, by providing that the employee could purchase the policy from the corporation. Of course, there would be no inclusion merely because the corporation could voluntarily choose to sell a life insurance policy to a terminating employee for its fair market value.
The safest course of action is for the corporation to name itself owner and beneficiary of the policy and to give the insured employee no rights whatsoever with respect to the policy or its values. The policy should be carried on the company’s books as key employee coverage and should not be mentioned in the DBO agreement with the employee.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM