Table of Contents
FOREWORD .............................................................................................................................. 1
BUSINESSES & INSURANCE ................................................................................................. 1
Where We're Headed .......................................................................................................... 1
CHAPTER ONE – BUSINESS OWNERSHIP BASICS ............................................................... 3
WHO'S RUNNING THE BUSINESS? .................................................................................. 3
SOLE PROPRIETORSHIP ......................................................................................................... 3
WHO MAY FORM A SOLE PROPRIETORSHIP? .............................................................. 4
Income Tax Consequences.................................................................................................. 4
MARGINAL TAX RATE....................................................................................................... 4
Latest Developments in AMT ............................................................................................. 4
Filing Taxes as Sole Proprietor ........................................................................................... 5
Start-Up & Pre-operating Expenses .................................................................................... 6
INDIVIDUAL TAX RATES .................................................................................................. 6
New Legislation .................................................................................................................. 6
Taxable Income Levels for 10% Rate Bracket.................................................................... 7
Capital Gains Tax Rates...................................................................................................... 7
Tax Rate for Qualified Dividends ....................................................................................... 7
POSITIVE ASPECTS OF A SOLE PROPRIETORSHIP ...................................................... 7
The Simple Start-Up ........................................................................................................... 7
Rugged Individualism ......................................................................................................... 8
The Gold Mine Is Mine ....................................................................................................... 8
Tax Advantages .................................................................................................................. 8
QUALIFIED PLAN, DEFINITION ........................................................................................ 9
The Simple Dissolution ...................................................................................................... 9
NEGATIVE ASPECTS OF A SOLE PROPRIETORSHIP ................................................... 9
Unlimited Liability.............................................................................................................. 9
Financial Stability ............................................................................................................... 9
Management and Personnel Issues.................................................................................... 10
Tax Disadvantage.............................................................................................................. 10
PARTNERSHIP ........................................................................................................................ 11
Who May Form a Partnership ........................................................................................... 11
INCOME TAX CONSEQUENCES ..................................................................................... 11
Effect of a Partner's Basis ................................................................................................. 11
Guaranteed Payments vs. Salary ....................................................................................... 11
General Partnership ............................................................................................................... 13
Limited Partnership ............................................................................................................... 13
Limited Partner's Limited Liability ....................................................................................... 14
Tax Advantages .................................................................................................................... 14
The Simple Dissolution ........................................................................................................ 15
NEGATIVE ASPECTS OF A PARTNERSHIP .................................................................. 15
Unlimited Liability for General Partners .............................................................................. 15
Lack of Control by Limited Partners..................................................................................... 15
Financial Stability ................................................................................................................. 15
Investment Withdrawal ......................................................................................................... 15
i
Tax Disadvantages ................................................................................................................ 16
OTHER FORMS OF PARTNERSHIPS .............................................................................. 17
Publicly Traded Partnership .............................................................................................. 17
Joint Ventures and Other Forms ....................................................................................... 18
CHAPTER TWO- CORPORATIONS ......................................................................................... 21
C CORPORATIONS ............................................................................................................ 21
Who May Form a Corporation .......................................................................................... 21
INCORPORATING .............................................................................................................. 21
Income Tax Consequences................................................................................................ 22
Are Distributions Dividends or Return of Capital? .......................................................... 23
S CORPORATIONS ............................................................................................................. 23
Income Tax Consequences................................................................................................ 23
S Corporation Eligibility ................................................................................................... 23
The Slippery Slope of S Corporations .............................................................................. 24
Recent Changes to S Corporation Tax Laws .................................................................... 25
Closely Held or Close Corporations ................................................................................. 25
Professional or Personal Service Corporations ................................................................. 26
POSITIVE ASPECTS OF A CORPORATION ....................................................................... 26
Limited Liability ............................................................................................................... 26
Separate Legal Entity ........................................................................................................ 26
Greater Financial Stability ................................................................................................ 26
Qualified Retirement Plans ............................................................................................... 27
Unlimited Life ................................................................................................................... 27
S Corporation Losses Are Currently Deductible .............................................................. 27
NEGATIVE ASPECTS OF A CORPORATION ................................................................. 27
Complex and Costly Start-Up ........................................................................................... 27
State Taxes and Fees ......................................................................................................... 28
Double Federal Taxation on C Corporations .................................................................... 28
C Corporation Losses Must Offset Corporate Income ...................................................... 28
Government Controls ........................................................................................................ 28
Centralized Control ........................................................................................................... 28
Difficult and Costly Dissolution ....................................................................................... 29
ACCUMULATED EARNINGS TAX .................................................................................. 29
PERSONAL HOLDING COMPANY TAX ......................................................................... 29
Professional Service Corporation ..................................................................................... 30
CHAPTER THREE - BUSINESS CONTINUATION INSURANCE ......................................... 33
INTRODUCTION................................................................................................................. 33
An Owner Dies ................................................................................................................. 33
CASH NEEDS ...................................................................................................................... 33
Final Expenses .................................................................................................................. 33
Administering the Individual’s Estate............................................................................... 33
Executor or Administrator? .............................................................................................. 34
Probate .............................................................................................................................. 34
Estate Administration Requirements and Problems ......................................................... 34
Living Expenses ................................................................................................................ 34
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Life Insurance Provides the Cash ...................................................................................... 35
The Business Is Dissolved ................................................................................................ 35
The Owner's Will .............................................................................................................. 35
Life Insurance as the Sharpest Tool in the Box ................................................................ 36
Income Tax Consequences of Life Insurance ................................................................... 36
DEFINING LIFE INSURANCE ........................................................................................... 36
Transfer for Value Rule .................................................................................................... 37
Other Taxable Situations............................................................................................... 37
FEDERAL ESTATE TAX........................................................................................................ 38
EXEMPTIONS ................................................................................................................. 38
VALUING THE ESTATE FOR ESTATE TAX PURPOSES ............................................. 39
Tangible Personal Property, Real Estate, and other Assets .............................................. 39
Joint Ownership of Property ............................................................................................. 39
Life Insurance.................................................................................................................... 40
Tax Planning for Life Insurance ....................................................................................... 40
Employee Benefits ............................................................................................................ 40
Gifts And Gift Taxes Paid Within Three Years Of Death ................................................ 40
Allowable Deductions and Exclusions ............................................................................. 40
Valuing Property for Estate Purposes ............................................................................... 40
Property Acquired as Beneficiary ..................................................................................... 41
THE MARITAL DEDUCTION & ESTATE TAX EXEMPTION ...................................... 41
Computing the Federal Estate Tax .................................................................................... 42
GIFT TAXES ........................................................................................................................ 42
Fundamentals .................................................................................................................... 43
Life Insurance as a Gift ..................................................................................................... 43
Strategies to Consider ....................................................................................................... 43
GENERATION-SKIPPING TAX......................................................................................... 43
Filing Gift Tax Return ...................................................................................................... 44
Policy Proceeds Payable to Estate or for Benefit of Estate ............................................... 44
Insured Had Incidents of Ownership in the Policy ........................................................... 44
Insured Transfers Policy for Inadequate Consideration .................................................... 45
MARITAL DEDUCTION .................................................................................................... 45
Policy Ownership .............................................................................................................. 46
The Will and Life Insurance ............................................................................................. 46
The Business Interest Is Sold ............................................................................................ 46
Specificity of Intent Through a Will ................................................................................. 47
BUY-SELL AGREEMENT ...................................................................................................... 47
KEY PROVISIONS IN A BUY-SELL AGREEMENT ....................................................... 47
FUNDING BUY-SELL AGREEMENT WITH LIFE INSURANCE................................... 48
Permanent vs. Term Insurance .......................................................................................... 49
Existing Policies vs. New Insurance ................................................................................. 49
Amount of Insurance ......................................................................................................... 49
Policy Ownership .............................................................................................................. 50
Tax Consequences ............................................................................................................ 50
Fair Market Value ............................................................................................................. 50
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LIFE INSURANCE PROCEEDS ......................................................................................... 51
Lump Sum Payment .......................................................................................................... 51
Payment in Installments .................................................................................................... 51
Interest Option................................................................................................................... 51
Policy Surrender for Cash ................................................................................................. 51
Endowment Contract Proceeds ......................................................................................... 52
ACCELERATED DEATH BENEFITS ................................................................................ 52
Viatical Settlement ............................................................................................................ 52
INHERITED PROPERTY .................................................................................................... 52
STEP-UP BASIS RULES ..................................................................................................... 52
STEPPED-UP BASIS IN COMMUNITY PROPERTY STATES ....................................... 52
CHANGE OF PROPERTY USE .......................................................................................... 53
SALE OF PROPERTY ......................................................................................................... 53
Gain ................................................................................................................................... 53
Loss ................................................................................................................................... 53
BUY-SELL FUNDING USING LIFE INSURANCE .............................................................. 53
BUY-SELL AGREEMENTS................................................................................................ 54
The Buy-Sell Agreement and Valuation for Estate Tax ....................................................... 54
Arm's Length Transaction ..................................................................................................... 55
Estate Freeze ..................................................................................................................... 55
Problems with Family Buy-Sell Agreement ..................................................................... 56
Valuing a Business ............................................................................................................ 56
IRS Rules on Valuation .................................................................................................... 56
ALTERNATIVE VALUATION........................................................................................... 57
Valuation by Negotiation .................................................................................................. 57
A Special Role for Agents .................................................................................................... 58
VALUATION BY FORMULA ............................................................................................ 58
Book Value ....................................................................................................................... 58
Capitalization of Earnings................................................................................................. 58
Valuation by Independent Appraisal ................................................................................. 59
Importance of Valuation for the Buy-Sell Agreement ...................................................... 60
Importance of Valuation for Estate Tax Purposes ............................................................ 60
Chapter 3 Review Questions ................................................................................................. 60
CHAPTER FOUR – BUSINESS CONTINUATION ................................................................... 63
The Proprietor Dies ........................................................................................................... 63
BUSINESS SUCCESSION CHALLENGES FOR PROPRIETORSHIPS .......................... 63
Spouse and Adult Children Heirs ..................................................................................... 63
THE WILL AND LIFE INSURANCE ................................................................................. 64
LIFE INSURANCE IN AN IRREVOCABLE TRUST ........................................................ 65
The Proprietorship Is Sold ................................................................................................ 66
Purchase by an Employee ................................................................................................. 66
Purchase by a Family Member .......................................................................................... 66
Purchase by a Competitor ................................................................................................. 66
USING A WILL, BUY-SELL AGREEMENT & LIFE INSURANCE .................................... 67
Premium Payment ............................................................................................................. 67
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TAX CONSEQUENCES ...................................................................................................... 68
A General Partner Dies ..................................................................................................... 68
Liquidating Trustees ......................................................................................................... 68
Problems with Liquidation ................................................................................................ 68
Reorganizing the Partnership ............................................................................................ 68
Life Insurance.................................................................................................................... 69
PARTNERSHIP BUY-SELL AGREEMENT FORMATS ...................................................... 69
CROSS-PURCHASE AGREEMENT .................................................................................. 69
Unequal Partnership Interests ........................................................................................... 69
ENTITY PURCHASE AGREEMENT ................................................................................. 70
Funding with First-to-Die Policies.................................................................................... 70
Tax Consequences for Partnership Buyouts ..................................................................... 70
INCOME TAXATION OF LIFE INSURANCE PROCEEDS ............................................. 71
INCOME TAX CONSEQUENCES FOR THE PARTNERS .............................................. 71
No Partnership Termination .............................................................................................. 71
Partnership Income ........................................................................................................... 71
(Formerly) Stepped-Up Basis ........................................................................................... 72
Alternate Valuation Date .................................................................................................. 72
INCOME TAX RATES ON CAPITAL GAINS .................................................................. 72
Partnership Entity Buyout or Liquidation ......................................................................... 72
Individual Cross-Purchase Buyout or Sale ....................................................................... 73
Avoiding Federal Estate Tax............................................................................................. 73
Value of the Decedent's Business Interest ........................................................................ 73
Policies Owned by the Deceased Partner .......................................................................... 74
A Stockholder Dies ........................................................................................................... 74
Buy-Sell Agreements for Corporations ............................................................................. 75
Cross-Purchase Agreement ............................................................................................... 75
Stock Redemption (Entity) Agreement ............................................................................. 76
Tax Consequences for Corporate Buyouts ........................................................................ 76
Premiums vs. Taxable Income .......................................................................................... 76
Income Taxation of Life Insurance Proceeds .................................................................... 77
ALTERNATE MINIMUM TAX .............................................................................................. 77
How AMT Can Affect How to Invest? ............................................................................. 78
When is the AMT Applicable? ......................................................................................... 78
NOTICE ................................................................................................................................ 78
Alternative Minimum Tax (AMT) 2007 ........................................................................... 78
LIFE INSURANCE AND AMT ........................................................................................... 79
Stock Redemption vs. Cross-Purchase Plans and AMT ................................................... 80
Stock Redemption and Accumulated Earnings ................................................................. 80
Income Tax Consequences of the Buyout ......................................................................... 80
Attribution Rules............................................................................................................... 80
SECTION 303 REDEMPTION ................................................................................................ 81
REQUIREMENTS ............................................................................................................ 81
SITUATIONS THAT MAY WARRANT USE OF SECTION 303................................. 82
(Previous) Stepped-Up Cost Basis .................................................................................... 83
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METHODS USED TO FUND A SECTION 303 STOCK REDEMPTION PLAN ............. 83
1. Cash.............................................................................................................................. 83
2. Loan ............................................................................................................................. 83
3. Insurance ...................................................................................................................... 83
Summary ........................................................................................................................... 83
AN ALTERNATIVE ............................................................................................................ 84
Federal Estate Tax ............................................................................................................. 84
Policies Owned by the Deceased Stockholder .................................................................. 84
Chapter 4 Review Questions ............................................................................................. 85
CHAPTER FIVE -KEY PERSON INSURANCE ........................................................................ 88
Definition of Insurance?.................................................................................................... 88
USES FOR THE INSURANCE ........................................................................................... 88
Who Is a Key Person? ....................................................................................................... 88
Critical Financial Role ...................................................................................................... 89
Proprietorships, Partnerships, Corporations ..................................................................... 89
How Key Person Life Insurance Works ............................................................................ 89
Owner and Beneficiary ..................................................................................................... 90
Term Insurance or Permanent Insurance ........................................................................... 90
Rewarding the Employee .................................................................................................. 91
EXISTING POLICIES AND THE TRANSFER FOR VALUE RULE................................ 91
VALUING THE KEY PERSON'S LOSS............................................................................. 92
TAXATION OF KEY PERSON LIFE INSURANCE ......................................................... 92
Premiums-Deductibility and Taxable Income .................................................................. 92
S Corporation Premiums ................................................................................................... 93
Premiums as Accumulated Earnings................................................................................. 93
INCOME TAXATION OF DEATH PROCEEDS ............................................................... 93
Income Taxation of Cash Surrender Value ....................................................................... 94
Federal Estate Taxation................................................................................................. 94
Chapter 5 Review Questions ............................................................................................. 94
CHAPTER SIX - SPLIT DOLLAR LIFE INSURANCE ............................................................. 97
DEFINITION ........................................................................................................................ 97
RECENT TAX DEVELOPMENTS AND FUTURE OF SPLIT-DOLLAR PLANS .............. 97
SPLIT DOLLAR CONCEPTS AND PLANS .......................................................................... 97
No Discrimination Problems............................................................................................. 97
ADVANTAGES TO THE EMPLOYER .............................................................................. 98
ADVANTAGES TO THE EMPLOYEE .............................................................................. 98
The Basic Split-Dollar ...................................................................................................... 98
Splitting the Premiums...................................................................................................... 98
Splitting the Benefits......................................................................................................... 99
Split-Dollar Policy Ownership .......................................................................................... 99
Endorsement Method ........................................................................................................ 99
Endorsement Method Variation ........................................................................................ 99
Collateral Assignment Method ....................................................................................... 100
Choosing the Best Method .............................................................................................. 100
Using an Existing Key Person Policy ............................................................................. 100
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FUNDING DEFERRED COMPENSATION ..................................................................... 100
Using an Existing Personal Policy .................................................................................. 101
SPLIT-DOLLAR VARIATIONS ....................................................................................... 101
Employer Pays All .......................................................................................................... 101
Level Employee Contribution (Averaging)..................................................................... 101
Using the Fifth Dividend Option .................................................................................... 102
Other Dividend Options .................................................................................................. 102
Taxable Death Benefit Received..................................................................................... 102
Death Benefits ................................................................................................................. 103
Bonus Plans..................................................................................................................... 103
Time Value of Money Factor .......................................................................................... 104
Equity Split-Dollar .......................................................................................................... 104
Reverse Split-Dollar........................................................................................................ 104
TAX CONSEQUENCES ........................................................................................................ 105
Premium Deductibility .................................................................................................... 105
Economic Benefit............................................................................................................ 105
Annual Cash Value Increases.......................................................................................... 106
Cash Surrender Values .................................................................................................... 106
Death Benefits ................................................................................................................. 106
FUTURE OF SPLIT-DOLLAR PLANS ................................................................................ 107
FEDERAL ESTATE TAXATION ..................................................................................... 107
Terminating the Split-Dollar Plan ................................................................................... 108
Rollout ............................................................................................................................ 108
Spinout ............................................................................................................................ 109
Conversion to Key Person Insurance .............................................................................. 109
Chapter 6 Review Questions ........................................................................................... 109
CHAPTER SEVEN - NONQUALIFIED DEFERRED COMPENSATION.............................. 112
NONQUALIFIED VERSUS QUALIFIED BENEFITS ......................................................... 112
What Is Deferred Compensation? ................................................................................... 112
Deferral Methods ............................................................................................................ 113
Salary Reduction Plans ................................................................................................... 113
Future Federal Tax Savings ............................................................................................ 113
SALARY CONTINUATION PLAN .................................................................................. 114
Top-Hats ......................................................................................................................... 114
Excess Benefit Plan-A Subspecies.................................................................................. 115
Funding Deferred Compensation Plans-or Not... ............................................................ 115
Disadvantages of Funded Plans ...................................................................................... 116
Constructive Receipt ....................................................................................................... 116
Economic Benefit Doctrine ............................................................................................. 117
The "Rabbi Trust" ........................................................................................................... 117
Protection from Employer's Creditors............................................................................. 118
ERISA Requirements ...................................................................................................... 118
ERISA Exemption for Unfunded Plans .......................................................................... 118
UNFUNDED PLANS ......................................................................................................... 118
LIFE INSURANCE FOR INFORMAL FUNDING ............................................................... 119
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Plan Is Not "Funded" by Policy ...................................................................................... 119
Benefits of Life Insurance for the Employer ................................................................... 120
TRUSTS.............................................................................................................................. 120
Irrevocable Trust ............................................................................................................. 120
Revocable or Living Trust .............................................................................................. 120
Present Interest Trust ...................................................................................................... 121
THE RABBI TRUST .......................................................................................................... 121
Acquiring a Business ...................................................................................................... 121
Impact.............................................................................................................................. 122
IRS Model Rabbi Trust ................................................................................................... 122
Life Insurance in a Rabbi Trust ....................................................................................... 122
Secular Trusts.................................................................................................................. 123
Springing Trusts .............................................................................................................. 123
Rabbicular Trusts ............................................................................................................ 124
Haircuts ........................................................................................................................... 124
Secular Trusts (Continued) ............................................................................................. 125
Components of the Plan and the Contractual Agreement ............................................... 125
Eligibility Requirements ................................................................................................. 125
Service Requirements ..................................................................................................... 126
Retirement Age ............................................................................................................... 126
Income Replacement Goals ............................................................................................ 126
Compensation Base ......................................................................................................... 127
DEFINED BENEFIT VS. DEFINED CONTRIBUTION PLANS ..................................... 127
Defined Benefit ............................................................................................................... 127
Defined Contribution/Money Purchase .......................................................................... 128
Forfeiture Provisions ....................................................................................................... 129
Vesting ............................................................................................................................ 129
EVENTS TRIGGERING BENEFITS ................................................................................ 129
Retirement ....................................................................................................................... 129
Death ............................................................................................................................... 129
Payment Methods ............................................................................................................ 130
Other Provisions.............................................................................................................. 130
Paying the Benefits-Methods and Tax Issues ................................................................. 131
EMPLOYER'S OPTIONS WITH AN INSURANCE-FUNDED PLAN............................ 131
Policy Surrender .............................................................................................................. 131
Policy Loan ..................................................................................................................... 131
Employee Receives Retirement Benefits ........................................................................ 132
Employee Taxable Income .............................................................................................. 132
Employee Withholding ................................................................................................... 132
Employer’s Tax Deduction ............................................................................................. 133
Death Benefits ................................................................................................................. 133
$5,000 Death Benefit Exclusion ..................................................................................... 133
Income in Respect of a Decedent .................................................................................... 134
Death Benefit Only (DBO) Plans .................................................................................... 135
Additional Tax Issues ..................................................................................................... 135
viii
Employer Premiums and Proceeds ................................................................................. 135
Accumulated Earnings Tax ............................................................................................. 135
Controlling Shareholders ................................................................................................ 136
Third-Party Guarantees ................................................................................................... 136
Estate Taxes of Deferred Compensation ......................................................................... 136
Section 457 Deferred Compensation .............................................................................. 137
OVERALL LIMIT ON DEFERRALS ................................................................................ 137
Elective Deferrals ............................................................................................................ 137
ROTH 401(k) PLANS ........................................................................................................ 137
Other Requirements and Restrictions ............................................................................. 138
Chapter 7 Review Questions ........................................................................................... 138
CHAPTER EIGHT - OTHER EXECUTIVE PROTECTION .................................................... 141
INTRODUCTION................................................................................................................... 141
SECTION 162 EXECUTIVE BONUS PLANS ................................................................. 141
ADVANTAGES OF THE PLAN ....................................................................................... 142
DISADVANTAGES OF THE PLAN ................................................................................. 142
Restricted Access ............................................................................................................ 143
RECENT RULING FOR EXECUTIVE BONUS PLANS & DEFERRED COMPENSATION
................................................................................................................................................. 143
Background ..................................................................................................................... 144
Rev. Rul. 2008-13 ........................................................................................................... 144
Temporary Transition Relief Under Rev. Rul. 2008-13 ................................................. 145
Using a Secular Trust ...................................................................................................... 145
Indemnification Insurance ............................................................................................... 146
Conclusion ...................................................................................................................... 146
Chapter 8 Review Questions ........................................................................................... 147
CHAPTER NINE - ETHICAL ISSUES ..................................................................................... 149
PROFESSIONALISM ............................................................................................................ 149
KNOWLEDGE AND SKILLS ........................................................................................... 149
PROFESSIONAL DESIGNATIONS ................................................................................. 149
Chartered Life Underwriter (CLU) ................................................................................. 149
Chartered Financial Consultant (ChFC) ......................................................................... 149
Certified Financial Planner (CFP)................................................................................... 150
CLIENT-FOCUSED ........................................................................................................... 150
AN INDUSTRY REPRESENTATIVE .............................................................................. 150
IN THE BUSINESS OF SERVICE .................................................................................... 150
FIDUCIARY RESPONSIBILITIES ................................................................................... 151
AGENCY AUTHORITY .................................................................................................... 152
ACTUAL OR EXPRESS AUTHORITY ........................................................................... 152
IMPLIED AUTHORITY .................................................................................................... 152
APPARENT AUTHORITY ................................................................................................ 153
CONSUMER PROTECTION AND ETHICS .................................................................... 153
Unfair Trade Practices ................................................................................................ 153
UNFAIR DISCRIMINATION ............................................................................................ 153
REBATING ........................................................................................................................ 154
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ILLEGAL POLICY REPLACEMENT ............................................................................... 154
MISREPRESENTATION AND FRAUD........................................................................... 154
DEFAMATION .................................................................................................................. 155
BOYCOTT, COERCION AND INTIMIDATION ............................................................. 155
ADVERTISING .................................................................................................................. 155
MISUSE OF FUNDS .......................................................................................................... 155
UNFAIR CLAIM PRACTICES.......................................................................................... 155
DELIVERING THE POLICY............................................................................................. 156
POLICY SUMMARY......................................................................................................... 156
PROTECTION FOR THE INSURANCE PROFESSIONAL ............................................ 157
ERRORS AND OMISSIONS (E&O) INSURANCE ......................................................... 157
A Final Word ...................................................................................................................... 158
Chapter 9 Review Questions ........................................................................................... 158
x
FOREWORD
Throughout this text it will be noted that one of the primary uses of life insurance in
business use is to alleviate financial strain caused by taxes. The original text was written
several years ago, and since that time there has been substantial changes in these laws
which, in some cases, alleviated the tax situation (such as in Estate Taxes) while in other
cases changed or increased the taxes to the point that traditional uses of business life insurance has changed drastically.
The tax bill of 2001 contained several significant changes in relation to estate, gift, and
generation-skipping transfer taxes. Therefore, the role of life insurance in business (and
personal) tax planning has changed drastically. If there are situations where the business
planning was based upon the older version of the tax laws, professional in the tax and insurance fields should be brought in so that the plan(s) is on sound tax footing.
While some laws are often considered as "chiseled in stone" when enacted, tax laws, in
particular, seem to be scratched in ice and must be continually rewritten as the ice melts.
Note: Throughout this text rather than use the clumsy gender designation in individual situations, such as he/she, his/her, himself/herself, etc., the masculine gender is used for simplicity.
There is no intent to diminish the contributions of those of the female gender to the insurance
industry or imply that they contribute less than do those of the male gender.
BUSINESSES & INSURANCE
This text addressees only business situations and needs arising from business activity, that can
be met through life insurance products. There are many other uses for insurance in any business
situation, including property and casualty insurance that includes fire, business interruption, theft,
burglary, etc. Liability insurance is another area that is of prime interest to businesses of all
types. However, for the purposes of this text, only situations involving life insurance, and in
some cases health insurance and retirement plans are discussed. Anything further would be beyond the scope of this text.
You will learn primarily about life insurance solutions to a variety of business needs. By focusing on specific areas rather than offering a survey of all possible types of insurance a business
might need, this course provides the opportunity for in-depth study that will help you become
proficient and effective in these areas.
You will notice this course does not cover two widely recognized business life and health insurance markets in detail but some mention will be made for group life and health plans and employer-provided tax-deferred retirement/pension plans funded with insurance products.
Where we’re headed
Here, then, are the topics you will learn about as you study this text:
The forms of business ownership permitted in the U.S., including reasons for selecting different forms of ownership and the legal and tax implications of each. Your study will include a simple primer on business types, designed to introduce you to the factors affecting the decisions
business owners make as they consider the insurance products you offer.
1
What happens to the different types of business entities when owners die and are unable to continue in the business, from the standpoint of the law and from the personal perspectives of the
owners and their survivors?

How buy-sell agreements funded by insurance are used to protect the financial interests of deceased business owners and to ensure that the business continues to operate rather than being forced to liquidate.

Insurance products that protect the business and its key people, owners and employees against financial losses resulting from death.

Using a deferred compensation plan funded by life insurance to reward valuable
employees or business owners, while avoiding the federal nondiscrimination rules
that apply to many employee benefits.

How split-dollar life insurance plans can be established for selected employees, allowing the business and the employees to share in both the costs and the benefits of
a life insurance policy.

Other uses for insurance products to provide extra benefits for business executives.

Ethical and professional considerations important to everyone involved in Insurance
transactions.
You will receive a thorough explanation of the business situations that give rise to insurance
needs, followed by a detailed study of the insurance products that can provide solutions, how the
products work, and how you can help your business clients implement strategies that result in
financial security. Throughout, we will examine the financial implications of each business situation that insurance can address, including how to deal with Uncle Sam's interest in garnering
revenues through income and estate taxes, offset by individual and business interests in denying
Uncle as much revenue as is legally possible.
2
CHAPTER ONE – BUSINESS OWNERSHIP BASICS
WHO'S RUNNING THE BUSINESS?
According to the U.S. Department of Commerce, about 17.5 million U.S. companies currently
operate in this country. Business ownership In the United States takes one of three basic forms:

Sole proprietorships, which are businesses owned by a single individual

Partnerships, which are businesses owned by at least two individuals under a legal
agreement to join together in a business activity.

Corporations, which are in businesses incorporated under state laws.
Beyond these basic descriptions, we will discuss each type more fully in later Chapters. The
most prevalent type of business ownership in the U.S. is the sole proprietorship, trailed distantly
by corporations and, finally, partnerships.
As an insurance agent who wants to enter or to grow in the business insurance marketplace,
you must first of all know who your prospects are. Then, you must know what kinds of challenges each business prospect faces in order to identify needs that insurance can fill. And, you must
have a working knowledge of the financial implications, including taxation, of various types of
insurance solutions to business problems based on the type of business ownership.
As you penetrate the business markets, you are most likely to encounter sole proprietors by virtue of their greater numbers. And, as you will see, sole proprietors have unique problems not
shared by other forms of business ownership. Some of these problems can be addressed by insurance products.
Corporations, the next largest group of business types, suggest bigness, but in fact, corporations can be any size in terms of numbers of people and production of income. Large or small,
corporations also have unique insurance needs, some of which are related to the size of the business.
Partnerships may be comprised of as few as two people or an unlimited number. Some of a
partnership's characteristics make it similar to a sole proprietorship, while others more closely
resemble the corporate structure. Partnerships, too, are subject to unique needs for which insurance can provide solutions.
In the remainder of this chapter we will examine the financial and organizational implications
of sole proprietorships and partnerships, in the next chapter we'll look at corporations. You will
note many references to taxation throughout the text because forms of business ownership are
inextricably linked to the Internal Revenue Code and Uncle Sam's interest in regulation and tax
collection. After you have assimilated the basic concepts of each type of ownership, later chapters focus on identifying incentives for different types of businesses to purchase insurance and
exploring the personal business, financial and tax consequences of a business owner's decision to
act or not act on the needs identified
SOLE PROPRIETORSHIP
The sole proprietorship form of business ownership is not only the most popular in the U.S.; it
is also the easiest to establish and to dissolve. A sole proprietorship also is usually the least costly
3
in terms of start-up costs, aside from the costs of producing or acquiring inventory, buying or
renting business real estate and other costs beyond simply establishing ownership. Depending on
the type of business, a sole proprietor might pay local fees to obtain a retail merchant's license or
perhaps a state board of health license for occupations such as cosmetology, food service and
others. Sole proprietors, however, need not incur the legal costs that are associated with forming
a partnership or a corporation. Both of which require preparation and filing of various legal documents.
WHO MAY FORM A SOLE PROPRIETORSHIP?
By definition, a sole proprietorship is a business that has only one owner. In actual practice
such a business may be owned by one person and his or her spouse who, if they file joint tax returns, are considered one person for taxation purposes. If even one additional person who is not
a joint-filing spouse owns part of the business, however, it becomes a partnership, not a sole proprietorship. Others may work in the business, but they may not own any part of it if the business
is to retain its sole proprietorship character. This section discusses unincorporated sole proprietorship.
Income Tax Consequences
Caution! In the following section and all parts of this text that deal with taxation, the material
presents the basic and general tax applications for the situations being discussed as of this writing. The tax code is complex and changes frequently; it is subject to tax court rulings that clarify
or, sometimes, further complicate the law. Within the past 8 years, there have been considerable
changes in the tax laws, and these changes are addressed within the text where they are applicable.
Additionally, any individual business may be involved in a variety of transactions that are taxed
differently (or not taxed), depending on unique circumstances. The purpose of presenting tax
information in this textbook is not to make you an expert in tax matters, but to present the general taxing considerations inherent in each type of business. Your clients must consult with attorneys or other tax experts to determine the tax consequences of all business decisions, including those that involve insurance funding.
For income tax purposes, a sole proprietor is the business; the proprietor and business are considered one and the same. For this reason, a sole proprietorship is often characterized as a "conduit" through which income flows directly to the owner.
Because income flows directly to the sole proprietor, only the owner pays income taxes on
business income. There is no separate taxation on the business itself, though special tax forms
must be included when the business owner files his or her individual income taxes to show the
source of the income and any business expenses, such as overhead and employee wages. Deductions for all business expenses are attributed to the individual proprietor rather than to the business as a separate entity.
MARGINAL TAX RATE
Latest Developments in AMT
Recently, Congress has repeatedly enacted temporary measures that significantly raised the applicable exemption amounts above the 2000 limits. The very recent data available (2008) indi-
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cates that this exemption expired in 2006, therefore the exemption for 2007 and beyond has reverted back to the levels that existing prior to 2001. For married filing jointly, the exemption is
reduced to $45,000 (down from $62,550; for single/head of household the exemption is $33,750
(down from $42,000); and for married filing separately, the amount is $22,500 (down from
$31,275).
Unless there is congressional action, there are going to be many more taxpayers subject to the
AMT as the result of their inaction. As of the moment Congress is looking at it, and it behooves
life insurance agents to check IRS Publication 553 (Highlights of 2007 tax changes) and it can be
obtained on www.irs.gov. From there, one can access AMT Assistance for Individuals and enter
specific information in order to determine the AMT for 2008.
Filing Taxes as Sole Proprietor
If you operate a business as a sole proprietor, you must file Schedule C to report your income
and expenses from your business. If you operate more than one business, or if you and your
spouse owned separate businesses, a separate Schedule C must be filed for each business. This is
of particular interest as full-time life insurance sales representatives, along with certain other
"statutory employees" you are considered an employee for Social Security and Medicare purposes; however, federal income tax withholding is optional. A statutory employee must report his
wages on Schedule C.
A sole proprietor files taxes as an individual on Form 1040. The advantages of a sole proprietor is that losses can be reported, and if there is a net operating loss, it can be carried back or carried forward to offset income in other years. Generally, a net operating loss can be carried back 2
years and forward for 20 years. There are exceptions, such as net operating losses occurring in
2001 and 2002 can be carried back for 5 years. Again, this is time for tax expertise.
Self-employment tax is composed of a Social Security tax of 12.4% and a Medicare tax of
2.9%—note that these percentages can change with new legislation. The maximum amount of
wages and/or self-employment tax subject to the Social Security part of the self-employment tax
is $97,500, but all net earnings are subject to Medicare portion of the self-employment tax.
This is not a "do-it-yourself tax manual," but to put taxation of self-employment in proper prospective, in a nutshell, filing taxes under the regular method would start by calculating the net
self-employment income (generally the net profit from the business). Using Schedule SE, determine how much is subject to self-employment tax—usually 92.35% of net self-employment income.
Then the self-employment tax is calculated. For 2007, as an example, if net earnings and wages and tips are not more than $97,500, multiply the net earnings by 15.3% which will give you
yourself employment tax.
IF there are no wages or tips, and net earnings are more than $97,500, then the basic method is
to multiply the net earnings by 2.9% for Medicare tax, add the result to $12,090 (12.4% of
$97,500) and that is yourself employment tax.
IF wages and tips were received in 2007 and net earnings from self employment plus wages
and tips are more than $97,500, a different form is used. Subtract total wages and tips from
$97,500 to find the maximum amount of earnings subject to 12.4% Social Security part of the
tax. If more than zero, multiply the amount by 12.4%, which gives you the Social Security tax
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amount. Then multiply your net earnings from self employment by 2.9%, which gives you the
Medicare amount. The total of the Social Security tax amount and the Medicare tax amount result in the self-employment tax.
There are also optional methods for certain situation.
Start-Up & Pre-operating Expenses
Start-up expenses are the costs of getting started in business before you actually begin doing
business, and may include such things as advertising, travel, utilities, repairs, or employee wages.
Start-up costs also include what is paid for investigating a prospective business and getting the
business started, such as feasibility studies, analysis of available facilities, travel for business
purposes, and salaries and costs of consultants and other professional services.
These costs can be substantial and as such, must bear close scrutiny of the IRS. Plus, if you go
into business, start-up expenses of a trade or business are not deductible unless they are deducted
according to certain IRS rules, such as a current deduction can be elected for a limited amount
(up to $5,000) of start-up costs occurred in the year when the business started. This amount is
reduced, but not below zero, by the amount by which the cumulative cost of start-up expenditures
exceeds $50,000. The remained of the start-up costs can be claimed as a deduction over the next
15 years. If start-up costs are $5,000 or less, these expenses can be deducted in full in the year
the business actively begins.
As indicated, there are a lot of IRS regulations that pertain to business taxation, and to try to
compare the individual tax return to that of a Sole Proprietor, while there are some similarities,
would be meaningless. Start-up costs are just one area in which there are large differences.
However, as a note of interest, according to Ernst and Ernst Tax Guide, 2008, there has been
substantial litigation in respect to when a business begins. The IRS, as one would expect, takes a
conservative stand, but they have been litigated on this point. The generally accepted rules seems
to be that even though a taxpayer has made personal commitments to starting a business and has
spend considerable sums of money to that end over a considerable period of time, the IRS takes
the position that he has actually not engaged in carrying on any trade or business until such time
as the business has began to perform as a going concern and has performed those activities for
which it was organized.
These start-up costs incurred after the start-up decision has been made are classified as capital
expenditures and may be deductible in the year in which the attempt to go into business fails.
INDIVIDUAL TAX RATES
New Legislation
The Tax Relief and Health Care Act of 2006 (TRHCA), and the Small Business and Work Opportunity Tax Act of 2007 (SBWOTA), will impact the amount of taxes paid by individuals.
TRHCA reinstated a number of provisions that had otherwise expired and that offered tax relief,
while extending other soon-to-expire tax incentives. This new law expanded the ability for some
taxpayers who had previously paid alternate minimum tax (AMT) to recover part of that tax previously paid as a tax credit. The amount of the new AMT refundable credit may even exceed a
qualifying taxpayer's total tax due for the year. The SBWOTA created a number of tax incentives for businesses, but also expands the reach of the kiddies-tax starting in 2008.
It is important to note that many of the provisions in these bills will only be in effect for a short
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while as several of them are set to expire at the end of 2007 unless Congress acts to extend
them…at this point no one can state for certainty what will happen. Therefore, these tax discussions may affect tax returns in the future by showing how new taxes may affect your individual
tax situation.
Further, since this text addresses business use of life insurance, in-depth discussion of individual tax calculations are beyond the scope of this text, but basic are important nonetheless.
Continuing through 2010, the regular individual income tax rates above 10% and 15% are
25%, 28%, 33% and 35% (the top individual rates). However, unless Congress acts, these reduced rates will expire starting for tax years beginning after Dec. 31, 2010. These rates also pertain to trusts.
Alternate Minimum Tax will be discussed later in this text as there have been considerable
changes in this tax and how it is applied.
Taxable Income Levels for 10% Rate Bracket
The 2004 tax act extended the size of the 10% rate bracket through 2010. The size of this
bracket is $7,000 for single individual, with annual indexing for inflation for all years after 2003
(in 2006 it was $7,550 and $7,825 in 2007). After 2010, the 10% bracket will expire entirely.
Capital Gains Tax Rates
The top individual rate on long term capital gains which had been 20% (10% for taxpayers in
the 10% and 15% bracket)—is 15% (zero for those in the lower brackets) for years 2008, 2009
and 2010. After 2010, these rates revert back to the old and higher rates. These rates apply to
both the regular tax and the alternative minimum tax, and apply to assets held more than one
year.
Tax Rate for Qualified Dividends
Certain dividend income, considered as "Qualified Dividend Income," is taxed at a maximum
rate of 15%. The 2006 tax law extended this lower maximum rate through 2010—prior to 2003
both dividends and interest was taxed at ordinary income tax rates. The top tax rates on qualified
dividend income (not including interest income) are now 15% for computing both regular income
tax and the alternative minimum tax. For taxpayers with qualified dividends taxed in the 10%
and 15% brackets, the tax rate on these dividends is zero in 2008, 2009 and 2010, after which
dividends will be subject to tax at ordinary income rates.
For a dividend to be eligible for the 15% reduced tax rate, the underlying stock must be owned
for more than 60 days during the 121 day period beginning 60 days before the "ex-dividend"
date, the day on which the stock starts trading without its next dividend. In the case of certain
preferred stock, the holding period is increased to more than 90 days during the 181 day period
beginning 90 days before the ex-dividend date.
POSITIVE ASPECTS OF A SOLE PROPRIETORSHIP
The Simple Start-Up
We've already touched upon the simplicity or ease with which a sole proprietorship may be
formed. Essentially, an individual decides what type of business to operate, selects a location,
pays any state or local charges for permits, inspections or other requirements, and the business
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becomes a business. Other forms of business ownership generally require significant legal paperwork and varying degrees of compliance with both state and federal laws.
Rugged Individualism
The frontier spirit of "rugged individualism" associated with taking complete personal responsibility for one's fate are not only alive and flourishing, but also persistently pervasive if the sheer
numbers of sole proprietorships can be used as an indicator. There's a certain charm (whether real
or perceived) in being able to say, "I'm my own boss" and "I control my own destiny." Sole proprietors are, indeed, in charge of what occurs in their businesses. They decide what products or
services to offer, establish the working hours, choose to hire or not hire helpers, and control the
disposition of business income. As agreeable as this scenario appears, however, there are certain
dangers inherent in being fully and personally responsible for a business. We'll look at some of
the negative aspects soon.
The Gold Mine Is Mine
Whereas a sole proprietor is the sole profit-taker after expenses are paid, other business forms
require the sharing of profits among all whom own the business. Control of the profits can mean
greater independence in business matters and is linked, of course, to taking personal responsibility for and controlling all aspects of the business.
Tax Advantages
The tax advantages of a sole proprietorship have been discussed above. Over the past 7 years,
there have been considerable changes affecting taxation of businesses, primarily sole proprietorships and partnerships.
Sole proprietorships also escape some additional taxable events imposed on other forms of
business ownership. While there are tax consequences for partnerships and corporations when
the owners use personal assets in the business, this is not true for sole proprietors, since proprietors and their businesses are considered to be one and the same “person”. Therefore, a sole proprietor may funnel personal assets into and out of the business as desired without fear of triggering a taxable event under the Internal Revenue Code.
For example, a sole proprietor might want to take $3,000 from his retail store's business bank
account to pay for a family vacation. Regardless of how the proprietor uses this money, taxation
is the same as for any other funds the proprietor takes from the business. When a business is incorporated, however, the government requires that all funds paid to an owner must be specifically
characterized as either a salary or a dividend, with different tax consequences. I f treated as a dividend, the same $3,000 taken by the owner will be taxed twice-first to the corporation and then to
the owner. We'll discuss corporate taxation in more detail in the next chapter, but you can see
from this example that a sole proprietorship is subject to simpler tax rules.
When a business is new, the owner sometimes anticipates losses rather than gains in the early
years of operation. If the business is a sole proprietorship, these losses flow directly through to
the owner, just as income does. As a result, income from any source can be offset by business
losses on the owner's individual tax return, resulting in less taxable income. Under corporate
ownership, on the other hand, the loss remains with the corporation and is not available to offset
the corporate owner's income as reported on an individual tax return.
Sole proprietors may establish for themselves and their employees, if any, qualified retire-
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ment plans, so-called because they qualify under Internal Revenue Code regulations for special
tax treatment comparable to the tax breaks larger businesses enjoy. These benefits include taxdeductible contributions to the retirement plan and deferral of taxation on earnings during the
years the contributions are growing.
QUALIFIED PLAN, DEFINITION
Under a qualified plan, participating employees may defer taxation on an employer's contributions into their individual accounts or for their vested benefits in qualified plans until some future
date of distribution. Additionally, the tax on the income the account generates may be deferred
until the money is distributed to the employee. The same deferred taxation is allowed under a
nonqualified plan as long as the employee's interest in the plan is simply an unfunded promise to
pay by the employer and meets requirements under a 2004 tax law change.
Again though, for high-earning proprietors, OBRA '93 has moderated the appeal of such plans
by reducing the maximum amount of compensation that may be considered for making a taxdeductible contribution to such a plan. As a result, non-qualified retirement plans-those that do
not have special tax benefits-may be more attractive to higher income proprietors. Later chapters
cover a number of non-qualified plans available to businesses.
The Simple Dissolution
As simple as a sole proprietorship is to form, it is even simpler to dissolve. The owner can
close the doors forever any time he or she chooses or may sell the business to a willing buyer
without consulting anyone else. As long as the business leaves no debts owing-a situation that
would attract the attention of creditors and legal authorities-the closing of a sole proprietorship is
no more than a tick in the country's financial heartbeat, from the perspective of the government
and the law. As you'll see, other forms of business ownership are not quite so easy to dissolve.
NEGATIVE ASPECTS OF A SOLE PROPRIETORSHIP
While a sole proprietorship appeals to the entrepreneurial spirit and offers certain advantages
not shared by other forms of business ownership, there are negative aspects to consider as well.
Unlimited Liability
Because the business and the owner are considered one and the same, a sole proprietor is subject to unlimited liability for any type of claim against the business, from business debts to personal injury claims. Thus, if the business does not have adequate assets to meet legitimate claims
against it, all of the owner's personal assets, including savings, bank accounts, investments, real
estate, automobiles, jewelry and other items, may be attached to settle creditors, claims.
Financial Stability
In addition to unlimited financial liability, the financial stability of a sole proprietorship can be
troublesome. Owners generally must rely on their personal assets both to start the business and to
keep it operating during times when business income is low. Borrowing from personal assets can
place the owner in a precarious financial situation. Borrowing from lending institutions is possible, but the amount a lender is willing to offer usually depends on the value of the owner's personal assets since the business is not considered a separate entity. No additional investors may be
brought into the business without losing the sole proprietorship characteristics. Doing so would
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require a partnership or corporate ownership not that this change is necessarily a negative. In fact,
sole proprietorships sometimes voluntarily progress to these arrangements with advantageous
results.
Additionally, the ongoing operation of the business that contributes to a sole proprietorship's
financial stability usually depends solely on the owner. If the owner dies or if personal indebtedness is too high, the business can fail.
Management and Personnel Issues
Sole proprietors take upon themselves all of the management responsibilities for the business.
Whether the owner is or is not a skilled and competent manager contributes to the success or
failure of the business. Few people are qualified to manage every aspect of a business, so some
choose to hire experts to handle portions of the business. However, because smaller proprietorships may struggle financially, some owners will not hire others and the business may suffer
where the owner's expertise is lacking. Finding high quality personnel to work as employees
can also be a problem. Individuals who want a career rather than just a paycheck may find it difficult to remain in a sole proprietorship where chances for advancement are limited by the owner's desire, willingness and ability to provide opportunities for employee growth. Thus, the very
people who could help the business become strong might be unable or unwilling to remain as
employees. And without reliable employees, owners may be unable to take vacations or otherwise find time needed for relaxation and recreation the rejuvenation required remaining effective
in business.
Tax Disadvantage
While we have discussed some possible tax advantages in the sole proprietorship arrangement,
you’ve seen that they are tenuous since tax laws can and do change regularly. This year’s tax advantages may turn into tomorrow's disadvantages. If financial success means the owner’s marginal tax rate is higher than corporate rates, which will be true for some sole proprietors as the
result of the 1993 tax law adjustments; this form of ownership becomes less attractive. Uncertainty about tax regulations and rates affects all types of businesses, of course, not just sole proprietorships.
A sole proprietor’s income represents self-employment income that is subject to withholding
for Social Security taxes. For a sole proprietor, self-employment taxes are not deductible as a
business expense. Although sole proprietors generally work in the business just as if they were
employees, owners may not pay themselves wages or salaries as they do for non-owner employees.
Businesses that follow federal regulations concerning employee fringe benefits (in addition to
retirement plans) may take tax deductions for paying for those employee benefits. For example,
many employers pay part or all of the insurance premiums for life and/or health insurance plans
and then take a tax deduction for the premiums as a business expense. While sole proprietors
may pay for and deduct such benefits for employees, any insurance premiums paid for the sole
proprietors themselves as employees are not tax deductible as a business expense. For a period of
several years, sole proprietors (and partners) have been allowed to deduct 25% of premiums paid
for health insurance for themselves, spouses and dependents. This provision has expired, then
been extended on several occasions.
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PARTNERSHIP
People who want to join together to do business may form a partnership. Although they represent the smallest number of business ownership types in the U.S. Partnerships of various kinds
that are described in this section include many business owners. You'll see that partnerships
share some of the same characteristics as sole proprietorships.
Who May Form a Partnership
Two or more owners must be involved for a business to be considered a partnership. The Uniform Partnership Act that governs whether a business is in fact, a partnership or some other
type of entity uses a simple definition:
An association of two or more persons can carry on a business for profit as co-owners.
The term "persons" may be deceptive because the law differentiates between a "natural person"
who refers to an individual human being, and an "artificial person" who refer to a legal entity
such as another business or a trust. Thus, a partnership could be comprised of two corporations or
an individual and a corporation or an individual and a trust or some other coupling.
This places no cap on the number of partners that may be involved, but as practical matter if
there are numerous partners the business is more likely to be incorporated rather than to operate
as a partnership.
INCOME TAX CONSEQUENCES
Like a sole proprietorship, a partnership acts as a conduit for income tax purposes as illustrated
using a retail store with two partners as an example. Earnings flow through the partnership entity
directly to the partners, who then report income, expenses and losses on their individual income
tax returns using special tax forms for partnerships.
Effect of a Partner's Basis
The amount of money each partner puts into the partnership is often termed the person's "basis." For example, if a new business is started with $50,000 from Partner A and $100,000 from
Partner B, Partner A's basis in the business is $50,000 and Partner B's basis is $100,000. The extent of deductions each partner may take for business expenses and losses is generally proportionate to each partner's investment or basis. If a deductible loss occurs, Partner A may deduct
one-third of the loss and Partner B may deduct two-thirds because of the proportion of each partner's basis unless the partners have agreed to some other means of allocating profits and losses.
Basis does not mean cash only: the value of property a partner contributes to the business also
adds to the basis. For example, if Partner A also contributes $50,000 worth of real estate to the
business, A's basis is also $100,000.
While only the individual partners-not the partnership entity itself-must pay income taxes, the
partnership itself must file a tax return showing how income, expenses and other items are allocated to the partners. The higher individual tax rates imposed by OBRA '93, discussed previously, apply to the individual partners.
Guaranteed Payments vs. Salary
As is true for sole proprietors, partners may not legally pay themselves wages or salaries as if
the partners themselves are employees of the business. This is true whether or not the partners act
as employees by working in the business. Any income partners received was traditionally viewed
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as a portion of each partner's distributive share of the partnership's income, based on how the
partners have decided to share profits. Eventually, however, the law was changed to recognize
that partners might give themselves a stipulated income regardless of whether there are profits to
share. That is, even if the business has little or no profits to distribute, the partners might receive
the equivalent of a salary. However, this is called a guaranteed payment, not a salary, for tax
purposes.
While this arrangement might appear to be quibbling over semantics, there can be different tax
consequences for guaranteed payments and salaries, as well as for guaranteed payments and distributive shares of partnership profits. If the guaranteed payment were simply salary, the partner
could report it as income in the year received, as is the case with any other income individuals
receive.
In the case of a partnership making guaranteed payments to partners, however, the partner must
report the payment as income in the year the partnership's tax year ends and the partnership reports the payment, even if that year is different from the partner's tax year. While the two tax
years may be the same, a business could have a different tax year. When the partnership reports
the payment to the partner is important because, even though the partnership's income is not
taxed, the partnership may deduct the payment as a business expense, thus reducing the income
that flows through to the individual partners as distributive shares.
For the individual partners, guaranteed payments and distributive shares of profits are taxed the
same as ordinary income. The primary difference in tax treatment occurs in a limited partnership
(discussed below), where the limited partners' earnings are not generally considered selfemployment income subject to withholding unless the income is a guaranteed payment.
Legal Requirements
A partnership may legally be formed simply on the basis of an oral agreement between two or
more parties. However, such an arrangement is risky since an oral agreement is nearly impossible
to prove if there is a dispute about it later. Therefore, although there is generally no legal requirement to do so, most partnerships are based upon a written contract called the articles of
partnership. Properly prepared by an attorney, the articles of partnership should very specifically set forth factual data about the business, such as the following:

Name, nature and location of the business.

Partners' names and amounts invested in the partnership.

Each partner's responsibilities for operating the business.

How business expenses, profits and losses will be share among the partners.

Amount of earnings, if any, each partner will take from the business and at what intervals.

Duration of the partnership and how it may be dissolved.
While the articles of partnership may be prepared and signed informally by the partners, it is
usually wise to use the services of an attorney who is experienced in drawing up such agreements.
Many states require partnerships to register with or otherwise notify certain state and/or local
officials that a new partnership has been formed. Sometimes this requirement depends on
whether the business is a general or a limited partnership.
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General Partnership
A partnership formed to operate a typical retail clothing store, a neighborhood restaurant, a
consulting service, or an independent pharmacy, to name just a few examples, is most likely to be
a general partnership. General partners are those who may obligate the business to perform certain actions, incur debt, and otherwise make decisions about how the business operates decisions
that require the business to perform even if only one general partner makes the decision on behalf
of the business. This is known as joint and several liabilities.
Let's use a retail clothing store as an example, with Creighton and LaVelle as the general partners. Without getting LaVelle's formal agreement, Creighton enters into a contract to purchase
inventory from HKB Manufacturing Company, thus obligating the clothing store to pay for the
HKB items. Creighton could not then claim that, because LaVelle did not join Creighton in ordering the inventory, the agreement with HKB is not valid. The fact that Creighton, as a general
partner, executed a contract on behalf of the partnership to purchase the inventory obligates the
business to fulfill the contract with HKB. Likewise, LaVelle could act on behalf of the partnership without Creighton's approval or knowledge, incurring obligations the partnership must fulfill. The principle of joint and several liabilities gives creditors the right to bring suit against all
partners jointly, as a group, or against each partner severally, or separately.
Limited Partnership
A business venture may instead, be formed as a limited partnership, which must include at
least one general partner and one or more limited partners. The general partner (or partners) can
be considered most responsible for what happens in the business because only general partners
may be active in managing the business. Limited partners provide investment money and share in
the business earnings, but are prohibited from actively engaging in the business operations. Doing so changes the nature of the business from a limited partnership to a general partnership,
which has different legal and tax consequences to the partners. A limited partnership is often
used instead of a general partnership when a general partner needs investment capital, but does
not want to have working partners.
Likewise, limited partners enter into such an arrangement because they have money to invest
and see the partnership as a growth instrument, rather than as a business they want to participate
in. In the heyday of tax shelter investments, limited partnerships burgeoned in industries ranging
from real estate ventures to oil drilling to cattle breeding. Tax law changes in 1986 eliminated
some of the most alluring features of such arrangements, many of which offered significant tax
breaks for investors. However, the limited partnership concept continues to provide attractive
investment opportunities.
General and limited partnerships share some of the same advantages and disadvantages, while
each arrangement also has unique positives and negatives to consider.
Positive Aspects of a Partnership
The Simple Start-Up
A partnership can be nearly as simple to form as a sole proprietorship. In some states, counties
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or cities, formal registration may be required, but that is generally no more complicated than for a
proprietorship. Partners may even choose to forgo the formal written articles of partnership, but
as indicated earlier, a contract prepared with the advice of an attorney is recommended. Some
government authorities impose special requirements on limited partnerships. Limited partners,
especially, are advised to have a written contract since they are not active in the business and
have no authority to decide how the business will be operated.
Sharing of Monetary and Management Burdens
While operating a business solo has some appealing features, a sole proprietor also must
bear the money and management burdens alone. A partnership, on the other hand, spreads the
burdens among two or more people. As a result, more capital may be available to start the business and to prop it up when earnings lag. Having more partners may also increase the likelihood
of diverse skills and knowledge and greater potential for success. Whereas a proprietor must be
all things to the business, a partner with sales talent but minimal accounting skills, for example,
can turn the accounting details over to another partner.
Limited Partners Limited Liability
Under a limited partnership, the limited partners have limited liability. Legally, a limited partner's liability for any type of debt is no more than the amount of his or her investment in the
business. When we look at the negatives, you'll see this is not the case for the general partner.
Tax Advantages
The partnership's earnings are taxed only as personal income to the partners. No separate income tax is due from the partnership entity. As is true for proprietorships, the 1993 tax law influences whether this is viewed as an advantage or a disadvantage, based upon the level of taxable
income.
Because the partnership is a conduit, each partner's taxable income may be offset by his or her
share of any business losses. While this can be advantageous, there is a limit on the amount of
loss that may be claimed. The maximum is the amount the individual invested plus any additional amounts for which the partner is “at risk.” Amounts at risk refer to any amounts the partner
could lose. For example, if the partnership has outstanding debt of $10,000 for which each of two
partners have 50% liability, an individual partner is at risk for $5,000 plus the amount invested in
the business. If losses are greater than the total amount at risk, no more than that total may be
used to offset income in anyone a tax year. However, the remainder of a loss may be carried over
for income reduction the next year and following years if necessary. In a limited partnership, other restrictions apply to loss deductibility as we'll discuss under tax disadvantages.
Like proprietorships, partnerships may establish qualified retirement plans for themselves and
their employees, resulting in tax-deductible contributions and tax deferral on plan earnings.
However, partnerships, like sole proprietorships, are subject to the 1993 tax law changes that
reduced the amount of compensation that may be considered for deduction purposes.
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The Simple Dissolution
When all partners agree to dissolve the business, dissolutions can be as simple as for a proprietorship. There are no tax consequences to the partnership entity since any income or loss resulting from the dissolution flows through to the partners. On the other hand, if one partner wants
out of the business and others want to continue the business, dissolution is not so simple. Under
tax disadvantages, we'll discuss why this can be a problem.
NEGATIVE ASPECTS OF A PARTNERSHIP
Unlimited Liability for General Partners
Under a general partnership, every general partner is responsible for all of the partnership's obligations. This means general partners have unlimited liability for claims against the business,
just as is true for proprietorships. So, while a benefit of being a limited partner is having limited
liability, the general partners have no such protection and are liable jointly and severally as described earlier.
Lack of Control by Limited Partners
Remember that limited partners are forbidden to participate in the management of the partnership. As a result, limited partners have no control over how the business is operated. For some
people this is a disadvantage because limited partners may disagree with how the business is
managed, but legally they may not become involved even if they could do a better job than the
general partners.
Financial Stability
A partnership may be more financially stable than a proprietorship because additional people
can provide more capital and capital-raising abilities. However, the partnership is really only as
solid as the partners. The personal worth or wealth of each partner often limits the partnership's
ability to obtain financing or additional capital to help the business.
Investment Withdrawal
While it is relatively easy to put money into a partnership, it is much more difficult to withdraw
any part of the investment without causing tax consequences or affecting the financial underpinnings of the partnership. Loans or other means of withdrawing funds from a partnership, while
legally permissible, can be considered taxable transactions. This is different from a sole proprietorship, where the proprietor and his or her business are considered one and the same, allowing
the proprietor to invest in and withdraw personal funds from the business at will.
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Tax Disadvantages
Under tax advantages, we said that each partner's taxable income maybe offset by a share of
any business losses. The disadvantage for a partnership is that such losses are deductible only up
to each partner's amount at risk, though excess losses carry over to other tax years. This is in contrast to a sole proprietorship, for which no limit is imposed on the amount of losses used to offset
income.
Additionally, under a limited partnership where limited partners do not participate in the business, losses are considered "passive" for the limited partners because losses result from a business in which the limited partners do not actively work. Likewise, income for the limited partners
is considered passive. The tax code allows passive losses to be deductible only against passive
income. Thus, a passive loss may not be used to offset the limited partner's other income, such
as earnings from the individual's employment. The tax code concerning what qualifies as passive
income and loss is considerably more detailed than the information provided here, which gives
you just a general idea of how passive income and losses affect taxpayers.
Just as was true for proprietorships, the marginal tax rate at which any partner's income is
taxed may be either an advantage or a disadvantage, depending on the person’s total taxable income.
Income that general partners receive from the partnership is considered self-employment income subject to withholding taxes. We said earlier, though, that such income is not selfemployment income for limited partners', so taxes are not withheld from limited partners' earnings unless any limited partner receives guaranteed payments for services actually performed.
Guaranteed payments are considered to be self-employment income subject to withholding. Of
course, all income must be reported by the limited partners and, whether or not subject to withholding at the time of payment, the income is taxable along with all other ordinary income.
Partners who provide and pay for certain fringe benefits for their employees may deduct any
such payments from the partnership income. However, like sole proprietors, partners may not
deduct any such payments made to provide benefits for themselves except for the 25% health insurance premium deduction discussed earlier.
Involuntary dissolution of the business has negative tax effects. By law, a partnership must be
dissolved when one of the principals leaves the partnership under most circumstances, even if the
remaining partners want to continue in business. Thus, the partnership suffers involuntary dissolution from the standpoint of the remaining partners. On the other hand, if all partners elect to
discontinue the partnership, the dissolution is voluntary. When a partner is removed from the
picture voluntarily or by death we'll discuss at length in a later chapter-the partnership legally
ceases to exist. An exception is the death of a limited partner, which does not generally terminate
the partnership.
For general partnerships, involuntary dissolution means a new partnership must be formed if
the business is to continue with different partners, resulting in the creation of a new tax year with
new tax consequences. The law requires that, if 50% or more of a partnership interest is transferred to a new partner within any 12-month period, the partnership is legally terminated. This
triggers a number of tax consequences concerning depreciation, tax elections and other factors,
essentially causing the partners to start over for tax purposes as if a completely new business had
been formed. For example, the tax year ends at dissolution. Even if the business continues to
16
operate with some of the same owners, the remaining partners must include in their individual
tax returns the income from two partnership tax years. Tax regulations may also require additional taxation when the partnership's tax year is different from the individual partners' tax years.
While it's beyond the scope of this text to discuss the details of the scenario mentioned above,
termination of the partnership in the eyes of the law is something to be avoided when some partners want the business to continue because the tax consequences can be severe. In another chapter you'll see how life insurance can help a partnership avoid legal termination when a partner
dies. Briefly, life insurance can fund an agreement, made in advance of death, legally avoiding
the partnership dissolution that would otherwise occur under law.
OTHER FORMS OF PARTNERSHIPS
In this section, we'll briefly review several other ”partnership” forms of business ownership.
This general knowledge has informational value for you even though you are not likely to prospect these partnership arrangements specifically to provide the types of insurance we'll discuss
later in the text.
Publicly Traded Partnership
A potentially more complex form of ownership is a publicly traded partnership, sometimes
called a master limited partnership. The tax code defines a publicly traded partnership as one
whose interests are either:
Traded on an established securities exchange or market or readily tradable on a secondary market (or the equivalent of such a market where liquidity is readily accessible).
Historically, the primary benefit of this type of partnership has been that the partnership acts as
a conduit for income and avoids the separate taxation corporations are subject to, while enjoying
limited liability, an "unlimited" life that doesn't stop if a partner leaves, and easy transferability of
ownership-the latter two features generally benefitting corporations rather than partnerships.
However, the tax code requires that any business enterprise displaying many characteristics of
a corporation will be taxed as if it were a corporation no matter what it calls itself. The type of
taxation that applies depends on whether an organization has several of the corporate characteristics defined in federal tax regulations. Here are the characteristics the tax regulations describe:

Business associates (as opposed to one owner).

Profit-making purpose.

Centralized management.

Limited liability.

Unlimited life (the business continues even when an owner leaves the business).

Easy transferability of ownership (such as that achieved by trading on a securities
market).
Most of these features can be avoided by all partnerships, including publicly traded partnerships. However, a 1987 change in the tax law requires that all new publicly traded partnerships
be taxed as corporations after that year unless 90% of the company's income is passive. Passive
income results from business activities in which the taxpayer does not "materially participate.”
Material participation is defined in considerable detail, but in general means the taxpayer is ac-
17
tively involved in the day-to-day business operations that result in income production. Common
examples of passive income include income taxpayers receive from investments in mutual funds
or certificates of deposit. Partnerships that were already in existence when the 1987 law was enacted received a ten-year grace period, which means corporate taxation for those partnerships begins for tax years after 1997.
Note, however, that most other types of limited partnerships, as discussed in the previous section, are treated as partnerships, largely because of legal battles that resulted in adoption by most
states of both the Uniform Partnership Act and the Uniform Limited Partnership Act. These state
laws are written to require federal tax treatment of most limited partnerships as partnerships rather than as corporations.
Joint Ventures and Other Forms
As indicated earlier, the Uniform Partnership Act defines what constitutes a partnership. In addition to the forms we've discussed, the definition also includes joint ventures and other unincorporated organizations. A joint venture may appear to be just another partnership. However,
joint ventures differ in that they are formed only to fulfill a specific purpose. As soon as the purpose is accomplished, the venture is dissolved. This differs from a more typical partnership that
is formed for an ongoing business purpose, such as to operate a chain of supermarkets. For example, an architect and a builder might enter into a joint venture to create a new museum. During
the life of the joint venture, the two enjoy the tax benefits of a partnership. When the museum is
completed, the architect and the builder dissolve the venture and each of these independent business people goes his or her separate way rather than continuing in business together.
Various types of unincorporated organizations might receive partnership treatment. Examples include groups of people or businesses that might pool their resources and work together to
earn income in a certain enterprise only, but who have different jobs or businesses that provide a
more steady flow of income. Sometimes business entities form a syndicate, using their combined
wealth and or leadership skills and clout to accomplish a specific purpose. There are a variety of
means to organize and receive the tax benefits of a partnership, but unincorporated businesses
must be careful to avoid taking on too many characteristics of a corporation, as discussed previously, or they will be taxed as corporations.
Chapter 1 Review Questions
1. Because income from a proprietorship "flows through" the business to the proprietor for tax
purposes, this form of business ownership is sometimes referred to as:
A. a limited venture.
B. an income conduit.
C. a syndicate.
D. a top evasion organization.
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2.
By definition, a sole proprietorship is a business that has:
A. two or more employees.
B. only one owner.
C. limited credit.
D. less than 1000 shares outstanding.
3. As a result of OBRA ’93 ________ earning significant incomes are subject to a _______
marginal tax rate.
A. sole proprietorship, higher
B. partnerships, lower
C. corporates, higher
D. corporates, lower
4. Life insurance premiums paid by a sole proprietor on his/ her life are
A. tax deductible.
B. tax deductible if the policy is “whole life.”
C. not tax deductible.
D. tax deductible up to 3% of the proprietor’s total income.
5. “An association of two or more persons to carry on a business for profit as co-owners” is a
A. sole proprietorship.
B. close corporation.
C. syndicate.
D. partnership.
6. The value of money or property a partner contributes to a partnership is the partner’s:
A. passive income.
B. guaranteed payments.
C. basis.
D. down payment.
7. A partnership may
A. be formed by an oral agreement or a written contract.
B. be formed by a written contract only.
C. not be formed by a husband and wife.
D. only be formed by filing the “articles of partnership” with the Secretary of State.
8. The fact the Partner X may incur legally enforceable obligations on behalf of the partnership
and all other partners is known as:
A. unlimited liability.
B. joint and several liability.
C. limited liability.
D. discretionary liability.
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9. What type of partnership arrangement provides limited liability for some partners?
A. general partnership.
B. cash basis partnership.
C. joint venture.
D. limited partnership.
10. A partnership’s earnings are taxed
A. to the partnership and the partners.
B. to the partnership only.
C. only as personal income to the partners.
D. at a higher rate than the partners other income.
ANSWERS
1B 2B 3A 4C 5D 6C 7A 8B 9D 10C
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CHAPTER TWO- CORPORATIONS
Although only 19% of U.S. businesses are incorporated, corporations play a significant part in
this country's economy, accounting for about 90% of all sales.
Corporations—in general—will be discussed first, followed by special corporate arrangements,
including S corporations and professional or personal services corporations, and finally, closely
held or "close" corporations, usually the best corporate prospects for business insurance.
C CORPORATIONS
The general federal and state laws and regulations regarding corporations apply to corporations
that are sometimes called regular, ordinary or C corporations, primarily to distinguish them from
the other types. The "C” refers to Subchapter C of the Internal Revenue Code, which governs
how such corporations are taxed, and notice will be taken of some special rules that exist for the
other types—S corporations and professional corporations. .
Who May Form a Corporation
From a legal viewpoint, a corporation is considered an "artificial person," created under the
laws of a state, as contrasted with a "natural person," which is a human being. The law distinguishes between those who form the corporation and the corporation itself, as opposed to proprietors where their businesses are considered one and the same. Furthermore, the life of the corporation is essentially unlimited; that is, it legally survives the departure, by death or otherwise, of
its owners, unlike the other business forms, which normally terminate with the death or departure
of an owner. However, the corporate artificial person may enter into legal transactions, own
property, buy and sell products or services, sue and be sued, and otherwise operate as if it were a
natural person.
Tax regulations required that corporations have certain characteristics:

Business associates (as opposed to one owner).

Profit-making purpose.

Centralized management.

Limited liability.

Unlimited life (the business continues even when an owner leaves the business).

Easy transferability of ownership (such as trading on a securities market).
Generally, any number of individuals may join together to form a regular corporation. Some
states require a minimum number of owners-often three, but no maximum applies to C corporations.
Owners of a corporation formed for profit (rather than nonprofit corporations) are called
stockholders or shareholders because they own a share of the business, backed up by stock that
entitles them to a portion of the business profits. Corporate stock may be bought and sold in the
open market, which means percentages of ownership may change.
INCORPORATING
Because state laws govern how a corporation may be formed, the requirements may differ
slightly from state to state. In fact, business owners often investigate various state laws carefully
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to determine whether incorporation is advantageous in a particular state and how state and local
corporate taxation will affect the business. The general rules for incorporation are fairly uniform
however, as highlighted in the next paragraphs.
Each state requires the owners to apply for a charter, which authorizes the formation of a corporation. This includes the preparation-usually by an attorney, and filing of articles of incorporation, a document that typically includes:

Name, location and mailing address of the business.

Purpose for which the business is being organized.

Period for which the corporation is intended to exist (which can be indefinite).

Initial amount of capital being invested in the business.

Number of shares of each type of stock the corporation intends to issue.

Voting rights and other regulations or restrictions concerning each type of stock.
In some cases, the articles of incorporation list the board of directors: in other cases, the board
is elected after the charter has been approved. The board of directors is a group of people selected by the shareholders to perform oversight functions: to elect the officers of the corporation: and
to decide who will manage the day-to-day business affairs. Many states require the owners to
develop corporate bylaws. In addition, the corporation must maintain and report certain information to the state and provide annual reports to shareholders. A corporation operating in more
than one state typically must post bond and acquire a certificate of authority from states other
than the one where it was chartered. Many of these requirements call for professional assistance
from attorneys and/or accountants
Income Tax Consequences
Unlike the other forms of business ownership, a C corporation does not act as a conduit for income, funneling earnings directly to owners and bypassing the business entity. Instead, corporations are subject to double taxation because income taxes are assessed against both the C Corporation and the shareholders.
Shareholder earnings, called dividends, are reported as dividend income on the individual
shareholders' income tax returns. In addition since individual shareholders may be employees of
the corporation, they must pay individual taxes on any wages as well. Under corporate ownership, however, wages paid to owner-employees are not considered self-employment income, but
are instead treated as employee salaries.
Corporate income paid out of profits as dividends to shareholders is not tax deductible for the
corporation, resulting in the double taxation of dividend amounts as income for both the corporation and the shareholder. A corporation attempts to reduce its taxable income as much as possible
by taking all deductions allowed, such as salaries and bonuses paid, business expenses and anything else the law allows. This is important for businesses earning less than $10 million since
corporate income tax rates for these businesses are graduated according to income levels, as is
the case for tax rates that apply to individual taxpayers.
Furthermore, Uncle Sam so likes the idea of double taxation on dividends that corporations attempting to retain too much income, rather than paying it out in dividends, are subject to a penalty called the accumulated earnings tax. This tax can be quite important and is discussed in
more detail at the end of this chapter as it affects different corporate forms differently.
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Are Distributions Dividends or Return of Capital?
Corporate earnings distributed to shareholders are dividends, upon which shareholders are
taxed. A dividend is taxed as a return on the shareholder's investment, representing money the
corporation pays the shareholder for allowing the business to use the shareholder's funds. It is
important to distinguish dividend distributions from distributions that represent a return of capital to the shareholder because a dividend is taxed, while return of capital is not taxed up to the
extent of the individual shareholder's capital investment or basis. And, if a return of capital exceeds the basis, the excess is taxed differently from dividends.
From the shareholder's perspective, a return of capital means shareholder receives, from the
corporation, all or part of the investment dollars (capital) the shareholder invested in the corporation. For example, suppose Carolyn Jones invested $15,000 in a small business known as Allenby Corporation, which is operated by two of Carolyn's friends. Several years later Carolyn wants
to sell her shares. Allenby agrees to buy the shares rather than have Carolyn sell them to an outsider. Because Allenby’s stock is now worth more than when Carolyn purchased her shares, Allenby buys her stock for $18,000. Of which $5,000 represents a return of capital to Carolyn. Assuming Carolyn's basis remains at $15,000. She pays no tax on the first $15,000 paid for her
shares: instead only the additional $3,000 is taxable income for Carolyn. The corporation itself is
also subject to additional tax rules when a distribution is a return of capital to investors rather
than a dividend. The specific details of how various types of distributions are taxed are beyond
the scope of this text.
S CORPORATIONS
Recognizing that some smaller businesses might want to take advantage of incorporation, but
could suffer from the double taxation, Congress provided legislation that permits special treatment of certain small corporations. These are called S corporations after Subchapter S of the Internal Revenue Code, which regulates such businesses.
Income Tax Consequences
As a result of this special part of the tax code, federal taxation of qualifying corporations is
more similar to partnership taxation than to C Corporation taxation since the S Corporation also
funnels income through the corporation to the shareholders.
For an S corporation, there is no double taxation, such as that assessed against regular corporations. Likewise, because all income passes through to the shareholders, S corporations avoid the
potential for paying the accumulated earnings penalty tax described previously.
Aside from federal taxation, S corporations are generally subject to the same regulations as
other corporations, plus additional limitations as discussed in the next several paragraphs.
S Corporation Eligibility
Eligibility to elect S Corporation status is limited to small business corporations, identified as
those meeting the following requirements:
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1. The corporation is domestic, which means it was incorporated in the United States.
2. Shareholders must be either individual citizens or resident aliens of the U.S. or estates or
specified types of trusts; no shareholder may be a nonresident alien, another corporation or
a partnership. Certain types of trusts are prohibited from ownership. The corporation may
not be part of an affiliated group, defined as one where at least 80% of the stock of each affiliated company is owned by other members of the same affiliated group. For example, when
a parent corporation owns a subsidiary corporation, both are considered part of an affiliated
group. Neither, therefore, could elect to be taxed as an S corporation. Other prohibited corporations are financial institutions, insurance companies and a few others specified in the
code.
3. The corporation may have a maximum of 100 shareholders. A wife and husband are considered to be one shareholder whether they file taxes separately or jointly. Other non-spousal
couples owning stock together are considered individual shareholders. More complex rules
apply in counting a trust's shareholders.
Only one class of stock is permitted. This rule is met if all shareholders that own outstanding
stock have the same distribution and liquidation rights. Differences in amounts of profit distributions or in how shareholders would share in liquidation proceeds constitute a different class of
stock. However, differences in voting rights are permitted without constituting another class of
stock. In other words, shareholders that control and/or operate the actual business may have different voting rights from other shareholders and still remain within the limits of one class of
stock.
Notice that "small" business eligibility has nothing to do with the corporation's volume of business; instead, "small" refers only to the number of shareholders. A three-person corporation that
generates $100 million dollars of business technically could qualify for S Corporation statusalthough such an arrangements highly unlikely.
The Slippery Slope of S Corporations
The benefits versus the limitations of electing S corporation taxation can be difficult to sort out,
especially when the business begins to generate significant income. In the past, S corporations
were often formed by business owners who expected the business to produce losses, rather than
gains, in early years. When a business begins to generate significant income and resulting profits,
the tax consequences become more complicated in terms of how profits and losses are distributed. The resulting taxation of individual share holders, is the amount of earnings that may be retained by the corporation, and numerous other tax considerations.
Thus, each owner must consider his or her own individual tax rates since S corporation profits
that are paid as dividends will be reported along with any other ordinary income for the tax year.
And, the corporation's rate has also been increased for taxable income above certain limits. All of
these considerations must be factored in when deciding whether S corporation treatment is advisable.
Finally, in conferring special tax treatment to S corporations, Congress attached a number of
complex regulations even more complex than regular corporation rules. For example, suppose
the S corporation fails, even temporarily, to meet one of the requirements discussed earlier, such
as having no more than 35 stockholders. This could happen inadvertently if husband and wife
stockholders, who are considered to be a single stockholder for counting purposes, are divorced.
24
The divorce causes each person to be considered a separate stockholder. If the corporation had
exactly 35 stockholders before the divorce, it now has 36 stockholders, exceeding the maximum,
which results in immediate termination of the S corporation status and reversion of the business
to a regular corporation. This, in turn, causes the end of the S corporation's tax year and possible
taxation that would not otherwise occur. A new tax year for the regular corporation starts immediately, with additional tax consequences, not the least of which is the owners are forced to deal
with two short tax years. While operating as an S corporation has some advantages, eligible corporate owners must consult with their legal and tax experts in order to consider all issues that
might affect their particular business and their personal tax situations before electing S status.
Recent Changes to S Corporation Tax Laws
Shareholders of S-corporation stock must file the K-1 form with the IRS and given to the
shareholders by the corporation so that shareholders can see their share of the company's income,
deductions and pass-through tax credits. S-corporations file the IRS 1120S income tax return,
although many S-corporations do not pay any income taxes.
The S-corporation is a pass-through tax entity as its income passes through to its shareholders
in proportion to their stock holdings. While taxable income is reported to a shareholder, and
listed as income on the shareholder's personal tax return, the shareholder may not actually receive
any income as the corporation may elect to retain its earnings—in which case, the income is
called "phantom income."
Other tax changes allow the capitalization and amortizing of organizational and start up costs.
Starting 2004, companies with under $50,000 in start-up costs can elected to deduct up to $5,000
in business start-up costs the year the business begins operation.
Also, the maximum number of shareholders was increased in 2004 from 75 to 100.
Originally, the S-corporation 2was designed to allow small business owners who operated as
sole proprietors to gain the limited liability protection of corporation status with a pass-through
system; however, the limited-liability company (LLC) is also serving that role.
Closely Held or Close Corporations
A characterization you're likely to hear in relation to both C and S corporations is "closely
held" or "close" corporations. This term does not refer to a separate type of corporation, but
simply means that the stock is "held closely," typically by a small group of stockholders, and is
not publicly traded on the stock market. Closely held corporations are often family-owned businesses or other small businesses where just a few people are the major stockholders. Often as few
as one or two people own most of the stock and control the business and these same shareholders
usually take an active role in both the management and the day-to-day operations.
While many smaller closely held corporations are S corporations, they need not be. Whether a
closely held corporation elects S status or chooses to operate as a regular corporation generally
depends on how favorable the tax situation is at any given time and whether or not the corporation can meet the eligibility requirements.
Smaller close corporations are of special interest to insurance agents because the owners are often more accessible than the owners or managers of large public corporations. In addition, many
smaller corporations are not yet adequately protected for the many potential business insurance
needs we'll be discussing in this text - needs that can adversely affect small businesses that fail to
provide for them.
25
Professional or Personal Service Corporations
Some closely held corporations are professional or personal service corporations, which essentially are sub-types of either S or C corporations for taxing purposes. The law defines such
corporations as those in which:

Substantially all of the activities involve performing services in the fields of health,
law, engineering, architecture, accounting, actuarial science, the performing arts, or
consulting and

Services are substantially performed by employee-owners and

Substantially all of the stock is owned by active employees, retired employees or the
estates of such employees who have died.
POSITIVE ASPECTS OF A CORPORATION
Limited Liability
Because a corporation is considered to be a separate "person" from its owners, shareholders enjoy limited liability for debts and other business liabilities. The shareholders' personal assets are
not generally at risk as they are under sole proprietorships and general partnerships. If the business is forced to liquidate, perhaps because of bankruptcy, each shareholder's loss is limited to
the amount invested.
This is the theory. In reality, however, small business owners, especially, might find they must
make personal guarantees simply to begin or stay in business, even if they are incorporated. For
example, if a small corporation needs to borrow money, the lending institution might require personal guarantees of repayment from the owners. In this case, liability for debt repayment extends
beyond the corporation to the individuals. Notice this unlimited liability exists only for debts the
owners personally guarantee not all business debts.
Separate Legal Entity
While a corporation's status as a separate legal entity has both positive and negative aspects,
an important positive aspect of regular corporations is that certain fringe benefits paid for owners
who are also employees are tax deductible to the corporation. Included are fringe benefits such as
life, disability and medical insurance. Remember that for other forms of business ownership,
owners may deduct costs of such fringe benefits paid for non-owner employees only. Unfortunately, there is a severe restriction on this deduction for S corporations. Fringe benefits are deductible only when paid for S corporation shareholders who own two percent or less of the business.
In addition, as a separate entity, a corporation may pay owner/ employees salaries, just as any
other employee is paid. Salaries then become a business expense for the corporation and owners
are not subject to self-employment income tax reporting since the corporation has already withheld the appropriate taxes.
Greater Financial Stability
Incorporation does not guarantee greater financial stability, but theoretically, access to more
capital is available to corporations. First of all, there are no limits on the number of owners who
26
may invest in a C corporation, which means capital can be raised from numerous sources if necessary. Even with S corporation election, which is limited to 35 shareholders, significantly more
capital may be available than for other types of ownership.
Furthermore, corporations may issues more shares of stock anytime after the initial offering in
order to raise additional capital through more investment in the business. This option is not
available to proprietors and partners, who may, of course, seek additional investment income
from others, but who have no stock to offer in return.
Another benefit of corporate stock is that shareholders are free to sell the stock they hold at
whatever price they and the buyers agree upon, potentially attracting more shareholders and more
investment in the business.
Qualified Retirement Plans
The original federal tax breaks for qualified retirement plans were designed with corporations
in mind. Today proprietors and partners have access to many of the same benefits, subject to limits described in Chapter One. For corporations, tax-deductible contributions on behalf of employees are readily available and employees, of course, enjoy tax deferral on earnings. And, unlike
proprietorships and partnerships, regular or C corporations may pay and deduct contributions for
owner/employees as well. Remember, however, that S corporations may do so only for two percent or less owners. The reduced maximum income that may be considered for retirement plan
contributions, imposed by OBRA '93 and discussed in Chapter One, applies to corporate contributions as well.
Unlimited Life
You've learned that proprietorships and partnerships dissolve when one of the principals is removed from the business. A corporation, on the other hand, has an unlimited life in most cases,
subject to some differences in state laws. Therefore, any one shareholder may completely liquidate (sell) his or her stock without causing an interruption in or termination of the corporation.
However, the indefinite life of a corporation also means it can be difficult for the shareholders to
go out of business if they desire, as discussed under negative aspects on the following pages.
S Corporation Losses Are Currently Deductible
A corporate benefit that applies only to S corporations, not C corporations, is that business
losses are currently deductible from the owners' individual income taxes, subject to certain limitations. This occurs because the S election causes income, gains, losses, etc., to pass through the
corporation directly to the shareholders, subject to taxation like a partnership. The ability to deduct losses currently is a significant tax benefit for businesses that expect to lose money in the
early years of operation.
NEGATIVE ASPECTS OF A CORPORATION
Complex and Costly Start-Up
Organizing and launching a corporation can be complex and costly, typically requiring legal
assistance to ensure compliance with state laws governing incorporation. Because state laws vary,
business owners generally want to gather information about the incorporation process in order to
decide whether or not to incorporate at all and, if so, which state offers the best business envi-
27
ronment. This research can be costly in terms of both time spent and actual expenses incurred.
Preparation of the articles of incorporation, meeting any special state requirements, and other expenses associated with filing for a state charter contributes to the cost and complexity.
State Taxes and Fees
In many states, corporations are subject to state income tax rules that do not apply to other
forms of business ownership. Some states require corporations to pay other taxes not assessed
against unincorporated businesses, as well as fees to gain a charter and/or to continue operating
in the state.
Double Federal Taxation on C Corporations
As stated earlier, C corporations are subject to double federal taxation. Shareholders who receive dividends from the corporation must pay federal income taxes and the corporate entity also
pays taxes on its profits. S corporations avoid the double taxation, but not every corporation is
eligible for S status.
Since most insurance solutions are targeted primarily toward closely held corporations, you
should know that, even under C status, close corporations rarely pay dividends. Instead, any
profits not required to operate the business are generally paid out as salaries or bonuses. Thus,
double taxation on dividends is avoided and the corporation may deduct these amounts as business expenses.
C Corporation Losses Must Offset Corporate Income
While S corporation losses may be deducted from the owner’s current income taxes, C corporation losses must offset corporate income, so they are not currently deductible. This means
that a C corporation experiencing a loss in the first year of operation, for example, must carry the
loss forward to a future year to offset income. Suppose the business has a $2,000 loss the first
year. In the second year, this $2,000 may be used to offset the corporation's taxable income-let's
say it's $10,000-thereby reducing taxable income to $8,000 for that year.
Government Controls
Incorporated businesses are especially subject to both federal and state government controls.
Corporations often must meet reporting requirements not imposed on other types of business.
These requirements mean the corporation must maintain records in a form dictated by the governing agency, provide annual reports, and conform to any other legal requirements related to
corporations.
Centralized Control
While centralized control by professional managers who operate the corporation can be a benefit, it also has a down side. Many shareholders will not be active in the business itself and, therefore, have almost no voice in business decisions. These shareholders can express opinions only
through voting for the board of directors. Some may see this as a disadvantage, especially if they
are not happy with the way the business is being operated.
28
Difficult and Costly Dissolution
If the owners of a corporation decide or are forced to completely terminate the business and
liquidate all assets, they will find that dissolution can be difficult and costly. Corporate liquidation regulations are among the most complex rules of the tax code, affected by such variables as
the type of corporation, whether assets are sold or are distributed to shareholders, when the liquidation occurs, whether assets have appreciated, amounts of gain or loss, amount of each shareholder's basis and numerous other factors. Couple all of these variables, and more, with frequent
changes in tax laws, the lack of clarity in the tax code, and the unpredictability of the IRS in interpreting and issuing rulings on individual cases, and the liquidation to the corporation and its
shareholders. While we cannot discuss the details here, in general both the shareholders and the
corporate entity are subject to taxation when a corporation dissolves. Later you'll learn how insurance products can help avoid the sometime financially devastating results of forced liquidation.
ACCUMULATED EARNINGS TAX
When comparing the limited liability company (LLC) and the corporation, you'll need to be
aware of special tax implications that specifically affect corporations, but not LLCs.
A corporation can accumulate its earnings: Once it pays tax on them at the corporate level, it
need not pay them out as dividends and can thus avoid the second part of the double taxation
scheme. This is true with some caveats.
From 2003 through 2008, the IRS imposes an additional "accumulated earnings" tax of 15 percent (previously set at the highest individual tax rate before enactment of the Jobs and Growth
Tax Relief Act of 2003) on earnings a corporation accumulates above $250,000. The limit is
$150,000 for certain "personal service corporations" (i.e., corporations in the fields of health,
law, engineering, architecture, accounting, actuarial science, performing arts or consulting, where
the owners provide the services – see below for more detail). This tax does not apply to LLCs.
This tax is designed to dissuade corporations from accumulating earnings just to avoid paying
taxable dividends. However, this tax is usually easy to avoid, for three reasons:

Earnings can be reduced to zero, through the withdrawal of earnings in deductible ways
such as higher salaries for the owners.

The corporation can accumulate earnings beyond these limits, provided it can prove it has
a business need to do so, such as payment of anticipated future operating expenses, a
planned business expansion, etc.

The corporation can elect to be treated as a conduit for tax purposes, by making a subchapter S election, which eliminates this problem.
PERSONAL HOLDING COMPANY TAX
A personal holding company is a regular "C" corporation that derives 60 percent or more of its
earnings through passive income (interest, dividends, rents, royalties, etc.), where more than 50
percent of the value of the stock is owned by five or fewer individuals. In 2003 through 2008,
the personal holding company tax rate is 15 percent of the corporation's undistributed earnings
(per the Jobs and Growth Tax Relief Reconciliation Act of 2003), and is in addition to the regular corporate income tax. The tax does not apply to LLCs.
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The tax is extremely complicated due to its many exceptions. In practice, the tax will not usually apply to small business owners. While the typical small business may be owned by five or
fewer individuals, in most cases its income will not be passive, or will fall within some of the
exceptions.
However, in an arrangement where a holding company and an operating company are used, the
tax may very well apply to the holding company unless a consolidated tax return is filed. That
consolidated return opens its own set of complications and complexities.
This tax can be avoided by making a subchapter S election, since S corporations are not subject to the tax. Once again, however, with an LLC you don't have to worry about dealing with
this tax, or avoiding it.
Professional Service Corporation
A professional service corporation is a designation created by law. Professionals in the fields
of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting (where the owners provide the services) may elect this business form.
The professional service corporation has to pay a flat tax of 35 percent on its earnings, rather
than using the progressive rate structure that normally applies to corporations. The result will be
higher taxes.
This tax scheme can be avoided by making the subchapter S election.
Both individual and corporate tax rates start at 10 or 15 percent and approach a top rate of nearly 40 percent, although the levels of income that are subject to each rate vary in each tax schedule. Whether your taxes on a given level of income would be lower in the LLC at the individual
rates or in the corporation at the corporate rates will depend on a number of factors, including
your filing status, personal and dependency exemptions, and your other sources of income.
Of course, when earnings are being distributed by the corporation as a deductible salary to the
business owner, the corporate earnings will be reduced to zero and, instead, taxed at the individual level anyway. This is a likely scenario in the small business corporation, as the owner seeks
to avoid double taxation of dividends. If the earnings are distributed in a non-tax-deductible way
(i.e., through the payment of dividends), the owner will experience the problem of double taxation of dividends.
Chapter 2 Review Questions
1. Corporations are organized under the laws of and must be chartered by the
A. federal government.
B. state.
C. state & federal government.
D. New York Stock Exchange.
2. Corporate dividends are
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A.
B.
C.
D.
tax deductible by the corporate.
taxed to the shareholder.
taxed to the corporate directors.
received tax free.
3. Corporations that retain what the government considers excessive income, rather than paying
the income out as shareholder dividends, are in danger of being assessed
A. offset income tax.
B. S corporate tax.
C. undistributed dividend tax.
D. accumulated earning tax.
4. Individual corporate owners are subject to what type of liability insofar as the corporation's
debts and liabilities are concerned?
A. limited.
B. unlimited.
C. no liability.
D. vicarious liability.
5. What type of corporation is not subject to double taxation?
A. C Corporations.
B. closely held corporations.
C. professional corporations.
D. S Corporations.
6. For S Corporation eligibility all of the following are required EXCEPT
A. a maximum of 35 shareholders.
B. the corporation is incorporated in the United States.
C. only one type of stock.
D. a shareholder may be another corporation.
7. In a Personal Service Corporation
A. the stock is usually traded on the NYS Exchange.
B. services are performed by employee owners.
C. all employees must be shareholders.
D. the stockholders are personally responsible for the debts of the corporation.
8. Shares of a closely held corporation
A. may be bought and sold.
B. are usually traded publicly on a national exchange.
C. cannot be transferred by will.
D. cannot exceed $50.00 in value.
9. When a shareholder of a corporation dies the
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A.
B.
C.
D.
corporation is dissolved.
spouse automatically becomes the new shareholder.
corporation continues in business.
remaining shareholders decide what happens to the deceased shareholders interest.
10. With a Corporation, corporate earnings are ________, and the shareholders that receive
dividends from the corporation are _______.
A. taxed, taxed.
B. deductible, taxed.
C. deductible, not taxed.
D. taxed, not taxed.
ANSWERS
1B 2B 3D 4A 5D 6D 7B 8A 9C 10A
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CHAPTER THREE - BUSINESS CONTINUATION INSURANCE
INTRODUCTION
One of the most pressing problems that business insurance can solve occurs when a business
owner dies. Careful planning that includes business continuation insurance can counteract the
negative financial consequences that result when no plan exists to address what will occur after
an owner dies. Because different forms of business ownership result in different consequences at
an owner’s death, sole proprietorships, partnerships and closely held C or S corporations will be
primarily discussed in this section.
An Owner Dies
When a business owner dies, one of three basic consequences results:
1.
The business is dissolved;
2.
The business owner’s heirs take the place of the deceased in the business, operating
either as a new proprietorship, partnership or corporate stockholder, or under a different form of ownership; or
3.
The business owner’s heirs sell the deceased person’s business interest.
The desirability and viability of each option depend on a number of factors, not the least of
which are the financial obligations Uncle Sam and the individual states extract.
CASH NEEDS
Final Expenses
Money is needed to cover the final expenses associated with death. Include are funeral and
burial costs, such as funeral home fees, casket or crematorium expenses, burial plot and others.
Final expenses also include any other costs that are directly related to the death. For example,
depending on the circumstances of death, the family might be liable for uninsured medical expenses, such as hospital and physician charges.
Furthermore, death often is the catalyst for creditors to seek immediate payment of outstanding
debts that would otherwise continue to be paid out of the business owner’s ongoing income from
the business.
Administering the Individual’s Estate
Death also creates the need for funds to pay expenses associated with administering the estate
of the deceased person. An individual’s estate consists of all real estate and personal property,
including money and other financial instruments, that the person owned while living and other
financial instruments, that the person owned while with administering an estate include legal
fees, debt payment, federal estate taxes and any state mandated death taxes. In addition, the person who actually administers the estate—the executor or administrator—usually is entitled to receive a fee for his or her work as well as to have access to funds that allow the estate to be
closed.
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Executor or Administrator
When an individual who dies has a legally executed will, he or she usually has named a specific person to take charge of finalizing the estate. Such a person, when named in a will, is known
as the executor. If the will does not name an executor or if the individual has not executed a will,
the appropriate court of law names someone to perform the same duties, in which case he is
known as the administrator. The difference between an executor and an administrator is essentially a legal technicality; the duties are the same.
Probate
Another term associated with estate administration is probate. Technically, probate refers to
actions that occur in a court of law in order to determine whether or not a will is valid. However,
in contemporary usage, the term is more often used to refer generally to all activities that occur in
administering an estate, not just those that prove or disprove a will's validity. Therefore, when
you hear that an estate is "in probate," this usually means the executor is carrying out the process
of collecting and liquidating assets, paying debts and taxes, and distributing the remainder of the
estate to heirs in accordance with the will and/or state laws.
Estate Administration Requirements and Problems
State laws usually require the estate executor or administrator to finalize the deceased person's
affairs quickly. The executor must, by law, use whatever assets are available to pay all debts, including those outstanding at the time of death, those incurred for funeral costs and other expenses
associated with the person's death, and taxes owed by the estate itself. Unless the business owner
has planned carefully and provided a financial mechanism for dealing with the business after
death, the estate administrator may have no choice but to liquidate some or all of the business
assets in order to close the estate.
While partial liquidation may be necessary, the result can be a disaster for the heirs. For instance, a small business (especially) may be financially weakened by the death of the owner,
making it difficult or impossible for heirs to continue business operations or to have sufficient
income for day-to-day living expenses. Or, the same circumstances could result in the business
being stripped of significant assets, effectively making it worthless to potential buyers. In either
event, two of the original options available to the heirs upon the death of the owner—continuing
the business and selling the business—may not be viable, leaving dissolution of the business as
the only alternative.
Living Expenses
In addition to the cash needs that arise solely because of the business owner's death, additional
cash is required to cover the normal and ongoing income needs of the survivors? For small
business owners, chances are high that the business provided regular income to pay for everyday
personal living expenses—mortgage and utility payments, groceries, transportation expenses,
schooling, clothing, credit card and installment loan payments, etc. While savings accounts and
income from investments might provide temporarily for everyday needs, the heirs of many smaller businesses may be unable to survive for long periods without the steady income the business
provided by the business.
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Life Insurance Provides the Cash
Cash can be provided quickly by life insurance on the business owner's life providing an immediate source of cash that permits the estate administrator to carry out the legal requirements of
closing an estate in an orderly manner without being forced to deplete business assets. With the
pool of funds life insurance provides, the administrator is in a better position to take care of all
outstanding debts while retaining the value of the business in order to dispose of it in the desired
manner. In many states, the executor is permitted to continue operating the business temporarily
while performing other duties related to estate administration. If life insurance proceeds are
available to allow this action, the business can continue to generate additional income until the
estate is closed.
Thus, instead of facing a forced sale or liquidation in order to meet expenses, the heirs still
have access to all of the original options and can choose from among them on their own terms,
rather than under the pressure of immediate cash needs. Additionally, sufficient life insurance
provides immediate cash for the heirs' needs, from paying for funeral and final expenses to covering everyday living expenses.
Regardless of the outcome desired upon the death of the owner—voluntary dissolution of the
business, continued operation by heirs, or sale of the business to another party—life insurance is
the only guaranteed way to ensure the desired outcome.
The Business Is Dissolved
Especially in the case of a sole proprietorship, where the deceased owner might be the only
family member involved in the business, the heirs may simply wish to dissolve the business and
sell off its assets rather than selling the business itself. Assets could include inventory, furnishings, fixtures, equipment and real estate. When the actual business is not sold, the selling price
does not include the value of intangibles that would accompany the sale of a business. Intangibles include goodwill generated by the previous owner, name recognition, location, marketing
and advertising techniques, customer lists or similar items. In other words, heirs decide to settle
for the value of the tangible assets. There's nothing wrong with disposing of a business in this
fashion if that is what everyone wants. In this case, liquidation of assets may be chosen rather
than occurring because the estate administrator is forced to liquidate to meet estate-closing expenses.
It would be less common for a surviving partner to want to dissolve a business when his or her
partner dies, because the survivor may want to continue in business alone or by taking on new
partners, although there may be sound reasons for a partnership to choose dissolution as well.
The same is true for smaller corporations, especially where the deceased owner was the major
driving force behind the corporation. A "one-person corporation" can operate similarly to a proprietorship (aside from the legal requirements); in which case the death of that person has essentially the same results as the death of a proprietor. In any event, to ensure successful dissolution
of the business, the business owners and heirs must plan in advance how the dissolution will
happen in an orderly and satisfactory way.
The Owner's Will
It is basic business and common sense that everyone should execute a Will. Part of the duties
of a professional agent would be to determine if there is a Will, and if there is not, then strongly
35
recommend they contact a lawyer and prepare a Will immediately.
The more sophisticated your business clients are and the larger the business, the more likely it
is they will have a current Will, but it must never be assumed. Also, Wills that are not prepared
by an attorney are accepted in many states, it's highly recommended that an attorney be involved,
especially when the estate is complex because of the presence of business assets and liabilities
that attract the attention of creditors and taxing authorities. The owner's Will, specifically addressing the desired dissolution of the business at his or her death, can specify:

The executor of the estate.

That an agreement exists between the deceased and any other owners of the business to dissolve the business by selling its assets if one owner dies.

How the executor may dispose of the deceased owner's share of business assets and
what funds (such as life insurance policies) are available to assist the executor in
selling the business interest and closing the estate.

Discretionary powers granted to the executor in order to ensure the best possible
terms of dissolution.

How proceeds of the sold assets will be distributed among the heirs.
These items, of course, deal only with the owner's business interest. The Will would also include any other provisions appropriate for the particular business plus provisions addressing personal assets aside from those of the business.
Life Insurance as the Sharpest Tool in the Box
By using life insurance policies to back up the wishes expressed in the Will, a business owner
can guarantee that cash is available to smooth the way for an orderly transition after death. Made
available to the executor, life insurance proceeds provide the cash to administer and close the estate without tapping into and depleting business assets that could be sold.
For the heirs, life insurance provides cash for new and ongoing expenses plus the ability to
avoid forced liquidation of business assets and to delay the sale until they are in a position to receive the best price for the assets. This can be especially important because many experts say that
a forced liquidation results in a loss of 50% or more of the value that could be obtained through
an unpressured sale.
Income Tax Consequences of Life Insurance
Generally, life insurance policy proceeds written for business purposes and paid in a lump sum
when a business owner dies are exempt from regular income taxation. That is, the beneficiary is
not required to pay income taxes upon receiving the proceeds. This is the general rule for all life
insurance death benefits, but under certain circumstances, some life insurance proceeds may be
taxable as income.
DEFINING LIFE INSURANCE
The first hurdle all life insurance policies must overcome is whether the death benefits qualify
by law as "life insurance proceeds." In establishing whether such proceeds qualify, the Deficit
Reduction Act of 1984 tightened up the definition of life insurance in response to the introduction of universal and variable life insurance, both of which have investment features. The purpose was to restrict favorable tax treatment to the pure life insurance benefits in such policies and
36
not to extend favorable treatment to investment vehicles. In order to qualify as life insurance
proceeds, policies must meet one of two "tests" described in the Internal Revenue Code (IRC).
Such tests are basically of an actuarial determination and outside the scope of this text, but, in
general terms the essence of each requirement is that life insurance policies must be written in
such a way that the purchaser pays relatively modest premiums for modest returns and that the
death benefit portion is always greater than any cash surrender value or investment portion. Policies that meet one of the two IRC tests qualify as life insurance proceeds and, therefore, avoid
income taxation under most circumstances.
Transfer for Value Rule
Another factor that can affect whether a beneficiary must pay taxes on life insurance proceeds
is application of the so-called transfer for value rule. This part of the Internal Revenue Code
requires that, when ownership of an existing life insurance policy is transferred to another person
in return for a "valuable consideration," a portion of any death benefits are subject to income taxation. Exempt from income taxes are the valuable consideration paid for the transfer of the policy plus any premiums the individual paid after gaining ownership of the policy.
As an example, suppose Lisa, a sole proprietor, owned a $200,000 policy on her own life. She
decided to transfer the policy to her adult son, Patrick, in return for $3,000. Patrick, as the beneficiary, pays premiums totaling $5,000 before Lisa dies in a traffic accident. Because of the
transfer for value rule, when Patrick receives the $200,000 proceeds, he must pay Income taxes
on all but $8,000. According to the law, a transfer for value does not necessarily have to involve
cash, such as the $3,000 Patrick paid his mother. If he had acquired the policy in return for some
other valuable consideration, the rule still applies. For example, Patrick might have received the
policy in return for providing Lisa with free consulting services for her business which would
also qualify as a transfer for value. On the other hand, if Lisa had given the policy to Patrick as a
gift, the proceeds would be tax exempt. While the transfer for value rule would apply to nearly
anyone to whom Lisa might transfer the policy for value to a brother, a sister, an employee, a
good friend-it does not generally apply to a spouse. Any death proceeds would still be tax exempt for Lisa's husband, for example, even if Lisa had received some value from him in return
for transferring ownership of the policy.
Other Taxable Situations
Finally, the tax code identifies a number of other situations that could result in income taxation
of life insurance proceeds, including:

Proceeds paid under qualified pension or profit sharing plans, tax sheltered annuities and individual retirement endowment contracts.

Proceeds paid to a person who has no insurable interest in the insured's life.

Proceeds paid from a life insurance policy assigned to the beneficiary for the purpose of repaying embezzled funds.

Proceeds from a policy that pays a creditor upon the debtor's death unless the creditor has an insurable interest in the debtor not related to the debt (for example, the
debtor is the creditor's father).

Proceeds that are taxable as dividends or compensation (applies to corporations, not
proprietorships or partnerships).
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Depending on the type of business and the arrangement made to pay life insurance benefits
covering a business interest, the beneficiary(s) might be individual family members, the business
itself, or the estate. Different tax effects can occur depending on who owns and who is the beneficiary of the policy. In most cases, arrangements can be made so the proceeds will be received
income tax free. However, a number of different factors can cause the proceeds of life insurance
policies to be subject to another form of taxation the federal estate tax.
FEDERAL ESTATE TAX
The federal estate tax laws have changed dramatically, as have most tax rates, including Gift
Tax, Generation-Skipping Tax and Unified Credit. Be warned, however, that this tax is repealed
in 2010, and unless Congress acts in the interim to permanently repeal the estate tax, the estate
tax will be reinstated starting in 2011 and revert back to the law as it was before the 2001 Tax
Act was passed. This discussion considers the estate tax as it exists in early 2008.
EXEMPTIONS
Current law provides for two major exemptions from federal estate tax:
1. There is no federal income tax on the first $2 million of assets for years 2007 and 2008; in
2009 the exempt amount increases to $3.5 million.
2. There is an unlimited marital deduction for assets passing to a spouse who is a US citizen.
Any amount that is left at death or given to a surviving spouse, regardless if it is given outright or
in certain types of trusts, is exempt from federal estate tax.
Under the current tax law, the top federal estate tax rated is 45% in 2007 through 2009, while
the amount exempt from tax is $2 million in 2007 and 2008, rising to $3.5 million in 2009 (see
below). The tax is repealed for the year 2010 only. At the present time, prior to the presidential
election, the repeal of this law is a plank in the Democratic party, which is described as a "tax
plan that helps only the very rich" even though it helps the small businesses to keep familyowned businesses alive after the death of the owner, and even though the largest group of employers in the United States are the small businesses…
The present two major exemptions would appear to make tax planning easier for most Americans, and in particular, the owners of small businesses who want to see the "fruits of their labor"
passed on to their heirs. With the high exemption amount presently, many insurance agents have
ignored estate planning uses of life insurance to keep assets for the heirs by using life insurance
to pay off any estate tax. At this time, with the uncertainty about which party will control Congress and the White House, and questions regarding future budgetary constraints, there is a good
chance that the estate tax will not be permanently repealed.
Many middle-income families now own homes that are worth several times what they cost, and
even with the recent "bust" in the real estate market, the values of homes still remain higher than
when the home was purchased. Even if present assets do not exceed the $2 million—or whatever
future exemption amount—they might exceed this amount at the time of death. Also, in some
cases, the proceeds of life insurance re also included in your taxable estate regardless of the beneficiary. Therefore, is it only good planning to focus on strategies that may help to freeze the assets in the estate of the client/business owner?
Basically, for calendar years 2007 and 2008, the estate and Generation Skipping Tax (GST) tax
at time of death transfer exemption is $2 million. The highest estate and Gift Tax rate is 45%
38
For calendar year 2009, the estate/GST exemption goes to $3.5 million, with highest estate and
GST tax rate at 45%.
For Calendar year 2010, all estate and GST taxes are repealed, and there will only be gift tax of
35%.
For calendar year 2011, the exemption for estate tax will be $1 million. For GST tax it will be
indexed from 2002 and will be $$1.1 million. The highest estate and gift tax rates will be 55%,
plus 5% surtax on certain estates over $10 million.
Note: The gift tax exemption remains at $1 million throughout this period.
VALUING THE ESTATE FOR ESTATE TAX PURPOSES
Estate tax, which is often called "death tax," is a tax on the property that is transferred at death,
and the gross estate will include the value of all property to the extent of the individual's interest
in the property at death. The types of property that would be included in the gross estate fall into
basically three categories.
Tangible Personal Property, Real Estate, and other Assets
This category includes all property that is transferred at death by Will and or state intestacy
laws, and is usually called the "probate estate." Examples of this property would be real estate,
stock, bonds, certificates of deposit, furniture and personal effects, jewelry and works of art and
Momma's mink coat, and for business purposes, an interest in a partnership, and an interest in a
sole proprietorship. It also includes bank accounts and promissory note or other forms of evidence of indebtedness that is owned.
Joint Ownership of Property
As a general rule, half of the value of property owned by a husband and wife jointly will be included in the estate of the first spouse to die. The unlimited marital deduction allows the transfer
of the property from the deceased spouse to the surviving spouse without being subject to federal
estate tax. Upon the death of the survivor, the entire property still being held at death will be
subject to taxation.
If two people who are not married own property jointly, then the entire value of the property is
included in the gross estate of the first to die—unless the estate can prove that all of part of the
payment for the purchase of the property was actually furnished by one or the other joint owner.
If, on the other hand, you and another joint owner acquired property by gift or inheritance, only
the fraction of the property owned by you is included.
Property that is jointly held will pass to another owner automatically on death, regardless if
there is a Will or the owner passed intestate. In some states, Transfer on Death (or Totten Trust
accounts) allows securities and bank accounts to pass directly to a beneficiary even if the property is not held in joint name.
39
Life Insurance
The client's gross estate will include life insurance proceeds that are received either (a) by or
for the benefit of the estate, or (b) by other beneficiaries if the client owns all or part of the policies at time of his death. In tax law, "ownership" includes the power to change the beneficiary of
the policy, the right to cancel the policy and receive the cash value, the right to borrow against
the policy and the right to assign the policies.
Tax Planning for Life Insurance
There can be substantial tax advantages by transferring ownership of a life insurance policy to
children or to a trust for the family's benefit. The first requirement would be to making a gift of
the policy at least three years prior to death. This three-year waiting period can be avoided for a
policy that has been newly purchased if another party, such as a trustee of an irrevocable trust,
applies for the policy and owns the policy from its effective date. These irrevocable trusts can be
structured so that the insured transfers money each year for premium payments. Often, therefore,
these payments can qualify for the annual gift tax exclusion. This is a very effective way of making sure that insurance proceeds go to the heirs without incurring gift or estate tax.
Employee Benefits
The value of the payments from qualified pension plans, IRAs and other retirement plans that
are payable to surviving beneficiaries or the estate of an employee—or the owner in case of a
Keogh/HR10 plan —usually is included in the gross estate.
Gifts and Gift Taxes Paid Within Three Years of Death
Gifts of property that are made during a lifetime are usually not included in the decedent's gross
estate, but must be included in the calculation of the estate tax if they exceed the $12,000 annual
gift tax exclusion. However, life insurance proceeds are included in the estate if the policies—or
ownership of the policies—were given away within three years of the death of the decedent. Also, any gift tax paid within 3 years of death is included. Lifetime gifts that a decedent in which
the decedent retains some interest in or control over (such as voting rights in closely-held stock)
will be included in the gross estate.
Allowable Deductions and Exclusions
Allowable deductions include funeral and administration expenses of the estat5e, debts, unpaid
mortgages and other indebtedness on property included in the gross estate. Also, a marital deduction and charitable deductions are allowed.
To be deductible, debts must be enforceable personal obligations of the decedent, such as outstanding mortgages, personal bank loans, auto loans, credit card balances, utilities bills, etc. Deductible taxes also include accrued property taxes, gift taxes unpaid at death, and income taxes.
Valuing Property for Estate Purposes
The "Fair Market Value" which is the price at which property would change hands between a
willing buyer and a willing seller. Property that is traded on an established market, such as publicly traded stocks, is easily valued. Stocks and bonds that are traded publicly are valued at the
high and low selling price on the date of death, or there is an option of using a date six months
after death (see below).
40
However, interests in closely held businesses or partnerships must be appraised, taking into
account the assets of the business, the earning capacity, and other pertinent factors. This is obviously, the area in which an accountant is necessary.
The gross estate is valued as of the date of death or six months later (alternative valuation
date), whichever is elected by the personal representative. An election to value the estate six
months after the date of death generally will apply to all of the assets in the estate, but is available only if the election results in a decrease in the gross estate and estate tax liability.
The amount that remains after subtracting any allowable deductions is the taxable estate and
the federal estate tax is computed on this amount. Gifts that are made after 1976 are also factored in and can increase the marginal tax bracket of the estate.
Property Acquired as Beneficiary
As a general rule, any property acquired from a decedent gets a new basis.
Basis is generally the cost of an asset or the amount used to calculate the tax.
Since the old new basis is almost always larger than the old basis, this is known as the
"stepped-up" basis. In most cases, the new basis is the fair market value at the date of death or
alternative valuation date, whichever is used for estate tax purposes.
NOTE: Under the new tax law, any property that is acquired from a decedent who dies in 2010
will not get a "stepped-up" basis. Therefore, if a beneficiary inherits property from a decedent,
he will usually receive a basis that is equal to lesser of the fair market value of the property on
the date of the decedent's death or the decedent's adjusted basis in the property—this is called the
"carryover basis." IF this new rule goes into effect, it becomes extremely important to keep accurate basis records so that they will be available for the heir. Also, if this new rule goes into
effect, there appears to be ways to make sure that certain types of assets are not eligible for the
basis increase, but a tax accountant must be involved.
THE MARITAL DEDUCTION & ESTATE TAX EXEMPTION
While the estate tax remains in effect until it is repealed (if it is) in 2010, most married individuals will want to take advantage of both the estate tax exemption and the unlimited marital deduction , which has the effect of reducing federal estate tax to zero for the estate of the first to
die.
One way to do this is by placing property in a special marital trust, thereby arranging for the
spouse to receive a lifetime income interest in certain property. After the surviving spouse dies,
then the property will be passed on to whoever is specified in the trust document.
Property transferred to a surviving spouse who is a non-US citizen by gift or death is not allowed, however the law provides that tax-free gifts to a non-citizen spouse can total only
$125,000 (for 2007) per year—which is adjusted for inflation. However, there is no lifetime limit to the total value of gifts that can be given tax-free to a spouse who is not a citizen of the US.
In addition, a Will can be drafted so that property placed in a Qualified Domestic Trust will have
the estate tax postponed until the property in the trust has been distributed or the surviving
spouse dies. This, of course, requires legal help in setting up such a trust.
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Computing the Federal Estate Tax
For year 2007, computing the estate tax is rather simple, although it must always be performed
by a tax attorney or accountant.
From the gross estate of the individual, deductions are subtracted—such deductions are assets
such as cash, marketable securities, business equity, residence, vacation residence, personal
property, deferred compensation, ordinary life insurance and group-term life insurance. The
amount of deductions depends upon the gross estate. In 2007, if the gross estate is $1,500,000,
then deductions from gross would be $1,500,000, so there would be no estate tax.
If, for instance, the individual has a gross estate of $2,500,000, deductions of $1,00,000, leaving a taxable estate of $1,500,000. The estate exemption for this year is $1,500,000, leaving zero
federal estate tax.
However, if the gross estate is $10,000,000, deductions (for example) of $6,500,000, this
would leave a taxable estate value of $3,500,000. The estate exemption is $2 million for 2007,
leaving a taxable estate after exemption of $1,500,000, leaving a tentative estate tax of $690,000.
As they say in the television commercials, "Don't try this at home!" Obviously, the large estates must be handled by professionals. These examples are provided to prove a point: When an
estate is worth 7 or more figures, don't even try to guess what the tax consequences are. The next
logical question is, for the professional insurance agents, then where do I start to determine how
much life insurance the individual needs so that there will be something left for the heirs?
This is very nebulous at this time because of the fluidity of possible estate-tax law changes.
Therefore, a professional agent must keep abreast of changing laws in order to provide the kind
of service that such clients require. Unless the agent has an IQ and retentive memory "off-thecharts," it would not be possible to provide specific advice. Therefore, the lesson here is
Become acquainted with accountants and attorneys who specialize in tax issues. Further,
continue your own education so that you can converse intelligently with them on matters that
affect your mutual interests.
Take time to take advanced insurance courses from the American College of Life Underwriters or comparable institutions. If at possible, become a CLU or obtain another professional designation. If nothing else, this training will build confidence so that the professional
agent can be of service to those who need professional assistance.
GIFT TAXES
Gifts of property made by the decedent during his lifetime, as a general rule, are not included in
the gross estate, but must be calculated in the estate tax calculation if they exceed the $12,000
annual gift tax exclusion. (Note, however, that life insurance proceeds are included in the estate
if the policies or ownership of the policies were given away within three years of the death of the
decedent. Lifetime gifts that a decedent retains some interest, such as a life income interest—or
control over (such as voting rights in a closely held corporation) will be included in the decedent's gross estate.
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Fundamentals
A (one) person can give up to $12,000 annually ($24,000 if the spouse consents) to as many individuals as the persons wants, without paying any gift tax. But, above that amount, gifts consume the lifetime gift tax exemption amount of $1 million (this amount does not increase) and
then can result in gift taxes. The reason for the gift tax is that people could simply give away
their estate and not ever have to pay estate taxes. CAUTION: One should think long and hard
about making significant gifts that would result in a gift tax payable in light of the possible permanent repeal of the estate tax.
Under the current tax law, the highest gift tax rate for 2007 through 2009 has been reduced to
45%; however, unlike the estate tax, the gift tax is NOT repealed. Beginning in 2010, the highest
gift tax rate will be equal to 6the highest individual income tax rate, which, by then, is scheduled
to be 35%.
The gift tax was retained largely to limit the amount of income tax that taxpayers can avoid by
giving income-producing and appreciated assets to family members in lower income tax brackets. The $1 million gift tax exemption will remain constant and will not be indexed to the inflation rate.
Any gift given above the annual exempt amount is included in the estate upon death. The value
is not the amount of the gift at the time of death of the giver/decedent, but the value at the time
the gift was given. In addition, there are some special rules.
Life Insurance as a Gift
A gift of life insurance made within three years of the death of the giver will be included in the
decedent's gross estate at its full face value.
Strategies to Consider
Since there is considerable uncertainty currently existing as to whether the federal estate tax
will be repealed, it would seem prudent to consider gift-giving strategies that minimize the size
of the taxable gift and that avoid gift tax to the extent possible.
The subject of gift taxes is extremely important in estate planning and can be extremely involved when children are involved. A professional estate planner must be aware of such gift-tax
saving vehicles as the Crummey Trust (where property can be transferred and the gift can qualify
for the annual gift tax exclusion), a Totten Trust (which is created when a donor deposits his own
money into a bank account for the benefit of a minor and names himself as trustee, thereby allowing the funds to avoid probate), and Section 529 (Qualified Tuition Programs).
GENERATION-SKIPPING TAX
An additional tax may apply to gifts or bequest that skip a generation, such as a gift of property
directly from a grandparent to a grandchild—the Generation-Skipping tax. The reason for the tax
is so there could be the imposition of the gift or estate tax that would have been paid if the intervening generation had received the gift or bequest.
This tax is rather stiff—in 2007 the tax is imposed at the maximum estate and gift tax of 45%,
which is payable in addition to any estate or gift tax otherwise payable as a result of the transfer.
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However, most will escape this tax as the first $12,000 ($24,000 if made with consent of the
spouse) outright gifts of the grandparents are included in the annual exclusion. Plus, each individual is entitled to an aggregate $2 million exemption from the tax for lifetime gifts and transfers at death. Since a married couple can "split the gift," they can make up to $4 million in generation-skipping transfers without incurring the tax.
Plus, any subsequent increase in value on the transferred property after it is given, will escape
the generation-skipping tax.
Filing Gift Tax Return
Only individuals are required to file a gift tax return, and it is not necessary to file a gift tax return if the person
1.
Made no gifts during the year to his spouse;
2.
Gave no more than $12,000 during the year to any one recipient; and
3.
All of the gifts were of present interests.
Policy Proceeds Payable to Estate or for Benefit of Estate
Life insurance policy proceeds must be included in the value of an estate when the proceeds are
payable to the insured's estate. Therefore, if the beneficiary of the policy is the estate, the proceeds are considered in determining the value of the estate. If the business owner wants to be
certain life insurance funds are available to close the estate, a separate life insurance policy can
be written for that purpose and identified in the Will, indicating the life insurance proceeds are to
be payable to the estate. While this causes the funds to become part of the estate, such an arrangement can provide the much-needed funds an executor might need to close the estate without
depleting the assets of the business to pay bills. This can be especially critical for a proprietorship, where the owner's death effectively causes the business to cease to exist.
Life Insurance must also be included in the estate when the proceeds are receivable for the
benefit of the estate. A policy beneficiary might be legally obligated to pay off the deceased
owner's existing debts, taxes and any taxes that arise because of the death. For example, consider
the case of a proprietor whose beneficiary is his wife. Since the spouse, like the proprietor, is
considered one and the same with the proprietorship, the business debts and taxes are the legal
responsibility of the surviving wife. The life insurance proceeds payable to the wife in this case
must be included in the husband's estate to the extent she is legally obligated to pay estate expenses
A different standard applies for including proceeds in the insured's estate in community property states. In these states, the law requires that all property acquired either individually by a
husband or wife or by both jointly during their marriage must be considered the common property of both, regardless of whose assets actually paid for the property. A life insurance policy purchased during the marriage is therefore considered community property.
Insured Had Incidents of Ownership in the Policy
Life Insurance policy proceeds must also be included in the estate when the insured had incidents of ownership in the policy when he or she died. This is true even if the beneficiary is not
the insured's estate. The Internal Revenue Code recognizes at least the following contractual
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rights under a life insurance policy as incidents of ownership:

The right to change the beneficiary.

The right to borrow from the cash value of the policy.

The right to cancel or surrender the policy for its cash value.

The right to assign the policy and to revoke the assignment.

The right to use the policy as collateral for a loan.
Individual court cases have identified other incidents of ownership in certain jurisdictionsrulings that might not be upheld everywhere. For example, one court ruled that the right to
change a policy's settlement option was an incident of ownership, while a court in another jurisdiction ruled the same right was not an incident of ownership.
Where the insured specifically wants to avoid having the policy proceeds included in the estate,
Incidents of ownership can generally be avoided by allowing someone else to own the policy.
An existing policy can be assigned or given as a gift to someone else. New policies can name
someone other than the insured as the owner. For example, the spouse of a proprietor, partner or
corporate stockholder may own the policy. Alternately, partnerships and corporations as entitles
may own and be the beneficiaries of policies on the partners and stockholder-owners. The insured business owner may personally provide the funds to pay the life insurance policy premiums
even though someone else owns the policy. Merely paying the premiums is not considered an
incident of ownership according to the IRS.
Insured Transfers Policy for Inadequate Consideration
Life Insurance proceeds are included in the insured's estate if the insured transfers the policy
to someone else for inadequate consideration and the transfer would otherwise be includable
under other sections of the Code. "Inadequate consideration" means that a genuine transfer
of the policy did not occur and the insured retained certain rights under the policy that make the
proceeds includable in the estate. For example, suppose an insured "sold" a $100,000 policy on
his life to his son and policy beneficiary for $1,000, but the insured retained certain rights in the
policy. Also suppose the policy had significantly more cash value than the $1,000 the son paid
for the policy. The IRS would likely consider this a transfer for inadequate consideration. In this
case, the difference between the amount the son paid and the fair market value of the policy
would be includable in the insured's estate.
MARITAL DEDUCTION
When the deceased person is married, an unlimited marital deduction is available to reduce
the estate size.
The marital deduction allows an individual to pass all of his or her property, including life
insurance policy proceeds, to the surviving spouse with no estate taxation at all. While this deduction solves the problem of paying estate taxes when the first spouse dies, the value of the surviving spouse's estate when he or she eventually dies is then subject to estate taxation and the
value might be greater at that time than when the first spouse died. Furthermore, the deceased
might not leave all property to the spouse; some property might pass to other heirs, in which case
no marital deduction is available for that portion of the property. As a result, property left to any
other heirs will be included in the value of the estate.
For jointly owned property, one-half of the value of property owned by a husband and wife
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jointly will be included in the estate of the first spouse to die. The unlimited marital deduction
allows the transfer of the property from the deceased to the surviving spouse without being subject to federal estate taxes.
Policy Ownership
Whether a life insurance policy is written for business or personal purposes, the general recommendation is that someone other than the insured should own the policy. In most cases, the
policy proceeds then can be partially or completely exempt from federal estate taxation, except
for the circumstances noted here.
Of course, the insured may intend for the proceeds to be payable to the estate to make the funds
accessible to the executor or administrator. In this case, the proceeds are subject to federal estate
tax, but that may be preferable to selling off assets in order to close the estate. It is important for
the insured to have competent legal and tax advice in determining the most appropriate solution
for his or her particular situation.
The Will and Life Insurance
A properly written Will and sufficient life insurance are the keys to:

Keeping the business intact.

Arranging for appropriate accommodation for all heirs.

Ensuring that the transition occurs with minimal problems.

Providing a source of cash to pay expenses associated with closing the estate.
The Will can be especially important when the business is to be continued because it clarifies
the arrangements that have been made to see that the transition occurs. Legally formalizing these
arrangements helps avoid many of the problems that could otherwise arise. Therefore, having a
Will that indicates the business will continue and sufficient life insurance to fund expenses during the transition period are necessary for all of the same reasons that exist when the business
will be dissolved.
In addition, when the business will be continued instead of dissolved, cash from life insurance
might be even more critically needed to maintain the business's reputation. Unfortunately, the
death of a business owner can cause both customers and creditors to question the solvency of the
business. Customers may take their business elsewhere and creditors may call in debts. Life insurance can alleviate these concerns by providing cash to maintain business operations at the
same level as before the owner died.
The Business Interest Is Sold
Instead of dissolving the business or having the heirs become owners, the deceased person's
heirs might sell the business interest. Surviving partners or corporate owners might not want to
accept a new business associate who has been essentially selected by the heirs by virtue of selling
to an outsider, therefore the best solution may be for the surviving partners or stockholders to
purchase the deceased person's interest from the heirs. The survivors maintain control of the
business and can decide for themselves whether or not to offer a share of the business to someone
else.
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Specificity of Intent through a Will
Planning for sale of the business when the owner dies begins with but does not end with a Will.
Additional legal documents, which we'll discuss, are needed to ensure the sale will occur as
planned, but the Will can also be used to document the business owner's wishes. Citing the sales
agreement in the Will along with the owner's personal bequests can also clarify that all legal statutes are met. For example, in most states, a spouse is entitled to receive a specified minimum
portion (often one-half) of the estate of the deceased spouse, regardless of what they Will specifies and regardless of any separate agreements the deceased might have made prior to death.
Therefore, mentioning the sales agreement in the Will can confirm in one document that the
spouse has been provided for legally elsewhere and that the business may be sold as planned.
BUY-SELL AGREEMENT
To ensure the business will be sold as intended, the owners must execute a buy-sell agreement. This legal document, which requires the advice and assistance of an attorney, ensures that
the purchaser will buy and the deceased person’s estate will sell the business as stipulated in the
agreement.
Properly written and funded (preferably by life insurance), a buy-sell agreement has benefits for
all parties. The purchasers have the confidence of knowing they will have the right and the money to purchase the business interest if the owner dies. They are relieved of concern about how
the business interest would be disposed of in the absence of a funded agreement.
For the sellers-the heirs or estate of the deceased-the guarantee that the buyer will purchase the
business provides peace of mind, both that the business will be sold promptly and for a fair price
and that the proceeds of the business sale will be forthcoming with a minimum of delay. The estate can be closed more quickly without fear that the administrator will be forced to liquidate the
assets that make the business valuable.
Even before a business owner dies, a funded buy-sell agreement can be used to demonstrate the
strength and soundness of the business to clients, business associates and creditors.
KEY PROVISIONS IN A BUY-SELL AGREEMENT
The buy-sell agreement is a legal document that binds all parties to its terms. For this reason,
the agreement must be prepared by an attorney who understands the purpose of the agreement
and the desires of both the seller and the buyer. The key provisions of buy-sell agreements are as
follows:
 Identification of the parties to the agreement. This might be a proprietor and a
named buyer: a partnership entity and each partner; all partners: a corporate entity
and each stockholder active in the business: or all active stockholders.
 A purpose statement that clearly describes the intent of the buy-sell agreement.
This is usually a simple statement that the owner intends to sell the specific business interest to the purchaser named and the purchaser intends to buy the interest
if the owner dies.
 Identification of the specific property/assets and liabilities if any, of which the
buyer will assume ownership when the sale occurs. This can be especially important for a proprietorship since a proprietor and his or her business are considered one and the same by law. The agreement should make it clear which business
47






property is part of the sale. In addition, business liabilities owed at the time of
death are not generally passed onto the new owner, but could be if that is how the
agreement is negotiated.
A valuation clause that either stipulates the purchase price or describes a method
for establishing the price (discussed later in more detail).
A description of the funding medium, such as life insurance policies with the
business owners as the insured’s, that will provide the purchase proceeds. Although there are other methods to fund a buy-sell agreement, life insurance is generally accepted as the best because only life insurance guarantees the funds will
be available when needed. The description would list and identify, by policy number and insurance company name, all insurance to be used for this purpose. The
agreement would also specify what happens to the policies if the buy-sell agreement is terminated and/or if the buyer dies before the insured person dies.
Provisions that bind the seller's heirs or estate to sell the business interest and bind
the buyer to purchase the business interest A description of the circumstances
under which the agreement becomes operative-the death of the business owner in
this case.
Descriptions of how the purchase price will be paid to the heirs or estate and
how the business interest will be transferred to the buyer. For a partnership,
the agreement might indicate that Partner A will collect the proceeds of the life insurance policies and pay the purchase price to Partner B's heirs or estate, at which
time the estate administrator will finalize the transactions needed to transfer the
business interest. Another possibility is to establish a trust to hold the policies
while the business owners are alive, receive the business assets when an owner
dies, pay the policy proceeds to the estate or the heirs and transfer the business to
the purchaser.
Provisions that grant the buyer the first option to buy the business if the owner
decides to sell before death. The owner might decide to retire or no longer wants
to operate the business. Rather than offer it to another buyer or dissolve the business, the owner is bound to offer it to the person in this agreement first. T he provision would also state a time limit during which the buyer must decide whether
or not to purchase the business as well as stating how the purchase will occur under these circumstances.
A description of conditions that terminate the buy-sell agreement. For example, the agreement could terminate if the business goes bankrupt or is otherwise
dissolved voluntarily or involuntarily, if either party is convicted of a felony, if
both parties are injured or die as the result of a common disaster, or any other provisions both parties agree upon.
FUNDING BUY-SELL AGREEMENT WITH LIFE INSURANCE
A buy-sell agreement that is funded with life insurance guarantees that the dollars to execute
the agreement will be available when the business owner dies. Some basic questions about the
life insurance need to be addressed at this point.
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Permanent vs. Term Insurance
For funding a buy-sell agreement, permanent insurance is nearly always preferable to term insurance. First of all, chances are the business owner will live, rather than die, so the odds are
smaller that the policies will be used for their original purpose. Permanent insurance builds cash
values that can be used for retirement or other purposes if desired.
Second, although term insurance might initially cost less than permanent insurance, rates will
rise as the policy is renewed and the insured person ages. In addition, term insurance will not
build cash values that could be used for other purposes.
Existing Policies vs. New Insurance
Agents involved in the sale of business life insurance often are asked whether or not existing
life insurance policies can be used to fund a buy-sell agreement. While there is no legal reason
why this can't happen, it is not a good idea for at least two reasons. First, the reasons the policies
were purchased probably still exist, such as protection for a spouse and children or accumulation
of cash values for specific purposes, etc. If the policies are used, instead, to fund a buy-sell
agreement, the original needs will no longer be met.
Second, transferring policies can have undesirable tax consequences. For example, there is the
transfer for value rule that requires a part of the death proceeds to be taxed as income—which
could occur if the potential purchaser pays the insured a lump sum for the existing policy, then
takes over the premium payments. The total of the lump sum and the subsequent premiums are
not subject to income taxation, but the buyer would pay income taxes on the amount of death
proceeds in excess of that total when the owner dies.
Furthermore, the transfer for value rule would apply even if the potential buyer were simply
named policy beneficiary or named in the buy-sell agreement to receive the policy proceeds-if the
buyer gives any kind of valuable consideration in return. Remember from our earlier discussion
that "valuable consideration" does not necessarily mean money.
For example, suppose the potential buyer is an employee of a sole proprietor. The insured proprietor agrees to name the employee as the beneficiary of the existing policy (in order to have the
money available to meet the terms of the buy-sell agreement) in return for the employee's agreement to perform certain services without pay. The proprietor has received valuable consideration, from the Internal Revenue Service's viewpoint, subjecting the employee to income taxation
under the transfer for value rule. Obviously, an attorney and/or tax accountant must be involved
in order to ensure the desired tax outcomes and to prevent undesired consequences.
While these rules apply to other situations as well, you can see that transferring existing policies to fund a buy-sell agreement can have far-reaching effects. Therefore, new life insurance
written specifically to fund the buy-sell agreement is preferable.
Amount of Insurance
Since the purpose of the life insurance is to purchase the business, the amount of insurance
should be at least as much as the agreed-upon purchase price. That sounds simple enough if an
exact amount is specified in the buy-sell agreement. However, some agreements do not stipulate
a specific dollar amount, instead describing a formula or some other method for determining the
business value in the future. The reason for using this type of valuation rather than a dollar
49
amount is to allow adjustments for future increases or decreases in the value of the business that
could occur before the proprietor dies. For example, the agreement could specify a purchase
price of $200,000 based on the value of the business in 1994. However, suppose that by the time
the owner dies in 2004, his or her share of the business is worth $800,000. While the purchaser
would be getting quite a bargain for $200,000, the heirs are likely to be unhappy if they must sell
for one-fourth of the actual value.
Policy Ownership
The question of policy ownership takes into consideration that the buyer is. Remember that
the insured should not own the policy to avoid the "incidents of ownership" tax complications.
So, whether the buyer is a proprietor's employee or a family member, a partnership or corporate
entity, an individual partner or stockholder, or someone else, that person or entity may own and
pay premiums for the policy on the person's life and also be the beneficiary of the policy.
Alternatively, a trust maybe established as the policy owner, with the potential buyer making
the premium payments. Under a trust arrangement, either the trust or the buyer may be named as
beneficiary. If a trust is beneficiary of the policy, the trust is, of course, bound by the buy-sell
agreement, so there is no question about whether the benefits will actually go to the buyer to purchase the business. When the buy-sell agreement is written, a provision specifically directs the
trustee to collect the life insurance policy proceeds and use them to arrange for transfer of the
business to the buyer. All details about how this happens are included in the buy-sell agreement
itself.
Tax Consequences
Depending on the details of the particular situation, a variety of tax consequences may come into play-for both federal estate tax and federal income tax purposes. The tax benefits available to
a life insurance beneficiary when ownership is properly arranged apply in the same way when life
insurance funds a buy-sell agreement. The beneficiary/buyer is able to purchase the business
with the life insurance proceeds, which are income tax free.
Regardless of how the business interest is disposed of, the value of the business must be included in the deceased owner's estate for estate tax purposes. That is, whether the heirs receive
the business without a buy-sell agreement or someone purchases the business-with or without a
buy-sell agreement-the value of the business is considered part of the deceased person's estate.
Determining the exact value for estate tax purposes is sometimes assisted by the existence of a
buy-sell agreement.
Fair Market Value
For federal estate tax purposes, the value of any property included in the estate is its fair market value defined in the estate tax regulations as:
"The price at which the property would change hands between a willing buyer and a
willing seller, neither being under compulsion to buy or sell and both having reasonable
knowledge of the relevant facts."
Furthermore, the value to be included in the estate is generally the fair market value on the date
the individual died. Alternatively, the regulations allow the property to be valued as of six months
from the date of death if the estate administrator believes valuation at the later time will result in
a smaller estate value and, therefore, lower estate taxes. Once the later valuation date is chosen,
50
this date is locked in so the administrator cannot later decide to choose valuation on the date of
death.
LIFE INSURANCE PROCEEDS
The major rule on taxation of life insurance proceeds simply says that life insurance proceeds
paid to you because the insured person dies, are not taxable unless the policy was turned over to
you for a price. This is true even if the proceeds were paid under an accident and health policy or
an endowment contract.
Lump Sum Payment
If death benefits are paid to you in a lump sum (or any method other than at regular intervals),
the recipient must include in his income only the benefits that are more that the amount payable
to the recipient at the time of the insured person's death. If the benefit payable at death is not
specified, the recipient must include in his income the benefit payments that are more than the
present value of the payments at the time of death.
Payment in Installments
If life insurance proceeds are received by the recipient in installments, the recipient can exclude
part of each installment from his income.
In order to determine the excluded part, divide the amount held by the insurance company—
usually the total lump sum payable at the death of the insured—by the number of installments to
be paid. Anything over this excluded part must be shown on the individual's tax form at interest
income.
If, for instance, you receive death benefit from a life insurance policy with the death benefit of
$100,000 and you elect to receive it over 10 annual installments. Therefore, any amount that you
receive in excess of $10,000 each year will be considered as taxable interest income to you.
Interest Option
If the insurance company pays you only interest on proceeds from the life insurance left on deposit with them, the interest that is paid is taxable as interest income. If the interest payment is
the only payment that is received under the policy, then the entire amount is taxable as interest
income. The individual or successor beneficiary, who would receive the principal of the benefit,
would receive that tax-free. For those receiving annuity death benefits, there are special exclusion ration rules that are applied.
Policy Surrender for Cash
If a life insurance policy is surrendered for cash, the rule is quite basic: Any proceeds that are
more than the cost of the policy is taxable. The cost is total of premiums that you paid for the
policy, less any refunded premiums, rebated, dividends, or un-repaid loans that were not included
in your income.
However, if, for instance, you terminated a policy that had a cash value of $100,000 and of that
amount you only paid $80,000 in net premiums. Therefore, $20,000 would be considered as taxable income to you at that point. But if you exchanged one life insurance policy for another policy, it is possible that you may not have a taxable transaction. The rules are rather technical on
this matter, so it is imperative that a tax advisor or consultant become involved.
51
Endowment Contract Proceeds
Endowment contracts are not as popular as they once were, and the tax rules are rather confusing as to what amount is taxable and how to calculate the cost. There are a number of ways in
which insurance proceeds can be paid, so if an endowment contract is involved, a tax expert
should become involved.
ACCELERATED DEATH BENEFITS
Certain amounts that are paid as accelerated death benefits under a life insurance policy or viatical settlement before the insured's death are excluded from income if the insured is terminally or
chronically ill.
Viatical Settlement
A Viatical settlement is the sale or assignment of any part of the death benefit under a life insurance contract to a Viatical settlement provider—defined as a person who regularly engages in
the business of buying or taking assignment of life insurance contracts on the lives of insured individuals who are terminally or chronically ill and who meets to requirements of section 101(g)
(2) (B) of the Internal Revenue Code.
Accelerated death benefits that meet the IRC requirements for terminal illness or for chronic
illness, are excluded from income for tax purposes. However, note that this exclusion does NOT
apply to any amount paid to a person (other than the insured) who has an insurable interest in the
life of the insured because the insured is a director, officer, or employee of the person, or, has a
financial interest in the person's business.
INHERITED PROPERTY
If you inherit property, your basis is considered to be one of the following:

The fair market value (FMV) of the property at the date of the decedent's death.

The FMV on the alternate valuation date if the personal representative for the estate elects to use alternative valuation.

The value under the special-use valuation method for real property used in farming or a closely held business if elected for estate tax purposes.

The decedent's adjusted basis in land to the extent of the value excluded from the
decedent's taxable estate as a qualified conservation easement.
If a federal estate tax return does not have to be filed, the basis in the inherited property is its
appraised value at the date of death for state inheritance or transmission taxes.
STEP-UP BASIS RULES
The 2001 Tax Act provides that the step-up basis rules are to be replaced with a carryover basis
system in 2010. As of this date, the carryover basis rules have not been determined by Congress.
STEPPED-UP BASIS IN COMMUNITY PROPERTY STATES
In community property states, the basis of the surviving spouse's one-half share of the community property will also receive a step-up in basis, normally to its fair market value, at the date of
the decedent spouse's death.
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TIP: If you receive property by inheritance, you should request a copy of the estate tax return
from the executor to determine your basis in the inherited property.
In community property states (does not include Florida) husband and wife are each usually
considered to own half of the community property. When either spouse dies, the total value of
the community property (including the part belonging to the surviving spouse) becomes the basis
of the entire property. At least half the value of the community property interest must be included in the decedent's gross estate, regardless if the estate files a tax return or not.
CHANGE OF PROPERTY USE
If property is held for personal use and then it is changed to business use, or used to produce
rent, the owner can then begin to depreciate the property at the time of change—starting with the
value of the property value at the time the usage was changed. An example could be something
as simple as changing residential property to business property, or renting the property.
The basis for depreciation is the lesser of the fair market value of the property on the date of the
change of usage, or the owner's adjusted basis on the date of the change.
SALE OF PROPERTY
If property that has been changed to business or rental use, is later sold or disposed of, the basis
to be used will depend upon whether there is a gain or loss.
Gain
The basis for determining a gain in property value is the adjusted basis in the property when the
property is sold.
Loss
The loss is calculated starting with the smaller of your adjusted basis or the fair market value of
the property at the time of the change to business or rental use. At that point increases or decreases for the period after the change in the property's use.
EXAMPLE: About ten years ago, you paid $150,000 to have a new house built on a $25,000
lot. You paid $25,000 for permanent improvements for the house, but a storm took off part of
the roof that cost $2,000 to repair before renting the property. Land is not depreciable, therefore
only the cost of the house is used for calculating depreciation.
The adjusted basis in the house when it became rental property was $173,000 ($150,000 plus
$25,000 for permanent improvements, less the casualty loss of $2,000). On the date that the
house was declared rental property, the fair market value of the property was $160,000 for the
house and $20,000 for the land, so the basis for figuring depreciation on the house is its fair market value on the date of the change ($160,000) because it is less than the adjusted value of the
house ($150,000 + $25,000 - $2,000 = $173,000).
BUY-SELL FUNDING USING LIFE INSURANCE
Profit-sharing plans with permitted discretionary annual contributions have been used by businesses for many years, particularly smaller businesses which often fall victim to unstable cash
flow and who have been attracted to profit-sharing provisions that enable them to forgo making a
contribution in any year as long as contributions are substantial and recurring. One of the ways
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that business owners have used their profit-sharing accounts is to purchase life insurance that is
designed to fund their obligations under a cross purchase buy-sell agreement.
BUY-SELL AGREEMENTS
The primary method of ensuring the continuation of a business after the death of an owner is to
use the buy-sell document. Sole proprietors are particularly sensitive to the problem of continuation after death of the principal, as without proper documentation, the company and the owner
die simultaneously.
Corporations have "eternal life," but even so, they can be (and often are) dangerously on the
precipice of financial failure upon the death of a stockholder-officer. Regardless of the type of
business, ensuring the continuation of the business under the direction of surviving owners is an
important business priority.
Except for sole proprietorship, buy-sell agreements may call for the business to purchase the
owner's interest at death—an entity-purchase agreement—or may provide for surviving owners to
purchase the deceased's interest in a cross-purchase agreement.
When an entity-purchase agreement is used, the business and each owner enter in an agreement
whereby the business agrees to purchase the owner's interest at death. When the purchase has
been accomplished at the death of the owner, the surviving owners' interest in the business will
have increased in value because the deceased owner's interest has been absorbed by the business.
The Buy-Sell Agreement and Valuation for Estate Tax
The existence of a buy-sell agreement sometimes helps in valuing property for estate tax purposes when the business is closely held. This can be any small business; don't confuse this terminology with closely held corporations. In this case, the law applies to any type of business controlled by one or only a few people, including proprietorships, partnerships and corporations.
If properly handled, the buy-sell agreement for a closely held business can establish a purchase
price that legally binds the Internal Revenue Service to accept that amount as the fair market value for estate taxation. The pertinent section of the Internal Revenue Code states that the value
established in a purchase agreement (such as the insurance-funded buy-sell agreement) may be
used for estate tax purposes-even if the value is less than the fair market value on the date of
death-provided all of these requirements are met:
1. The agreement is a bona fide business arrangement.
2. The agreement is not a device to transfer property to the deceased person's family for less
than full or adequate consideration.
3 The terms of the agreement are comparable to agreements entered into in an "arm's length
transaction" (defined below).
4. The heirs or the estate must be obligated to sell the business when the person dies.
5. The business owner must be obligated, if he or she chooses to sell the business while alive,
to first offer to sell to the purchaser at the price established in the agreement.
6. The purchase price must be fair and adequate at the time the agreement is executed.
7. The purchase price must be established in the agreement or the agreement must include a
formula or other method for determining the price.
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Arm's Length Transaction
The term "arm's length" in this case is used primarily to demonstrate the lack of a close relationship between the parties involved. An arm's length transaction is one that is negotiated between unrelated parties, acting independently to serve their own best interests. The assumption is
that, because of the independent interests, the arrangement negotiated is based on the fair market
value of the property or services involved in the transaction.
A transaction between two related or affiliated parties that is conducted as if they were unrelated, so that there is no question of a conflict of interest. Or sometimes, a transaction between two
otherwise unrelated or affiliated parties.
In determining whether or not a transaction occurred at arm's length, tax regulations cite certain
factors to consider:

Expected term of the agreement. While the term of a buy-sell agreement is expected to be until the owner dies, these rules also applies to other types of agreements that might have a more limited term, such as a contract to deliver goods.

Current fair market value of the property. This refers to the value when the
agreement is executed. If the sale is for significantly less than the current fair market value, it will probably not qualify as an arm's length transaction.

Anticipated changes in value during the term of the agreement. For a buy-sell,
changes could be based on periodic reviews stipulated in the agreement, but could
be estimated when the agreement is drawn up. The expectation that a business's
value will increase is one reason for not using a fixed dollar amount in a buy-sell
agreement.

Adequacy of any consideration given in exchange for the rights granted.
Under a buy-sell, the "rights granted" include the rights to purchase the business at
the owner's death as stipulated in the agreement and to have the first option to
purchase while the business owner is still alive. We've already discussed the implications of transferring property for less than adequate consideration.
The IRS especially scrutinizes smaller and/or family-owned and managed businesses for abuse
of the arm's length transaction requirements since families are more likely to make financial concessions for each other that result in loss of tax revenues for Uncle Sam. Thus, the IRS expects
family members to perform business transactions with each other in the same manner they would
with total strangers if the purchase agreement is to represent true value for estate tax purposes.
Estate Freeze
A term used in regard to valuing property for estate tax purposes is an "estate freeze" or a
“valuation freeze." The "freeze" refers to establishing a value that will be used for inclusion in
the gross estate regardless of the actual or fair market value at the time of death, which may establish a lower value than might otherwise apply if property has increased in value during the
time between the agreement's execution and the time of death. Please note, however, this is a
highly technical action and will require the services of a tax attorney or accountant.
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Problems with Family Buy-Sell Agreement
Tax problems can arise in attempting to establish the business value for estate tax purposes
when a buy-sell agreement for less than fair market value exists between family members. For
example, a proprietor and a relative might enter into a buy-sell agreement, or an individual's sibling might be one of the partners in a partnership.
Using a buy-sell agreement as a means to establish value for estate tax purposes where the purchase price is less than fair market value when the business owner dies, as stated earlier, the IRS
will require that (1) The agreement is a bona fide business arrangement; (2) The agreement is not
a device to transfer property to the deceased person's family for less than full or adequate consideration; and, (3) The terms of the agreement are comparable to agreements entered into in an
"arm's length transaction."
All three conditions are considered to be fulfilled if more than 50% of the property's value (the
business value in this case) is owned by people who are not members of the family and not the
"natural objects of the decedent's bounty." Liberally interpreted, the "natural objects" might be
not just a spouse and children, but also parents, siblings, grandparents, uncles, aunts, nephews,
nieces and cousins of both the deceased and spouse. This requirement obviously excludes a
100% family-owned business no matter how distantly related the family members is. In actual
court cases involving family businesses and buy-sell agreements, these requirements have resulted in some unexpected and unfavorable estate tax consequences.
This relatively recent section of the Code can cause tax problems for family members entering
into buy-sell agreements. In any discussion of providing life insurance funding in such a situation, the client must have consulted with a tax attorney or accountant.
Valuing a Business
There are a plethora of methods for valuing a business and there are often disagreements between professionals involved in business valuations. For the purposes of this text, the most
common methods will be discussed, starting with the IRS input in business valuation.
IRS Rules on Valuation
In valuing a privately owned business-the type you will most often be involved with-companies
must comply with general IRS rulings. The IRS advises that valuation requires careful analysis
of all financial data available and all other relevant factors that might affect the fair market value.
These "other relevant factors" are then listed—but not intended to be all-inclusive—as follows:
 Nature of the business and its history from the time the business first began operations.
 General economic outlook as well as the specific condition and outlook of the industry in
which the business is engaged.
 Book value of stock (or other assets in the case of non-corporate forms of business) and
the financial condition of the particular business.
 Earning capacity of the business.
 Dividend-paying capacity of the business (corporations only).
 Goodwill or other intangible values the business can claim.
 Comparable sales of freely traded stock of corporations in businesses similar to this business (corporations only).
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In any given situation, some of these factors weigh more heavily than others. Even in the case
of corporations, for example, smaller closely held corporations are not likely to pay dividends at
all, so the dividend-paying capacity is a negligible or nonexistent consideration. While these are
just general guidelines, each guideline that is appropriate should be applied in order to support an
honest and fair business valuation
ALTERNATIVE VALUATION
The alternate valuation date is the earlier of the date 6 months after death and the date on which
the estate's assets are distributed, sold, exchanged or otherwise disposed of. Alternate valuation
may be elected only if it is necessary to file an estate tax return. Furthermore, use of the alternate
valuation date must result in a decrease in the estate tax. The election must be made for all property included in the estate and includes only property that is not sold, distributed or otherwise
disposed of within six months after the decedent's death.
Tax experts, such as Ernst and Ernst, believe that choosing an alternate valuation date may be
helpful in reducing estate tax if the market value of the assets in the estate is declining. However, in that situation, the tax basis of those assets must also be reduced which means there will be
increased income taxes in the future if the market value of the assets rises and they are then sold.
Therefore, the decision to elect the alternative valuation date to reduce estate tax should be balanced against a possible increase in future income taxes.
If the decedent used property that he owned for forming, trade or business purposes at the date
of death, the executor of the decedent's estate may, under most situations, choose the special-use
valuation method for that property. Therefore, the property is included in the decedent's estate at
the value based on its current use and not at the value based on what its most lucrative uses might
be—if the property is used for farming, the value of the property is based upon its worth as farmland, and not what it might be worth for industrial or residential purposes.
There are special conditions that must be met before the special-use valuation method can be
used, and they are sufficient complex to require the advice of a tax advisor.
The maximum amount that the special-use method can decrease the value of the estate is
$940,000 (in 2007), increased each year for cost-of-living adjustments.
Valuation by Negotiation
One of the most popular approaches to business valuation for purposes of a buy-sell agreement
is negotiation—the parties to the agreement simply negotiate and agree upon a price that all
parties believe is fair. This is sometimes referred to as the agreed value method-though it is less
a method than simply a means of assigning a price. Both the owner and the potential purchaser
are in good positions to know how much the business is worth and to trust each other's judgments-especially if they are already co-owners of the business. However, it is often a good idea to
have a professional appraisal because business owners have been known to both overprice and
under-price the value of a business inadvertently. An appraisal will indicate whether the perceived value is at least close to the appraised value.
When a business is valued by negotiation, subsequent annual evaluations are absolutely necessary and provisions for these annual reviews must appear in the buy-sell agreement. Since the
value of a business is subject to both increases and decreases, this step is vital to providing a fair
business deal for both parties. For example, Partner X and Partner Y might agree upon a pur-
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chase price of $150,000 for each partner's business interest. Ten years later, Partner X dies after
the two partners have built a million dollar business. It is easy to see how unhappy the deceased
person's heirs will be to accept $150,000 for a business interest now worth half a million dollars.
Surprisingly, though annual reevaluation is so important, it is often overlooked. As a result,
many buy-sell agreements also include a provision that if a new price is not agreed upon annually, one of two things will occur: either another valuation method (usually a formula approach as
discussed below) automatically takes precedence; or an independent professional appraisal will
determine the purchase price if the buyout is triggered by the individual's death and no recent review (timing of "recent" must be specific) has occurred, e.g., the agreement could stipulate the
appraisal must occur if no new price has been agreed upon within two years after the date of the
last valuation.
A Special Role for Agents
The agent can play a special role in the annual evaluation as an increase in the business value
calls for additional life insurance to fund the buy-sell agreement. A calendar should be maintained by the agent of the annual valuation dates and then notifying clients when it is time to arrange the review. This would be mandatory for the agent that had arranged the funding policies
for the original buy-sell agreement—by neglecting to inform the client, the agent is leaving additional insurance "on the table."
VALUATION BY FORMULA
Book Value
Book value is the value any given asset is assigned for purposes of the business's balance
sheet, based on the cost of the asset minus accumulated depreciation. Considering the entire
business as an asset, book value is the company's net worth—the sum of its assets minus its liabilities. The major problem with book value is that, because it is based on the original cost of the
asset without regard for intangibles or for conditions in the marketplace, the book value of a
business can be significantly different from its fair market value. Very often, the book value is
less because a significant part of a business's success can be attributed to intangibles the owner
has built up over the years, such as goodwill, trade secrets, exclusive contracts, advertising techniques and even increase in property value of the business location.
Adjusted book value is book value that has been modified. For example, the value of certain
assets could be adjusted to their current market value and book value could be adjusted to reflect
accounts receivable and payable. Although book value is unacceptable for many types of businesses, it can be useful when certain conditions exist. For example, in some businesses, most
assets are current assets, such as inventories or accounts receivable. Assets such as these frequently can be liquidated quickly at a price close to their actual value. However, for businesses
that do not have this profile, book value is less realistic.
Capitalization of Earnings
Some formulas involve capitalization of earnings, which refer to the firm's average net earnings over a specified period of several years, multiplied by a certain factor. The multiplier or
capitalization rate used for this purpose is usually one that has been established for a particular
industry and can be obtained from a trade association. For example, if average net earnings over
the period are $100,000 per year and the multiplier is three, value is set at $300,000. Like book
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valuation, however, this formula method ignores intangibles. Furthermore, capitalization of
earnings also ignores the value of any other tangible assets such as inventory, equipment and accounts receivable, all of which can be significantly valuable in certain businesses. On the other
hand, capitalization of earnings formulas can work well when the value of the business is based
almost exclusively on professional services such as those provided by accountants or lawyers.
Exceptions include professional operations that want to include the value of real estate or, in the
case of a professional business with important name recognition, the value of the name, which
could be a significant intangible asset.
The "value of the name" of the business, or its reputation, brings up another important consideration in using a capitalization of earnings formula. The death of the owner who built the reputation that goes with the name could conceivably result in a sudden drop in earnings. For example, suppose a law firm's reputation is closely tied to founder J. J. Barlow, even though Barlow
employs dozens of competent attorneys who perform 95% of the legal work. If the association
with Barlow is the factor that makes the firm successful, Barlow's death can result in business
being moved elsewhere even if a new owner has the right to retain the Barlow name. Therefore,
potential loss of earnings should be considered in valuing a business based on capitalization of
earnings.
A common criticism of formula approaches is that, while they may appear accurate and fair for
any one year of business, formulas might produce unfair results for another year when changes
occur in economic conditions or in the business itself. To counteract the problems with formulaic approaches, some buy-sell agreements include provisions that tie the capitalization multiplier—for example—with a known economic indicator. Other provisions might specify that, if
profits exceed or do not meet certain margins in certain years, those years will be excluded in determining average earnings or that instead of net earnings, gross revenues will be used.
Valuation by Independent Appraisal
Particularly, for a large business or rapidly growing business, an independent outside appraisal performed by a professional appraiser is often used. Later, reevaluations are required to
keep the value up to date. While annual appraisals are not necessary, changing economic conditions should trigger periodic reviews. Professional appraisals can be costly and are not always
perfect as often with large businesses or those with exceptional growth, there are no other similar
businesses with which to compare. However, a competent appraiser is likely to ask the questions
that generate information about what makes a particular business unique and as a result, might
actually add intangible value.
One of the benefits in using professional appraisers, when appraisals are questioned, particularly involving third parties and/or the IRS, courts have usually relied upon independent appraisals
in business valuation questions. All parties are likely to be more satisfied with the opinion of an
unbiased outsider, especially if the buyer and the seller have wide differences of opinion regarding the value of the business. Also, this gives the owners more than just a "feel" for the value of
their business and often the independent evaluation can use the appraisal in various business
transactions, such as opening a line of credit with suppliers, borrowing from financial Institutions
and even dealing with a corporate board of directors.
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Importance of Valuation for the Buy-Sell Agreement
The need to appropriately value a business for purposes of funding a buy-sell agreement with
life insurance is readily apparent. The amount of life insurance purchased to fund the buyout
should equal, as nearly as possible, the purchase price. If full life insurance funding is economically unfeasible, buy-sell agreements may be written to provide for a down payment from
the buyers, who will then make a series of smaller periodic payments. In this case, the initial
amount of life insurance should equal at least the agreed-upon down payment. However, clients
should be encouraged to purchase as much insurance as they can afford in addition to the down
payment to provide for cash needs through the transition period after an owner's death. And, at
each annual or other periodic review of the buy-sell agreement, be prepared to offer additional
life insurance to meet increased cash needs, whether for funding the buyout or for other expenses
that arises at death.
Importance of Valuation for Estate Tax Purposes
As stated earlier, an accurate business valuation for a buy-sell agreement can freeze the value
for estate tax purposes. One of the most important issues is that the price must be acceptable to
the IRS, which ultimately decides how much estate tax is due. Whether the agreement is between a business owner and an outsider, an employee, or a family member, fulfilling the arm's
length transaction requirement is a key factor. Many IRS rulings and court cases have held the
buy-sell agreement valuation to be binding for estate tax purposes provided the value was reasonable when the agreement was executed, even if the price appears to be less than fair market
value when the owner died, and the valuation could be justified on its own merits. In other
words, an arm's length transaction, while key, is not sufficient per se if it appears an inadequate
price was arbitrarily set.
In establishing the buyout price, the parties to the agreement must also be careful because if the
IRS does not accept the price for estate tax purposes, the heirs can suffer a double loss. First, the
price is likely to be binding for the sale; that is, the heirs must sell the business at the price in the
agreement. However, the IRS may assign a greater value that must be included in the estate for
taxation. The result is that the estate must pay more taxes on a value greater than the estate actually received from the sale of the business. In summary, then, valuation for a buy-sell agreement
can be binding for estate tax purposes if the parties involved are careful to use a reasonable approach in establishing a value and are able to substantiate for the IRS that the value is appropriate
and meets IRS guidelines.
Chapter 3 Review Questions
1. A term that technically refers to proving the validity of a Will, but which is commonly used
to describe the entire process of administering an estate is
A. for value.
B. estate freeze.
C. Will verification.
D. transfer probate.
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2. Life Insurance proceeds are generally
A. exempt from income taxation.
B. taxable.
C. taxable for the portion that exceeds the premiums paid.
D. taxable, unless the beneficiary is the deceased person’s spouse.
3.
The federal estate tax applies to
A. an individual’s right to transfer property to others upon the individual’s death.
B. all income earned by a deceased person in the 3 years prior to his/her death.
C. property left to a deceased person’s spouse.
D. all property owned by an individual at the time of his/her death.
4. Federal gift tax is not imposed on gifts of _____________ or less per year per beneficiary.
A. $60,000
B. $30,000
C. $20,000
D. $12,000
5. Life insurance policy proceeds must be included in the value of an estate when the
A. estate pays the premiums.
B. proceeds are payable to the insured’s estate.
C. proceeds are payable to the insured’s heirs.
D. policy was term insurance.
6. The ________ provision of the tax code allows an individual to leave all property to a spouse
at death free of estate taxes.
A. unified credit
B. gift tax
C. unlimited marital deduction
D. income tax
7. A properly written buy-sell agreement
A. binds the seller and buyer to the purchase price stipulated in the agreement.
B. gives the seller’s spouse the ability to void the agreement.
C. leaves the purchase price to be determined by the seller’s heirs in the future.
D. does NOT bind the seller’s heirs or estate.
8. The minimum amount of life insurance that should be purchased to fund a buy-sell agreement is:
A. $500,000.
B. an amount at least equal to the purchase price.
C. an amount equal to the stipulated purchase price plus 10% to account for future increases
in the value of the business.
D. an amount determined by the agent.
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9. When a business owner dies the value of his/her business interest
A. is not included in his/her estate.
B. must be included in his/her estate.
C. is not included in his/her estate if there is a buy-sell agreement.
D. passes directly to the heirs’ estate tax free.
10. The IRS requires that the value of property to be included in the deceased person's estate
is the fair market value on (at)
A. the date the deceased originally acquired the property.
B. six months from the date the individual died.
C. the date the individual died.
D. the date the individual died or six months later, at the executor's option.
ANSWERS
1D 2A 3A 4D 5B 6C 7A 8B 9B 10D
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CHAPTER FOUR – BUSINESS CONTINUATION
The Proprietor Dies
Because a sole proprietor and his or her business are considered one and the same, the proprietor's death can also mean the death of the business. However, as you've seen, there are other possibilities that do not result in the end of the business. When a sole proprietor dies,
here are the three basic options:
1. The proprietorship is dissolved.
2. The proprietor's heirs continue operating the business, either as a new proprietorship or
under some other form of ownership.
3. The proprietor's heirs sell the business.
Which of these options is the best choice depends upon the primary needs, i.e., paying for final
expenses associated with the proprietor's death; administering the estate as quickly and efficiently as possible, funding on-going living expenses.
BUSINESS SUCCESSION CHALLENGES FOR PROPRIETORSHIPS
Assuming the estate closure leaves the business sufficiently intact that continued operation
seems feasible, there is the additional consideration of whether or not the heirs actually should
continue the business which should be addressed before the proprietor makes a Will and arranges
for life insurance to continue the business.
Very often, there is the vision of the family continuing the business with ownership going from
generation to generation. The problem is that heirs may not want to continue the business, or if
they have the desire, frequently they are unable to continue the business. Some very basic questions about whether heirs will be able to continue the business successfully include:
1. Were the heirs’ active in the business before the proprietors died and, therefore are they
knowledgeable about the business?
2. Do they have the necessary skills, separately or collectively, to manage aspects of a business?
3. Which of these heirs will be the decision-maker(s) and are they qualified?
4. Will the other heirs defer to the decision-maker(s) or will tensions arise over who is actually
in charge?
There are several possible scenarios for heirs' continuing the business, depending on exactly
who the heirs are, whether they want to be involved In the business and whether they are qualified to do so.
Spouse and Adult Children Heirs
There are a plethora or situations and combinations of personalities and circumstances that may
arise if the family is going to continue the business and, interestingly, this is one of the basic
plots of movies and television programs—in particular, TV "soap" operas.
While the best chance for business success occurs if the person in charge is the person who has
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the appropriate skills, relationships in a family business often take precedence over good business decisions, particularly where there are numerous heirs.
Then the major problem becomes the compensation for non-active heirs. If the business is
small, then the problem is exacerbated as there usually is insufficient funds to both run the business and at the same time, pay for other's share of the inheritance. Small businesses, in particular, rarely can survive a family feud and still continue a profitable business.
When there is a spouse and minor children as owners of a business, then new questions arise as
whether the surviving spouse wants to continue the business. If the spouse does not want to run
the business, is there a trusted employee that can run the business for the spouse and minor heirs.
Of should the business just be sold?
There is also the possibility that the owner may have had only adult heirs, maybe not even family members, in which the case the questions must be asked again, but without the possible
"family" reason to keep the business going.
Conclusion: Often, a sole proprietorship is successful largely because of the proprietor and
customers were drawn to the unique personality of that business owner and no matter who the
heirs are or how talented they are, the business may decline simply because a popular proprietor
is no longer there.
THE WILL AND LIFE INSURANCE
In every scenario described previously (with the exception of failure because a specific person
is absent), the overriding problem is related to cash. With the proprietor gone, will the business
be able to generate enough cash to ensure the financial soundness of the business and the income
needs of the heirs? For too many small businesses, unfortunately, the answer is "no," unless the
proprietor has planned carefully in advance for the eventuality of his or her death. Sadly, much
sole proprietorship is unable to continue successfully after the death of the proprietor simply because the proprietor failed to plan adequately.
Once again, a properly written Will and sufficient life insurance are the keys to:

Keeping the business intact during estate administration.

Arranging for appropriate accommodation for all heirs.

Ensuring that the transition occurs with minimal problems.

Providing a source of cash to pay expenses associated with closing the estate.

Providing income for survivors.
As indicated earlier, the Will is vitally important when the business is to be continued because
it clarifies who the proprietor intends to inherit and operate the business and what arrangements
the proprietor made to see that the transition occurs. Legally formalizing these arrangements
helps avoid many of the problems that could otherwise arise. Informally, any heir could attempt
to continue the business, but from a legal standpoint, no right exists for an heir to do so unless
the proprietor's Will so specify.
Furthermore, because there is no differentiation between a proprietor and the business, an heir
who takes over the business during estate administration is responsible for all of the business liabilities. At the same time, any profits being generated must be included in the estate for the benefit of all heirs. This is just one of the problems that can occur if heirs continue the business
when there is no Will providing the legal authority to do so.
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LIFE INSURANCE IN AN IRREVOCABLE TRUST
One way a proprietor can use a Will and life insurance policies to provide for continuation of
the business is by establishing-with the help of an attorney—an irrevocable trust and placing the
policies on the proprietor's life into that trust. When the proprietor dies, the trust provides cash
for the heirs and generally keeps the proceeds out of the insured's estate.
An irrevocable trust is one that is set up so the person establishing it, the grantor, has no right
to change the terms of the trust, to benefit from it personally or to terminate it. By surrendering
control of property in the trust, the grantor helps ensure that the value of the trust property (life
insurance proceeds in this case) will escape inclusion in the estate.
Any type of trust, which is a legal entity created under the laws of a certain state, involves three
parties:
1. The grantor who establishes and funds the trust.
2. The trustee who manages and administers the trust.
3. The beneficiary, who receives the funds and its benefits
As the grantor, a proprietor may place policies on his or her life into the trust, naming one or
more heirs as beneficiaries. The grantor must not have any "Incidents of Ownership" within three
years of his or her death in order to keep the trust's insurance proceeds out of the estate, following the same rules described previously. The trust, not the insured, owns the policies and the insured may not retain any rights associated with the policies.
In order to keep the value of trust property, called the trust corpus from being included in the
insured's estate, the trust must be established while the insured is living. This type of trust is
called an inter vivos or living trust, as contrasted with a testamentary trust, which is dictated by
the person's Will and established only upon the individual's death. A testamentary trust does not
work for the purposes we’re considering because, since the trust doesn't exist until the proprietor
dies, the proprietor controls the property that will eventually make up the corpus. This control
subjects any life insurance proceeds in a testamentary trust to the "incidents of ownership prohibition.
Under an irrevocable living trust, the trustee holds the policies until the proprietor dies, then
pays the funds to heirs according to the Will and the trust agreement. These funds may then be
used for whatever expenses occur in connection with continuing the business. To avoid inadvertently including the life insurance proceeds in the proprietor's estate, the agreement must be
written so there is no requirement that the proceeds be used to pay estate taxes or debts. Under
current law, the trust beneficiary may, however, lend the proceeds to the estate to pay these costs
without causing the proceeds to be included in the estate.
Placing life insurance policies in such a trust is another safeguard to ensure the proceeds are
available when the insured business owner dies. Since the trust owns the policies, the insured
avoids incidents of ownership and possible inclusion in the estate valuation. In addition, if a family member, for example, owned the policies, he might be tempted to borrow from the policies or
cash them in for their surrender value in the event of economic hardship. As a result, the policies
would not be available for their original purpose of continuing the business and providing cash
for survivors when the insured dies. The irrevocable trust eliminates the possibility that the life
insurance policies will be used for purposes other than originally intended.
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The Proprietorship Is Sold
It was discussed previously, the prospects of selling the proprietorship to a willing buyer, rather
than having the business continue under the direction of an heir. This may be the best option
from the standpoint of the proprietor's heirs, but the question then becomes, "Who will buy the
business and at what price?"
Remember that the estate's administrator is required by law to close the estate as quickly as
possible. If there are debts to be paid, the administrator must use whatever assets are available to
close the estate including, if necessary, the assets that make a business attractive to a buyer. If a
business sold quickly and at a fair price, the problem may be solved: debts are paid and the survivors receive immediate financial relief for their income needs.
However, that's a really big “if” as he commercial classified ads in a big city newspaper shows
numerous small businesses are on the market at any given time, and often for a very long time.
All too frequently, the sale of a small business following the owner's death occurs under pressure
to pay bills, close the estate and provide funds for the survivors. A forced sale often results in the
business being sold for considerably less than it is worth and less than the survivors had reason to
expect from a formerly thriving enterprise.
Purchase by an Employee
Instead of offering the business for sale on the open market, however, perhaps the survivors
know that a capable employee is interested in owning the business. A successful proprietorship
may employ one or more people who have the business knowledge, management skills, willingness and desire to carry on the business in the owner's absence. Such an employee is a prime
candidate for buying and successfully continuing the business when a proprietor dies and the employee has the funds to act quickly.
Purchase by a Family Member
Another possibility is that a family member who will not inherit the business wants to purchase it. For example, suppose Amelia, the sole proprietor, has three children, Shannon, Keenan
and Bryan. Shannon works actively in the business with her mother, while Keenan and Bryan are
employed elsewhere and have no interest in running the business. Rather than leaving the business to three children (or to none of the children), Amelia could arrange in advance for Shannon
to purchase the business and for all three children to share in the value of the estate after Shannon has purchased the business.
The purchasing family member, of course, need not be a child or other direct descendant of the
proprietor. For example, Amelia's brother, a cousin, or some other family member might be interested in owning the business. The key element in any case, is having the necessary cash to buy
the business when the proprietor dies.
Purchase by a Competitor
Still another potential purchaser is a competitor. Assuming the sole proprietor operates, near a
major university, a small bookstore that deals primarily in rare literary classics, with a smattering
of related book titles. Across the campus is a friendly competitor who offers a broader range of
titles.
The competitor, however, would be interested in taking over the proprietor's business if the oc-
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casion should arise. This type of sale following the proprietor's death could also be arranged,
again if the competitor has the funds available at the right time.
USING A WILL, BUY-SELL AGREEMENT & LIFE INSURANCE
In the case of a sole proprietorship, sale to an employee who knows the business may be the
best alternative for everyone when the sale is planned in advance and funded by life insurance.
The employee is assured of continuing employment in a business he or she knows and now owns
and the heirs are assured of receiving a fair price for the deceased proprietor’s business interest.
To make it happen, the Will, the buy-sell agreement and the life insurance policy must be in
place as we’ve been emphasizing. All documents must be prepared by competent experts, the
attorney, the tax accountant and the agent, naming the purchaser and describing exactly how the
sale will occur if the proprietor dies.
An employee, who is the potential buyer, whether or not the employee is a family member, has
more security about his or her future in the event the proprietor dies. Working for a business
from the perspective of eventually becoming the owner gives the individual not only a sense of
financial security, but also increased loyalty, purpose and determination to make the business
profitable. The same would be true for any family member who hopes to own the business oneday. Even a friendly competitor would be encouraged to take an interest in and informally promote the business that he or she might someday purchase. Whoever the buyer is, a funded buysell agreement guarantees that individual will have the opportunity to buy the business.
Premium Payment
A problem that sometimes arises when a proprietorship buy-sell agreement involves an employee is whether or not the employee can afford to pay the life insurance premiums. Sole proprietors who sincerely want the employee to be able to buy the business can help the employee in
one of several different ways. One way is to increase the employee’s annual salary to match the
annual premium. In this case, the employee must pay current income taxes on the increased salary, but may not take a tax deduction for paying the insurance premiums. The insurance death proceeds then escape federal income taxation, so many employees will agree to this arrangement.
However, some employees may feel their income level is not great enough to take on the additional tax burden without an immediate benefit.
Another method is for the proprietor to lend the amount of the insurance premiums to the employee. However, there are no particular tax benefits to either party under a loan arrangement
and, in fact; a loan can complicate the tax situations for both parties.
A popular arrangement that provides benefits for both the proprietor and the employee is split
dollar insurance (discussed in detail later), but the basic method of how split dollar insurance
can fund a buy sell agreement between a proprietor and an employee is as follows:
A life insurance policy is written with the proprietor as the insured and the employee as the
beneficiary. Both parties “split” all of the dollars involved. Each person pays a portion of the
premiums and shares in the benefits because the employee, as beneficiary, assigns part of the
death benefit to the proprietor's estate. Generally, the estate will receive insurance proceeds
equal to the amount of premiums the proprietor has paid and the balance goes to the employee to
purchase the business.
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TAX CONSEQUENCES
The sale of a proprietorship results in income tax and federal estate tax consequences as discussed earlier. Taxation becomes more complicated when the form of business ownership is a
partnership or a corporation.
A General Partner Dies
When a general partner dies, the immediate cash needs that arise are basically: Final expenses; Estate administration expenses; and, Living expenses for survivors.
In addition, because at least one other business owner is involved in a partnership, the deceased
partner's share of the business must be disposed of for the benefit of both the deceased person's
heirs and the remaining partner or partners. Remember that we are discussing only general partners in this section since in a limited partnership arrangement; the death of a limited partner has
no particular effect on the partnership itself. On the other hand, the death or other departure of a
general partner legally dissolves the partnership. Under certain circumstances, however, the surviving partners may arrange to reorganize and continue the business. First, though, certain legal
requirements must be met when a partner dies.
Liquidating Trustees
Unless an agreement to the contrary is prepared in advance of death to deal with a deceased
partner's interest in the business, any surviving partners become, by law, so-called liquidating
trustees of the partnership. As liquidating trustees, the partners are required to perform a number
of duties to close out the business. These duties include collecting accounts receivable, paying
all partnership obligations, completing any transactions in progress at the time of the death, selling partnership assets and splitting all proceeds proportionately among surviving partners and the
deceased partner's estate or heirs.
Problems with Liquidation
Obviously, if surviving partners want to continue the business, liquidation under these circumstances isn't favorable. First of all, the business cannot be continued if assets are sold. Secondly,
you've learned that forced liquidation generally results in a considerably smaller return than a sale
that occurs under unpressured circumstances. Thus, even if the surviving partners are willing to
liquidate and start over, it is possible they will have little capital from the liquidation proceedings
to do so. Likewise, the heirs of the deceased partner may inherit considerably less than they had
expected. However, if the partners have the foresight to agree in advance what will happen when
a partner dies, forced liquidation can legally be avoided.
Reorganizing the Partnership
Even though the existing partnership is legally dissolved when one partner dies, the surviving
partners may reorganize the partnership while continuing to operate the business. Unless a preexisting legal agreement defines the terms under which reorganization will occur, problems can
arise.
Similar to a proprietorship, a question to be answered is “Who will actively work in the business?" Heirs of the deceased partner who did not previously work in the business are not good
candidates. Even if the heirs are interested in becoming partners, they might not have the needed
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experience or skills to replace the deceased partner. Furthermore, the surviving partners might
not want the heirs to take their deceased partner's place.
Another possibility is that the heirs might choose to sell the deceased person's interest to another party who would then become a partner. Whether or not such a buyer has the necessary expertise, the surviving partners might not want an "outsider as a partner. The optimum choice is generally for the surviving partners to purchase the deceased partner's interest from his or her heirs.
Control of the business then remains with the reorganized partnership. The heirs receive a fair
price for their share, and the partners have the option of accepting new partners of their choice or
simply continuing in business with one less partner.
Life Insurance
A buy-sell agreement funded by life insurance is again the guaranteed solution to business continuation when a partner dies. The same basic principles involved in ensuring a smooth and efficient transfer of a business from one party to another when an owner dies are critical to a successful partnership buyout:

The deceased partner's Will, should note the existence of the buy-sell agreement
and the insurance to fund the agreement.

The buy-sell agreement should specify the exact terms under which the buyout
will occur, obligating the heirs to sell and the remaining partners to buy the deceased person's business interest.

One or more cash value life insurance policies should be purchased to fund the
buyout and should be identified in the buy-sell agreement.
PARTNERSHIP BUY-SELL AGREEMENT FORMATS
By law, a partnership is a business entity separate from its owners even though the partnership
acts as a conduit through which business income flows to each individual partner. Because a
partnership is a separate entity unlike a proprietorship, partners may select one of two basic
forms of buy-sell arrangements.
CROSS-PURCHASE AGREEMENT
Under a cross-purchase arrangement, the partnership entity itself is not a party to the agreement. Instead, each partner agrees with every other partner to buy out the interest of any partner
who dies. When a cross-purchase agreement is funded by life insurance, each partner purchases
a life insurance policy on the life of every other partner. If a partner dies, the life insurance proceeds are paid from each individual policy to the partner who owns that policy. In turn, the surviving partner uses the proceeds to purchase part of the deceased person's interest in the business.
For example, if there are two partners, the surviving partner purchases the entire interest of the
deceased. If there are three or more partners, each of the survivors purchases a proportion of the
deceased person's interest as agreed upon in the buy-sell contract.
Unequal Partnership Interests
The previous discussion assumes each partner owns an equal share of the business, but this is
not always the case. Suppose Marlowe and Norman originates a two-person partnership, each
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owning 50% of the business. Several years later they decide to take on a third partner, Oliver,
who purchases 10% of the existing business interest, with Marlowe and Norman now owning
45% each instead of 50% each.
Various buy-sell arrangements are possible. For example, if Marlowe, who is a 45% owner,
dies, the agreement could stipulate that Norman, the other 45% owner, will purchase 30% resulting in 75% ownership after the death) and Oliver, the 10% owner, will purchase 15% (resulting
In 25% ownership).
Or, each surviving partner might purchase 22.5%, resulting in 67.5% and 32.5% ownership respectively.
And another possibility: If Oliver, the 10% owner, dies, each survivor might purchase half of
Oliver's interest, again restoring the 50-50 ownership.
The amount of insurance on each partner's life would be adjusted to meet the requirements of
the buy-sell agreement, both originally and when additional insurance is purchased following the
death of a partner.
ENTITY PURCHASE AGREEMENT
Another approach is an entity purchase buy-sell agreement, under which the partnership entity, not the individual partners, agrees to buy a deceased partner's interest. In this case, the partnership purchases policies on the lives of each partner and the proceeds are paid to the partnership business when death occurs. The partnership is then bound to purchase the interest from the
deceased person's heirs and, of course, the heirs are obligated to sell at the agreed upon price. An
entity purchase arrangement can be less cumbersome when there are many partners, requiring
numerous individual policies. But aside from sheer numbers, an entity purchase plan might be
selected simply because that is the form the partners prefer.
This is a market for additional life insurance policies covering each surviving partner. Once
again, an agent who has stayed current with this partnership is in a position to sell the additional
insurance.
Funding with First-to-Die Policies
An insurance concept sometimes used for buy-sell agreements-for either partnerships or corporations-where there are several owners is a first-to-die policy that covers all owners under the
same policy. The life insurance proceeds are paid upon the first death. Surviving partners then
have the option to replace the policy with another first-to-die policy covering the survivors, without requiring medical exams or proof of insurability. In addition to forgoing medical underwriting, such policies offer the convenience of dealing with just one policy and generally lower premiums than are required for individual policies. Typically, the business entity owns the policy
and pays the premiums and then uses the proceeds to purchase the deceased owner's share as described above.
Tax Consequences for Partnership Buyouts
Premiums paid for life insurance to fund a buy-sell agreement are not tax deductible, whether
paid by the individual partners or by the partnership entity. You'll recall that this is true for buysell agreements initiated for the purchase of proprietorships. However, many of the same tax advantages also apply when the death proceeds are paid to fund the purchase.
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INCOME TAXATION OF LIFE INSURANCE PROCEEDS
One of the major advantages of using life insurance (in addition to the guarantee that funds will
be available when needed) is that proceeds are generally income tax free to the beneficiaries, the
surviving partners or the partnership as the case may be. Death proceeds lose this tax exemption
only by violation of the transfer for value rule. Unlike situations involving family members,
where buying or selling a policy can cause loss of tax-exemption, however, partnership principals
may freely transfer policies to and from other partners or the partnership. This exception to the
transfer for value rule, benefitting partnerships, is specifically provided in the tax law.
Life insurance proceeds are not income tax free if the IRS determines they do not pass one of
the "tests" for life insurance according to the Internal Revenue Code definition. The primary
consideration is that if benefits paid from a policy do not qualify under the tests as life insurance
proceeds, they will be taxed as investment income instead of being received tax-free.
INCOME TAX CONSEQUENCES FOR THE PARTNERS
No Partnership Termination
A partnership is automatically terminated when 50% or more of a partnership interest is transferred in a 12-month period, and some unfavorable tax consequences can result. However, when
a partner's interest is transferred to one or more surviving partners because of death, the partnership are not considered to be terminated as long as some form of payment is made to transfer the
interest from the deceased to the partnership or individual partners. Even if there are just two
partners, each owning 50% or one owning more than 50%, no termination occurs when these requirements are fulfilled.
Partnership Income
The death of a partner closes the partnership's tax year for that partner. Generally it does not
close the partnership's tax year for the remaining partners. The deceased partner's share to be distributed must be calculated as if the partnership' tax year ended on the date the partner died/.To
avoid an interim closing of the books of the partnership, the partners can agree to estimate the
decedent's distributive share by prorating the amounts the partner would have included for the
entire partnership tax year
A partnership's tax year closes with respect to a partner whose entire interest in the partnership
is terminated by death. Therefore the partnership income must be allocated between and reported
by the decedent and the decedent's successor in interest. The final individual income tax return
should include the decedent's share of partnership income and deductions for the partnership's tax
year that ends within or with the decedent's last tax year (the year ending on the date of death),
and the final return must also include income for the period between the end of the partnership's
last tax year and the date of death. The income for the partnership's tax year after the partner's
death is reported by the estate or other person who has acquired the interest in the partnership.
There are several methods available that ensures the immediate transfer of the partnership interest to the spouse upon the partner's death. This can be rather complicated and expert tax advice is needed.
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(Formerly) Stepped-Up Basis
Prior to 2001 Tax Act, the stepped-up basis of property acquired from the deceased, there is
no taxable gain (or loss) for those acquiring the partnership interest and the basis of the surviving
partner or partners would have been. However, the 2001 Tax Act provided that the step-up in
basis rules are to be replaced with a carryover basis system in 2010. As of this date (2008) the
carryover basis rules had yet to be determined by Congress.
Alternate Valuation Date
The alternate valuation date is the earlier of the date 6 months after death and the date on which
the estate's assets are distributed, sold, exchanged, or disposed of. Alternate valuation can be
elected only if it is necessary to file an estate tax return. But when the alternate valuation date is
used, it must result in a decrease of the estate tax. The election is required for all property that is
included in the estate and includes only property that is not sold, distributed, or otherwise disposed of within 6 months after the decedent's death.
Choosing an alternate valuation date may help to reduce the estate tax if the market value of the
assets in the estate is declining. But, if the value of the assets is so declining, then the tax basis
of those assets must also be reduce, which means that the income taxes in the future will be increased if the market value of the assets rises and they are than sold. Therefore, any decision to
use the alternate valuation date to reduce estate tax should be balanced against a possible increase
in future income taxes.
Income Tax Consequences of the Buyout for the Estate
The deceased partner's estate itself is subject to income taxation on the sale of the partner's interest, though adjustments could occur to the basis of the partnership's property—such as adopting an alternate valuation date.
INCOME TAX RATES ON CAPITAL GAINS
One of the best ways to save tax dollars is to generate long-term capital gains, which are profits
that the business makes from the sale of assets, such as stocks, bonds and real estate. However,
in order to qualify for long-term capital gains, the capital asset must be held for more than one
year.
Under the (recent) tax law, the top tax rate applicable to most long-term capital gains is 15%
(unless the taxpayer are in the 10%-15% income tax bracket, then it is 5%), such rates applicable
through 2010. The net capital gain equals the net long-term capital gains less net-short-term capital losses, A 28% rate applies to collectibles held over 12 months, a 25% rate applies to real estate gains to the extent of depreciation. The short term capital gains tax and ordinary income tax
is 35%.
Partnership Entity Buyout or Liquidation
When the partnership entity purchases the deceased partner's interest, income to the estate is
taxed according to IRS rules for the liquidation rather than the sale-of a partner's interest. The
primary difference between liquidation and a sale concerns how the value of goodwill is treated.
(See the next section for taxation on the basis of a sale.) In recent years, the value of goodwill
was typically treated as ordinary income unless the buy-sell agreement stipulated treatment as a
capital asset, in which case the liquidation payments to the estate would be subject to capital
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gains taxation.
As stated above, capital gains are profits from the sale of capital assets. The advantage of capital gains taxation is that taxpayers may deduct any capital losses from capital gains for the year
and report only the excess, if any, as income, potentially reducing the amount of taxable income.
This excess income is then included in gross income and taxed at an individual's regular marginal
tax rate. In the case of a buyout because of a partner's death, the rate would be the estate's income tax rate. The point is, if the value of goodwill included in the purchase price is treated as
capital, the estate may benefit from offsetting capital losses, just as an individual may so benefit,
rather than having the entire amount fully taxed as ordinary income.
On the other hand, from the partnership's point of view, treating the amount paid for goodwill
as ordinary income allows the partnership to take a tax deduction for that amount. So, while capital gains treatment has the potential to benefit the estate, ordinary income treatment has the potential to benefit the partnership. The partners themselves could decide which choice to make and
incorporate that decision in a written agreement, such as the original partnership articles or the
buy-sell agreement. It is time for legal or accounting professional help again.
The determination as to whether goodwill is to be considered as ordinary income, and the taxing of income from personal services is from fees, commissions or other types of compensation
is presently complex and is in changing. Any discussion at this time could be erroneous, at least
until tax year 2010 and the new (?) Congress addresses the confusion. These laws are of interest
to life insurance agents, but practically speaking, some of the changes, regardless of magnitude to
the taxpaying public, require tax expertise from professionals.
Individual Cross-Purchase Buyout or Sale
When a cross-purchase buy-sell agreement is used, under which each individual partner purchases the deceased partner's business interest, the transaction is treated as a sale, rather than liquidation. While the rules are similar to those for liquidation, the tax code provides that the entire
transaction must be treated as a capital transaction. This means there is no option to treat as ordinary income any portion of the purchase price that is allocated to goodwill.
Avoiding Federal Estate Tax
Remember that life insurance policy proceeds used to fund buy-sell agreements can also escape
federal estate taxation in the deceased person's estate, provided:
1.
Proceeds payable to or for the benefit of the estate.
2.
Incidents of ownership by the insured person.
3.
A gift of the policy within three years of death.
4.
A transfer of the policy for inadequate consideration.
Value of the Decedent's Business Interest
While life insurance proceeds are not included in the estate as long as these requirements are
met, the value of the deceased partner's business interest is included. As a result, because life insurance proceeds paid to the partnership increase the partnership's value, a part of the proceeds
could be included unless:
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1. The buy-sell agreement specifically excludes the proceeds and
2. The buy-sell agreement establishes valuation for estate tax purposes.
Policies Owned by the Deceased Partner
Under the cross-purchase type of buy-sell agreement, the partner who dies still owns life insurance policies on the lives of the now surviving partners. Actually, the value of those policies is
included in the deceased person's estate. Typically, the buy-sell agreement should give the surviving partners the option to purchase the policies on their own lives, usually for an amount equal
to the cash values in the policies. The benefit to the partners is acquiring insurance coverage for
premiums determined at their younger ages and without now having to prove they are still insurable. Because there is an exception for sales of policies to the insured’s themselves, the transfer
for value rule discussed previously is not a problem. That is, the policy proceeds do not lose their
tax-exempt nature because the policy is sold or transferred as long as the policy is sold to the insured person.
Alternatively, suppose there are two surviving partners. Each of the survivors may purchase
from the estate the policy on the other partner's life, again without losing the tax exemption for
the proceeds. This is true because the transfer for value rule makes another exception for policies
sold or transferred to the insured's partner or the partnership. Thus, if the partners decided to
change from a cross-purchase plan to an entity plan, the partnership entity could also purchase
the policies from the estate without a transfer for value problem.
A Stockholder Dies
As indicated elsewhere, the corporations most likely to be receptive to discussing business continuation insurance are closely held. Closely held corporations can be either C or S types and
may include professional or personal service corporations. In addition, many such corporations
are owned by various members of the same family, although this is not necessarily the case.
And, in the case of S corporations, the businesses often operate more like partnerships than corporations. In many cases, one significant owner holds the majority of the stock in a closely held
corporation: in others, there are just a few stockholders, with perhaps as few as two owning most
of the stock.
As a result, the death of a single stockholder can have a negative effect on the business as potentially devastating as the death of a proprietor or a partner even though the corporation, unlike
a proprietorship or partnership, does not cease to exist legally. Unlike a large public corporation,
for example, a close corporation usually:

Is managed by the same people who are the stockholders.

Pays most of its income out as salaries rather than as dividends.

Has stock that cannot be freely traded on the open market.
When a closely held corporation stockholder dies, therefore, the immediate cash needs and
problems associated with continuing the corporation is nearly identical to those of incorporated
businesses:

Final expenses must be paid.

The deceased stockholder's estate must be closed quickly.

The deceased stockholder's family needs income for ongoing living expenses.
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

The deceased stockholder's heirs want to receive their fair share the business interest.
The surviving stockholders want to continue the business without taking on new
stockholders not of their choosing who have inherited or purchased the deceased
person's stock.
All of these needs and potential problems have been discussed in connection with proprietorships and partnerships. The separate nature of a corporation, however, means some additional
concerns must be considered and planned for in advance in order to provide for fair and equitable
treatment of stockholders who are actively working in the business and heirs who are either inactive stockholders or non-stockholders.
The answer, of course, lies in the stockholder's Will, a buy-sell agreement and insurance to
fund the purchase of the corporate stock when a stockholder dies.
Buy-Sell Agreements for Corporations
The advantages of using a buy-sell agreement funded by life insurance are generally the same
for close corporations as for other business types. Some of the tax factors inherent in incorporated businesses do play a role and will be discussed thoroughly. For the most part, though, such
an agreement assures the money will be available to purchase the deceased person's stock, benefitting both the business and the heirs, all parties are bound by the terms of the agreement and the
value of the business may be fixed for estate tax purposes.
Cross-Purchase Agreement
Under a cross-purchase stock buyout agreement, each stockholder agrees to purchase the stock
of any other stockholder who dies. The surviving stockholders are obligated to buy and the heirs
and/or estate are obligated to sell at the price (or based on the method of valuation) stipulated in
the agreement. Each stockholder owns and pays the premiums for a life insurance policy on the
life of every other stockholder. When a stockholder dies, the policy proceeds are paid to each
surviving stockholder, who then uses the funds to purchase the deceased person's stock.
In some cases, the owners might prefer a cross-purchase plan to an entity plan even when there
are many stockholders. To avoid dealing with many individual life insurance policies, a trust can
be established to own the policies. The trustee buys and owns the policies, but the stockholders
actually pay the premiums by first contributing them to the trust. The trust is then the beneficiary
of the life insurance proceeds, but is, of course, obligated to use the proceeds to execute the buyout according to the terms of the buy-sell agreement.
Caution is in order concerning such trusts because of recent tax memoranda addressing this
very issue. Care must not be exercised in establishing the trust to be certain that stockholders do
not retain any incidents of life insurance ownership, nor have any right for the trust to revert to
them. This appears to be a sticky issue for buy-sell agreements funded with life insurance policies that might conceivably be returned to stockholders after other stockholders die. It should be
mandatory for a client who is considering a trust arrangement to consult with tax and legal counsel first.
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Stock Redemption (Entity) Agreement
The stock redemption type of buy-sell agreement is equivalent to an entity purchase agreement
because the corporation, rather than the individual surviving stockholders is the party that agrees
to purchase or redeem the deceased person's stock. While this type of agreement, funded by life
insurance, is more convenient when there are many stockholders, it does pose some unique tax
considerations, as you'll soon see. As a result, some corporations may choose the cross-purchase
plan, even when it must include a large number of individual life insurance policies. Alternately,
the corporation might fund the agreement with a first-to-die policy.
Tax Consequences for Corporate Buyouts
Premiums paid by either the corporation or individual stockholders for the insurance to fund
the agreement are not tax deductible. While a corporation that benefits directly or indirectly from
the policy would be disqualified from taking the deduction in any event, there is another factor
that precludes the deduction for a corporation. Businesses may deduct only ordinary and necessary business expenses. Life insurance premium payments to fund buy-sell agreements do not
represent such expenses, instead being considered a capital expense, expense made to acquire an
asset, which in this case is the stock. This rule applies whether the premiums are paid by the
corporation itself or by the stockholders.
Premiums vs. Taxable Income
Generally speaking, premiums paid for insurance to fund buy-sell agreements are not considered taxable income for the owners unless the policy proceeds will be paid directly to the owner's
estate or other beneficiary the insured personally selected (such as a spouse, children or other
heir). However, even when a personal beneficiary is named, if that beneficiary is obligated to sell
the stock in order to receive the proceeds, the premiums are not taxable as income.
On the other hand, the IRS has ruled that such premiums represent dividends in the case of
close corporation. Characterized as dividends, then, the premiums are taxable income to the
stockholders. If the corporation pays the premiums but the stockholders own the policies, the
premiums are taxed as dividends.
Although S corporations are generally subject to the same rules, when the premium is considered to be a distribution of profits as a dividend; taxation follows different paths depending on
whether or not the corporation has accumulated earnings—earnings in excess of requirements
to meet "reasonable needs of the business."
Sometimes S corporations that were formerly C corporations have such earnings from previous
years. If an S corporation does have previous accumulated earnings, it's possible that all or part
of the premium will be treated as a dividend and taxed as current income. Whether or not that
occurs depends on the specific circumstances.
However, if the S corporation does not have accumulated earnings from previous years, the
premium is treated partly as a return of the stockholder's investment and partly as capital gain,
the exact proportions depending on the particular situation. The precise details of how taxation
is determined are beyond the scope of this text, but you can see that S corporation taxation is
even more complex than corporate taxation in general.
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Income Taxation of Life Insurance Proceeds
Life Insurance proceeds paid to fund corporate buy-sell agreement are, in general, income tax
free to the beneficiaries as long as all IRS requirements have been met. However, another factor
comes into play: the possibility that life insurance cash values and/or proceeds will trigger an alternative minimum tax.
ALTERNATE MINIMUM TAX
This section briefly discusses an additional tax that some taxpayers may have to pay. Simply
put (as much as is possible) since the tax laws give special treatment to some kinds of income
and allows special deductions and credits for some kind of expenses, the IRS has devised a way
to get some of that money back into its coffers. This is done by using a minimum amount of tax
through an additional tax—the alternate minimum tax (AMT).
The purpose of the AMT was to make sure that the "rich" paid at least some minimum amount
of tax. Until recently, there were very few situations of taxpayers being subject to the AMT.
However, the IRS gives and the IRS takes away…since the regular income tax rates were reduced, our legislators could not stand it unless there was a corresponding increase in the AMT.
In actuality, the AMT is a separate tax system with its own allowable deductions and exclusions, often completely different from those allowed for income tax purposes. To arrive at the
AMT, the regular income tax must be calculated, then calculate the tax under the AMT system
and then pay the greater of the two amounts. Some (just some) of the more common items that
are treated differently under the two tax systems that can affect the AMT amount:

State & local income taxes and sales taxes

Real estate and personal property taxes

Large medical and dental expenses

Miscellaneous itemized deductions

Interest expense from a mortgage or home equity loan that is not used for the purpose of acquiring, constructing or improving a principal residence or second home

The "spread" on the exercise of incentive stock options (ISOs)

Deductions for standard exemptions

The standard deduction
Sharp eyes may have already noticed that one of the differences relates to the State, local income, sales and real estate taxes —they are allowable as a deduction against your income for
regular tax purposes but not for the AMT. As an example that illustrates the difference (without
going into all the specifics) would be where a typical family with 2 children and with gross wages of $250,000. Further assume that their local income and real estate taxes were $22,500 and
mortgage interest of $20,000. If they have no interest, dividend, or capital gain income, in 2002
their federal income tax would have been $52,933, but not subject to the AMT because that calculation was only $52,780.
Now (2007) arrives, and assume that all income and deductions remain constant, and with no
inflation adjustments, their regular income tax would be $44,223. However, their AMT will be
$53,900—$9,677 more than their regular tax amount. That's the way it is, even though their regular tax rates have decreased.
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How AMT Can Affect How to Invest?
There are many little items that can affect the AMT; such as if part of an investment portfolio
consists of municipal bond holdings—oh, oh! Private activity bond interest is an item that can
make it more likely that the taxpayer can be subject to the AMT. This means, in actual practice,
even though one can earn higher interest on private activity bonds than other municipals, if the
taxpayer is subject to the AMT, the effective yield will be slashed. If a person invests in various
types of bonds, they MUST contact their tax advisor.
Long-term capital gains and qualifying dividends as subject to the same maximum rate 15% for
AMT calculations as they are for regular tax purposes. But since these items are included in the
AMTI, which could reduce the allowable exemption, so the actual marginal rate could be as high
as 22%. The lesson here is that prior to investing in securities that generate this type of income,
the AMT must be taken into consideration.
Without going into lengthy detail, in the example above, if long-term capital gain of $100,000
is added to their $250,000 income, one might expect that the additional tax burden under AMT
would be $22,000. However, if these folks lived in a state that had an 8% tax rate, the amount of
taxes due on the $100,000 would be $30,000.
When is the AMT Applicable?
Generalities again, but to get a feel for this tax, the taxpayer may have to pay the alternative
minimum tax if the taxable income for regular tax purposes, combined with certain adjustments
and tax preference items, is more than $45,000 for married filing joint return (or qualifying widower) with dependent child; $33,750 if single or head of household; or $22,500 if married filing
a separate return.
NOTICE
As indicated in discussions of taxes of various kinds, Congress continues to reenact temporary
measures that consistently raised the applicable exemption amounts above the 2000 level. At
this particular time, the last temporary increase expired at the end of 2007. The new rules are as
shown below. For further information the publication is available on www.irs.gov , Publication
553 (4/2008).
The basic rule is still:
Individuals, trusts and estates must pay the alternative minimum tax (AMT) if it exceeds their
regular tax liability for the year.
Alternative Minimum Tax (AMT) 2007
The following changes to the AMT went into effect for 2007. For more information, see Form
6251, Alternative Minimum Tax—Individuals, and its instructions.
AMT exemption amount increased. The AMT exemption amount has increased to
$44,350 ($66,250 if married filing jointly or qualifying widow(er); $33,125 if married filing
separately).
AMT exemption amount for a child increased. The AMT exemption amount for a child
under age 18 has increased to $6,300.
Hurricane Katrina additional exemption expired. The additional exemption for taxpay-
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ers who provide housing for a person displaced by Hurricane Katrina has expired. Therefore,
the additional exemption amount (formerly line 6 of Form 8914) is no longer allowable for
the AMT.
Deduction for qualified mortgage insurance premiums allowed for the AMT. In most
cases, no AMT adjustment is required for the deduction of qualified mortgage insurance
premiums.
Foreign Earned Income Tax Worksheet revised. The Foreign Earned Income Tax Worksheet in the Form 6251 instructions has been revised to reflect changes made by the Tax
Technical Corrections Act of 2007.
Certain credits still allowed against AMT. The special rule that allows the credit for child
and dependent care expenses, credit for the elderly or the disabled, education credits, residential energy credits, mortgage interest credit, and the District of Columbia first-time homebuyer credit to be applied against the AMT was scheduled to expire at the end of 2006. However,
Congress has extended the special rule through 2007, so those credits can be applied against
the AMT for 2007.
Again, while this is obviously of importance to many businesses and business-persons, this is
so complicated and so susceptible to changes, that further discussion is of little value. Even
though the IRS information can be obtained on the Internet, it is so complicated that even the
small part that applies to life insurance is complex.
LIFE INSURANCE AND AMT
For corporations, the presence of corporate owned life insurance policies-such as those used to
fund a stock redemption buy-sell agreement-adds to the possibility that the corporation will have
to pay the AMT. The reason is that one of the tax preference items involves the corporation's socalled book income shown on its financial statement, which will include certain values of life
insurance policies. The next paragraph explains when and how life insurance policies play a role
in the AMT. Remember, though, that corporate owned life insurance policies alone do not trigger
the tax; they are just one of many factors that can contribute to the requirement to calculate
AMTI.
In determining AMTI, C corporations (but not S corporations or individuals) must perform an
adjustment to regular income to show adjusted current earnings (ACE). This is another complicated item that we will not discuss in detail, instead focusing on the role of corporate owned life
insurance. The tax code requires the ACE calculation to include the inside buildup (cash values)
of life insurance policies and the death proceeds in certain cases. Therefore, corporate owned life
insurance policies can contribute to the AMT problem when:
1. The annual increase in a policy's cash value is greater than that year's premium.
2. The amount of death benefits paid is greater than the policies cash value.
After a few years in force, nearly all life insurance policies sold today would result in cash value increases greater than the annual premium. And, in essentially all cases, death benefits are always far greater than a policy's cash values. As a result, life insurance policies owned by the corporation, combined with other tax preference items, have a significant potential to trigger the alternative minimum tax.
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Stock Redemption vs. Cross-Purchase Plans and AMT
From the C Corporation’s point of view, the threat of triggering the alternative minimum tax
might be enough reason for the owners to consider implementing a cross-purchase plan rather
than a stock redemption plan. When each individual stockholder owns and is the beneficiary of
the policies and the corporation is neither the owner nor the beneficiary of any life insurance policy, the AMT problem for the corporation is eliminated insofar as the life insurance is concerned. Remember, though, other factors can trigger AMT, so the stockholders should consult
with their tax and accounting experts in making this decision.
Stock Redemption and Accumulated Earnings
Stock redemption buy-sell agreements funded by life insurance also have the potential to affect
a corporation's accumulated earnings situation since the cash values of corporate owned policies
can represent accumulated earnings. The amounts the corporation retains from earnings to pay
premiums are also accumulated earnings. Unfortunately, the IRS and the courts have been at
odds in various cases involving accumulated earnings and what constitutes a reasonable need of
the business. Generally, corporations can make a valid argument that accumulating funds to pay
for a stock redemption in the event of a stockholder's death falls within the guidelines of reasonable business needs. This is further bolstered by the fact that, in many states, the law requires
surviving stockholders of certain professional corporations to purchase the deceased person's
stock.
In general and in the absence of any clearly state across-the-board IRS rulings, a corporation
can expect not to have to pay an accumulated earnings tax based on the presence of corporate
owned life insurance that funds a stock redemption agreement. If additional tax rulings or new
laws clearly change that position, however, the problem could be solved by using a crosspurchase agreement instead.
Income Tax Consequences of the Buyout
One of the major problems with corporate stock redemptions concerns whether the redemption
will be deemed by the IRS as being the equivalent of a dividend distribution. This characterization is to be avoided because dividends are taxed doubly first to the corporation (which may take
no deduction for a dividend distribution) and then to the stockholders. Therefore, the goal is for
stock redemptions to receive capital gains treatment. One problem is that when a C corporation
makes a payment to a shareholder (or the shareholder's estate), the IRS characterizes payments as
dividends rather than as a capital sale. Fortunately, the tax code also provides some exceptions.
When the corporation redeems all of a stockholder's shares, the IRS treats this transaction as a
sale, not a dividend. In the case of a deceased stockholder, this seems simple enough. However,
the law provides that the corporation must redeem not only the stock the deceased (or the estate)
actually owns, but also stock that is constructively owned. The provisions of the tax code that
address this issue are called the constructive ownership or attribution rules.
Attribution Rules
The attribution rules apply only to stock redemption agreements. The terminology comes
from the fact that stock owned by one party is, in some cases, attributed to or considered constructively owned by other related parties. For example the law attributes stock owned by a ben-
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eficiary of an estate to the estate. Suppose the deceased stockholder is Ralph, whose estate receives his shares of stock? Ralph's son Mark, who is a beneficiary of the estate, is also a stockholder in the corporation. Mark's shares of stock, therefore, are attributed to or considered owned
by Ralph's estate. The result is that, even if the corporation redeems all of Ralph's shares, the law
does not consider it a complete redemption because Mark's stock is attributed to the estate. And
without the completely redemption status, the payment is considered a dividend, not a sale.
The situation becomes especially sticky in corporations where family members comprise most
or all of the shareholders because of family attribution rules. Family attribution attributes stock
owned by an individual's spouse, children, grandchildren and parents to ownership by that
individual. Only these relationships cause attribution; note that there is no mention of siblings,
grandparents, aunts and uncles, nieces and nephews, cousins, or In-laws.
Considering the severe problems associated with family attribution rules, it might appear there
is no way to avoid having a corporate stock redemption treated as a dividend distribution in family cases. However, the law does provide various ways around these rules. In general, when a
stockholder's direct interest is completely terminated, the family attribution rules may be waived
under certain conditions, allowing the redemption to be treated as a sale. The details of these arrangements are beyond the scope of this text. In addition, remember that attribution problems can
be avoided by using a cross-purchase agreement.
SECTION 303 REDEMPTION
Section 303 of the Internal Revenue Code permits a corporation to redeem all or a portion of a
decedent's stock in such a manner that it will not be taxed as a dividend. Redemption under Section 303 can provide cash for estate taxes and other expenses without the income tax consequences associated with the declaration of a dividend.
REQUIREMENTS
1) The value of the stock that is redeemed must be included in the gross estate of the decedent
in calculating the federal estate tax.
2) For federal estate tax purposes, the value of the stock that was included in the decedent's estate must be greater than 35 percent of the adjusted gross estate. For the purpose of Section
303, adjusted gross estate is defined as the gross estate minus deductions for expenses,
debts, and estate taxes.
3) There is a limit on the amount of stock that can be redeemed and still receive favorable tax
treatment. This amount is equal to all estate, generation skipping and state inheritance taxes
plus the funeral and administration expenses associated with the stockholder's death.
4) There is also a restriction on who can sell the stock in Section 303 redemption. The corporation must purchase the stock from the person who is responsible for paying the estate taxes
and administrative expenses.
In order for a corporation to redeem shares it obviously must have funds available. A convenient method to have these funds available could be to keep the funds on hand in a corporate account.
However, there is a potential problem with this strategy called "excess retained earnings." According to IRS regulations a corporation that has more than $250,000 may have "excess retained
earnings" and be subject to a penalty.
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SITUATIONS THAT MAY WARRANT USE OF SECTION 303
(IRS) Section 303 is a special section that could be have interest if:
1) It would be advantageous to keep control of a closely held corporation.
2) The closely held corporation's stock represents a substantial portion of the estate and it is
undesirable to liquidate the business for the purpose of paying estate taxes and administration expenses.
3) A plan to provide the corporation with the capital to redeem the stock has been implemented.
Section 303 rules are complex. While the above provides an overview, careful review by a
competent tax or legal advisor is necessary to determine eligibility and application of Section 303
Section 303 of the tax code provides relief for family businesses while guaranteeing that a partial stock redemption will be treated as a capital transaction (sale or exchange) rather than as a
dividend. Named after the pertinent part of the code, a Section 303 redemption overrides the difficult attribution provisions and related dividend treatment we just discussed. Section 303 redemption is generally available only for smaller, closely held family businesses where the stock
is a large part of the estate.
Since the estate's basis in the decedent's stock will be the stock's fair market value at the date of
death (for decedent's dying before 2010) only post-death appreciation will be taxed upon the redemption and only up to the maximum long-term capital gains tax rate (generally 15% for sales
and exchanges before 2009). To qualify for the Section 303 redemption, the value of all the
stock of the corporation included in the decedent's gross estate must exceed 35% of the decedent's gross estate. The adjusted gross estate is the gross estate less the allowable deductions for
funeral and administration expenses, debts, the family-owned business deduction, and certain
losses (but before any charitable deduction or marital deduction). A qualifying redemption under
Section 303 is limited in amount to the sum of the following:

Federal and State death taxes,

Funeral expenses, and

Estate administration expenses.
Note: The advantages of sale and exchange treatment under Section 303 may be rather diminished under the tax law which taxes certain qualified dividends at the lower capital gains (as contrasted to ordinary income) rate. As long as the redemption by the estate results in qualified dividend treatment, the estate would be taxed at 15% on post-death appreciation without meeting the
Section 303 requirements.
Also, an estate does not actually have to be illiquid in order to qualify for this special exemption. The estate may redeem stock up to the maximum amount referred to above, if the estate has
sufficient liquid assets to take care of its expenses and taxes.
When all of these requirements are fulfilled, a partial redemption will be considered a sale and
will receive capital gains tax treatment rather than being treated as a dividend. Both C and S corporations are eligible for section 303 redemptions. The primary purpose of this provision is to
help small family businesses avoid involuntary liquidation or bankruptcy by virtue of needing
funds to pay final expenses and taxes associated with a stockholder's death.
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(Previous) Stepped-Up Cost Basis
As discussed earlier in the discussion of Partnerships, while there was a stepped-up cost basis
that must be taken into consideration prior to the 2001 Tax Act, this is no longer the case and
Congress has yet to act with a promised carryover basis system by 2010, which as of 2008 had
not yet been enacted.
Under a stock redemption, where the corporation makes the purchase, the other stockholders
are not involved at all. As a result, no increase in cost basis is available. However, each stockholder's proportionate share of the corporation's value increases. With no complementary increase in basis, then, a later sale will result in greater taxable income (assuming the stock value
increases).
On the other hand, under the S corporation structure, the stockholder's basis is increased no
matter what form of buy-sell is used since the S corporation's transactions flow through to each
stockholder.
METHODS USED TO FUND A SECTION 303 STOCK REDEMPTION PLAN
There are three ways that a corporation can fund a Section 303 stock redemption plan:
1. Cash
The corporation could accumulate sufficient cash to redeem the stock at the death of the owner.
In many cases it would take many years to save sufficient funds, while the full amount may be
needed in a few months (or years), also, accumulated earnings tax may arise.
2. Loan
Even if the corporation could obtain a business loan at a time when corporate credit is likely to
be impaired, borrowing the purchase price requires that future business income be used to repay
the loan—plus interest, of course. Perhaps the surviving spouse or an adult child could lend the
money to the corporation to fund the redemption, if they have access to sufficient funds. Even
then, future corporate earnings would be needed to repay the corporate debt.
3. Insurance
Life insurance can guarantee that the cash that is needed to redeem the stock will be available
exactly when needed. A life insurance policy on the owner in an amount equal to the expected
partial redemption is the most efficient and effective source of funds for Section 303 stock redemption purposes.
Summary
As indicated, if accumulated earnings are used to fund a partial stock redemption under Section
303, every dollar that is uses costs the corporation a full dollar. If, instead, it uses the borrowed
money, the cost of the transaction is increased by the interest that the corporation must pay. For
illustrative purposes, assume that it borrows the necessary funds on a 5-year note at 8% interest;
then the additional cost for each borrowed dollar is $.40, bringing the cost for each dollar used to
make the redemption at $1.40.
If life insurance is purchased and the purchase is made using the policy's death benefits, the aggregate premium paid for the each stock redemption dollar would be less than 50¢. There are
also other benefits, such as timely providing of cash; eliminating the needs to deplete cash or bor-
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rowing; avoiding possible accumulated earnings tax problems; increasing the value of the corporation (making it easier to meet the 35% test); and to top it all off, a tax-free receipt of the death
benefits.
As a general rule, if the life insurance is used to fund a 303 stock redemption, the corporation is
the applicant, owner and beneficiary of the policy.
AN ALTERNATIVE
An alternative is where the proceeds of the life insurance policy are paid to a surviving spouse,
who then lends the necessary funds to the corporation for the stock redemption—however; the
stock redemption must qualify under Section 303. The advantage of this approach is that if the
stock does not qualify for the favorable tax treatment of 303, the surviving spouse has the proceeds of the life insurance company instead of the corporation having the proceeds.
If this alternative is used and the business is a regular corporation, the business owner may
want to purchase the life insurance under a split-dollar plan, which would allow the business
owner to use basically corporate funds instead of personal funds, the purchase the life insurance.
Also, in order to avoid paying interest or recognizing imputed income resulting from a belowmarket loan, the endorsement split-dollar method should be used.
Federal Estate Tax
In general, the federal estate tax consequences of a corporate buy-sell stock redemption or
cross-purchase plan funded by life insurance are determined under the same circumstances described for partnerships as discussed earlier in this text and are under a state of flux at this time,
particularly as to the amount of exemption.
Under a stock redemption plan, the payment of life insurance proceeds to the corporation may
increase the value of the deceased owner's stock-and therefore the value included in the estate for
estate tax purposes. This problem can be avoided if the buy-sell agreement adequately establishes the value of the stock according to the requirements discussed previously. In this case, there is
no taxable gain to the estate because the purchase price will be the same as the stepped-up basis
or fair market value.
Policies Owned by the Deceased Stockholder
Under a corporate cross-purchase buy-sell agreement, the stockholder who dies still owns life
insurance policies on the lives of the surviving stockholders. Normally, the buy-sell agreement
provides an option for surviving stockholders to purchase the policies on their own lives, usually
for an amount equal to the cash values in the policies—when an insured partner purchases the
policy, the death benefit does not lose its tax-exempt status under the transfer for value rule because of an exception.
Unlike a partnership, however, a corporation's stockholders may not purchase the policies on
each other's lives without losing the tax exemption. The transfer for value rule allows this exception only for partners, not for stockholders. On the other hand, the corporation itself may
purchase the policies on its stockholders' lives from the deceased person's estate without causing
loss of the death benefit tax exemption.
Loss of tax exemption under the transfer for value rule can also be a problem if an existing
stock redemption buy-sell agreement is changed to a cross-purchase plan. For example, suppose
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Zee Corporation owns policies on the owners, stockholders Allan and Beth, to fund a stock redemption buy-sell agreement. If the plan is changed to a cross-purchase agreement and Zee Corporation sells (or even gives) the policy on Allan's life to Beth and the policy on Beth's life to Allan, the death proceeds of both policies lose their tax exemption because of the transfer for value
rule.
The tax exemption is not lost, however, when a cross-purchase plan is changed to a stock redemption plan. In this case, Allan may transfer his policy on Beth's life and Beth may transfer
her policy on Allan's life to the corporation without losing the tax exemption. This is true because one of the exceptions in the transfer for value rule allows this transaction when the insured
is an officer or shareholder of the corporation acquiring the policies.
Chapter 4 Review Questions
1. For a proprietorship, a buy-sell agreement with an employee who does not have the financial
resources to pay the premiums for insurance funding may be accomplished when the owner
and the employee share the premiums under what type of arrangement?
A. entity purchase plan.
B. first-to-die policy.
C. key employee insurer.
D. split-dollar plan.
2. Under partnership laws, when a general partner dies and no formal provisions have been made
to deal with the deceased person’s business interest, surviving partners become
A. liquidating trustees.
B. insolvent.
C. executors.
D. heirs.
3. Under what type of buy-sell agreement does the partnership itself purchase a deceased partner’s interest?
A. cross – purchase plan
B. entity purchase plan
C. stock redemption plan
D. partnership liquidity plan
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4. Partners A, B, & C each own a life insurance policy on every other partner to fund a buy-sell
agreement. This arrangement is known as?
A. a cross-purchase plan.
B. an entity-purchase plan.
C. a stock redemption plan.
D. a first-to-die policy plan.
5. A buy-sell agreement funded by life insurance guarantees?
A. the liquidation of a partner’s interest upon death.
B. partnership will continue after a business owner dies.
C. an audit by the IRS.
D. the partner’s heirs will gain control of the partnership upon his/her death.
6. When there are several business owners agreeing to a buy-sell agreement and use a ______ life
insurance policy for funding, they can guarantee future insurability after one owner dies.
A. stock redemption
B. split-dollar
C. first-to-die
D. limited term
7. Life insurance policy proceeds used to fund a buy-sell agreement can escape federal estate
taxation if:
A. proceeds are payable to the estate.
B. there are incidents of policy ownership of the insured.
C. there was a transfer of the policy for inadequate consideration.
D. they are payable to the owner’s spouse.
8. When an entity purchase buy-sell agreement is used by a corporation, the agreement is often
termed a
A. testamentary agreement.
B. liquidation agreement.
C. stock redemption agreement.
D. corporate benefit.
9. If the IRS characterizes premiums paid by a close corporation on life insurance policies as
dividends, the premiums are
A. exempt from taxation as a business expense.
B. deductible from taxation as a business expense
C. included in the value of the stockholders estate.
D. taxable income to the stockholder .
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10. With a corporate cross purchase type of buy-sell agreement, funded by life insurance, the
policies are owned by the
A. individual shareholders.
B. corporation.
C. directors.
D. beneficiary.
ANSWERS
1D 2A 3B 4A 5B 6C 7D 8C 9D 10A
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CHAPTER FIVE -KEY PERSON INSURANCE
Definition of Insurance
Especially in businesses that are small to medium sized, a few key people may be vital to the
continued success of the business. If any one of these key people is removed from the workplace
by death, the business stands to suffer severe financial loss or even insolvency. Often times, such
a fate can be thwarted by the infusion of money into the business. Key person insurance can
guarantee that money is available to help the business through the transition when a key person
dies. Key person insurance is not a certain type of insurance policy but insurance dedicated to a
particular purpose—to pay a cash benefit to the business if a key person dies.
USES FOR THE INSURANCE
The primary purpose of key person insurance is to protect the business against losses that occur
when someone whose presence is vital is no longer available to fill a key role. Sometimes, benefits payable for the key person's benefit are offered as well, but that is a secondary concern. A
business generally needs the insurance benefits for one or more of several needs that arise when a
key person dies.
 To substitute for earnings formerly generated by the key person. If the
key person is personally responsible for a significant portion of earnings, sales
can decrease. And, the death of any key person can cause clients to delay placing business with the company until they see how the person's absence will affect the business overall.
 To recruit and train a replacement for the key person. Not only are direct
expenses incurred in recruiting and training, but also indirectly, there is a cost
associated with business that maybe lost during the transition. In addition, the
new person is likely to be less profitable during the initial employment period.
 To reassure creditors that the business remains solvent and able to meet current and future obligations. Like clients, suppliers and lenders sometimes decide to wait and observe how the business handles the departure of a key person before acting on requests for their services. This is especially true when the
key person is also an owner of the business. In some cases, creditors ask for
outstanding debts to be paid immediately if a debtor dies.
 To cover other costs arising from or associated with the key person's death,
as well as ongoing expenses that are no longer being offset by the key person's
contributions to the business.
 To fund a buy-sell agreement.
Who Is a Key Person?
Deciding exactly who is a key person in a business is sometimes easy, sometimes more difficult. Generally, in a smaller business owned by one person or just a few people, the owners can
88
easily be identified as key people. However, even in very small businesses, certain employees
who are not owners may also play key roles. The example of a chief photographer mentioned
previously serves well here. Even if the photographer is a non-owner employee, he obviously is
important to the success of the ad agency and is a candidate for key person insurance.
Critical Financial Role
Whether the person is an employee or an owner-employee, the individual must serve a role that
is critical to the financial health of the business. The role might be in management, finance, sales,
professional or technological expertise, production or any other area or combination of areas in
which, without that person's contribution, the business would be in danger of suffering financial
loss. As you attempt to identify employees or owner, employees who qualify as key people, look
for unique skills, business contacts, technical knowledge or other contributions that could not
easily or quickly be replaced by someone else. Having an employee who serves in such a capacity
gives a business and insurable interest in the key person-an interest that may legitimately be fulfilled by insurance.
It is interesting to contrast the characteristics that identify a key person with someone who does
not fit that profile. For example, sometimes high compensation is used as a guideline, but salary
alone is not adequate for identifying a key person, especially when the person works for a larger
business. High compensation may equate with a highly competent executive of a large business,
but if others in the business could step in immediately to assume that person's responsibilities,
very little, if any, negative financial consequences would occur. Without an adverse financial result, there is no need for key person insurance.
On the other hand, a similar individual employed by a small or medium-sized company that
employs no one else with the same talents is likely to be a key person whose absence could cause
financial problems. You'll find that some insurers will not even write key person insurance for
large businesses that employ many people in similar capacities.
Proprietorships, Partnerships, Corporations
Key person Insurance is available to all forms of business, regardless of the type of ownership.
Sole proprietors may purchase key person insurance on their own lives and/or the lives of one or
more key employees.
Each partner in a partnership may be covered, typically by a policy the partnership entity owns.
Partners, too, might have key non-owner employees for whom key person insurance is appropriate.
And both C and S corporations are eligible to purchase key person insurance on owners and
key employees. In all cases, however, the best prospects are smaller or closely held companies
where business success hinges on relatively few people-possibly just one person. As you might
suspect, the tax consequences may differ depending on the type of business ownership: we'll see
how soon.
How Key Person Life Insurance Works
Let's first consider key person life insurance, which pays benefits if the insured key person dies
while the policy is in force. Remember, this insurance is written for the benefit of the business,
not the key person.
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Owner and Beneficiary
The business applies for and purchases a policy covering the life of the key person. The business is both the owner and beneficiary of the policy. For example, suppose the business is
Temple Brothers, a partnership owned by Warren and Franklin Temple. They are both considered
key people. The Temples employ Andrew Nash, whose contributions qualify him as a key employee. The Temple Brothers entity could apply for, own and be the beneficiary of three separate
policies on Warren's, Franklin's and Andrew's lives.
If the business were incorporated, Temple Brothers, Inc., the corporation could purchase the
policies in the same way. On the other hand, the owner of a new small corporation might prefer
to own the policy personally rather than have the corporation buy it. Unfortunately, many small
businesses fail in the early years. When this occurs, the corporation's assets—including life insurance policy cash values—are subject to creditors' claims. If the small corporate stockholder
owns the policy personally, cash values should be safe from creditors of the business.
Since a proprietor and his business are considered the same, the procedure would differ slightly, but the principle would not. Let's say Cloris Batchelor is a sole proprietor with a key employee, Marge Spotz. Cloris could apply for, own and be the beneficiary of a policy on Marge's life.
Marge could do likewise, even if she needed some financial help from Cloris to pay the premiums. Alternately, if Cloris has no key employees, she or her spouse, if any, could own the policy
on Cloris's life. By owning the policy herself, Cloris subjects the death proceeds to being included in her estate, but in many cases that is preferable to the absence of life insurance altogether.
The key person whose life is being insured must agree to the insurance. In other words, a business may not arbitrarily decide to purchase a life insurance policy covering an employee without
the employee's prior knowledge.
Whether the business entity or an individual owns the key person policy, when the key person
dies the proceeds are paid to the beneficiary-either the business or the individual business owner.
This is one of the key features of this type of insurance coverage: the business receives the death
proceeds, not the key person's heirs or estate.
Term Insurance or Permanent Insurance
Depending on the overall plan a business develops for the use of key person life insurance, either term insurance or permanent cash value life insurance might be acceptable. Term insurance,
of course, can provide significant premium savings in the early years of the policy. However, the
lower premiums may be offset by much higher premiums later if the policy is continued for a
long period. Still, term coverage may be best if the business believes the need will be short-termfor example, the owners expect the business to be able to accumulate adequate funds outside of
the insurance to offset a key person's loss. Alternatively, a new business could consider purchasing a convertible term policy, paying the initially lower premiums, and then converting to a cash
value policy when business income has increased.
In many cases, a permanent policy that builds cash values is more appropriate because the
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cash values are available to the business for additional or optional uses. For example:
 The business may borrow from the cash values, often at a relatively low interest rate.
 The business may use the policy cash values as collateral for a loan from a lending institution.
 If the employee quits, the business may surrender the policy to the insurer for its cash
surrender value.
 If the employee quits, the business may sell the policy to the terminated employeeinsured.
Rewarding the Employee
Sometimes, companies earmark the cash values of permanent life insurance policies to further
reward a loyal employee. For example, if the key person remains with the business but does not
die before retiring, the policy values can provide additional retirement Income for the employee.
This would be a nonqualified deferred compensation arrangement, discussed at length later in
this course. Alternatively, the business could turn the policy over to the employee at retirement,
relinquishing its positions as both owner and beneficiary. The employee would then have the option to retain the policy, naming his or her own personal beneficiaries, or to surrender the policy
for its cash values.
EXISTING POLICIES AND THE TRANSFER FOR VALUE RULE
An agreeable employee or a key person/owner might want to use existing life insurance policies to provide the key person insurance. For example, the key person sells to the business a policy he or she already owns on his or her own life. In some cases, this arrangement is acceptable. In
others, the transfer for value rule can cause problems.
Under this rule, remember, and under certain circumstances, the death proceeds can lose their
income tax exemption beyond the amount paid to acquire the policy and any premiums paid after
the transfer. One circumstance that does cause loss of the tax exemption occurs when an insured
employee who is not an officer or shareholder transfers a policy to a corporation. The distinction
between officers and shareholders and those who do not hold those positions, then, is obviously
important to the income tax consequences.
Here again are the exceptions to the transfer for value rule included in the tax law that is the
following transfers don’t cause the death proceeds to lose their tax-exempt nature:
 The policy is sold or transferred to a corporation in which the key person/employee who
is the insured is an officer or shareholder.
 The policy is sold or transferred to a partner of the insured or to a partnership in which
the key person/employee who is the insured is a partner.
 The policy is sold or transferred to the insured person.
Some additional exceptions to the transfer for value rule apply when policies are transferred
from one spouse to another, when the policy is given partly as a gift, and when a corporation is
involved in a tax-free reorganization. All of these situations concern the determination of basis
(for gain or loss purposes) when the original owner's basis must be taken into consideration.
Your clients should consult their tax attorneys if these circumstances play a role in determining
whether or not to use existing policies for key person insurance.
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VALUING THE KEY PERSON'S LOSS
Deciding how to value the loss of a key person for insurance purposes is partly art, partly science and partly educated guessing. Factors that can cause the value to vary include the particular
type of business, its geographical location, the economic climate, and the role the specific person
plays in the business, availability of people of similar skills, and many other variables. Two
guidelines commonly used are:
1. The estimated value of income lost to the business as a result of the key person's death.
For example, if the key person can be attributed with generating $100,000 of income annually,
the policy could be written for that amount, on the assumption that a replacement could be found
quickly, but that person would not be able to generate the same income or income enough to offset the costs of acquiring the new person during the next year. Or, the $100,000 could be reduced
by the amount of income it is estimated a new person would be able to produce.
2. The cost to replace the key person, including recruiting hiring, relocating, training or orienting and possibly paying a higher salary. While the deceased key person's salary would no
longer be required, the business might be required to pay more to attract the right person.
Added together, the value of income lost and the cost to hire a replacement result in a close estimate of the economic loss the business would suffer if the key person dies. Insurance companies sometimes use certain formulas applied to figures such as these to help decide the value of a
key employee's loss. These formulas might take into consideration the type of business, the key
person's position and other factors such as those mentioned above, as well as the estimated time
to replace the key person.
A really simplistic approach is to multiply the key person's annual salary by a predetermined
figure, such as three, five or ten, to arrive at the amount of insurance needed. For example, if the
individual is earning $70,000 annually and the multiple is five, the amount of insurance would be
$350,000.
The insurers with whom you do business can advise you about the approach they prefer. Whatever system or formula is used, it is important for both your clients and you as an agent to schedule frequent reviews of the amount of insurance to keep pace with increases in the key person's
economic contributions to the business. We mentioned that key person life insurance can be
used to fund a buy-sell agreement as explained in previous chapters. When that is the purpose of
the insurance, of course, the valuation takes on even greater significance because of the estate tax
considerations. Therefore, the valuation principles discussed in relation to buy-sell agreements
take precedence.
TAXATION OF KEY PERSON LIFE INSURANCE
Many of the taxation principles you've already learned apply to key person life insurance.
We'll review briefly and mention other tax considerations.
Premiums-Deductibility and Taxable Income
The premiums paid for key person life insurance are not a tax-deductible expense no matter
who pays them. This is true under all forms of business ownership and whether an individual or a
business entity pays the premiums.
Even when a business pays the premiums for a key person policy on the life of an employee,
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there is no taxable income to the employee since the employee receives nothing. This differs
from insurance under which the employee's personal beneficiaries’ benefit. For key person insurance, the business alone benefits, so no transaction taxable to the key person occurs.
S Corporation Premiums
The different rules that apply to S corporations can cause some different consequences for the
shareholders when an S corporation pays premiums on key person life insurance. By law, the
premiums will be considered either a nondeductible expense, deductible compensation or a nondeductible dividend.
The premium paid by an S corporation for a key person policy for which the corporation is the
owner and the beneficiary as described above is considered a nondeductible expense. Because
an S corporation's transactions pass through to the shareholders, though, each shareholder's basis
is reduced by his or her proportionate part of the expense. For example, if there are four equal
shareholders, each reduces the basis by 25% of the nondeductible premium expense.
The premium is considered compensation if the key person is an employee who either owns
the policy or benefits from it in some way. Consider the case of an S corporation owner, Jason,
who is also a key employee. If Jason owns a key person policy on his own life, the premium is
considered compensation on which Jason must pay income taxes. The premium is deductible to
Jason's S corporation as a business expense. The same is true if Jason does not own the policy
but has a personal interest in it. For example, if Jason's wife, who is also a shareholder, owns the
policy and will receive the death proceeds, the premium is considered compensation for Jason.
Finally, if the S corporation is closely held, the IRS may consider the premium payment to be a
dividend. As you learned in Chapter Four, taxation of premiums in this case depends on whether
the corporation has accumulated earnings. If so, part of the premium might be treated as a dividend, taxable to the key person/employee and nondeductible to the corporation. If there are no
accumulated earnings, the premium is treated partly as a return of the investment (and not taxable) and partly as a capital gain, which is taxed.
Premiums as Accumulated Earnings
You've learned that, for any type of corporation, accumulated earnings can be a concern. If
the corporation pays premiums on key person insurance, it must somehow accumulate the funds
to do so. But remember that the IRS requires corporations to pay taxes on excessive accumulated
earnings in order to discourage withholding of taxable dividends. Earnings accumulated to pay
premiums on key person life insurance should be able to escape taxation, however, if the company can show they fall within the "reasonable business needs" guidelines.
INCOME TAXATION OF DEATH PROCEEDS
Normally, there will be no income taxation on the death proceeds of a key person life insurance policy paid to the business, assuming:
1. The insurance passes the "tests" to qualify as life insurance proceeds and
2. The death proceeds do not trigger the alternative minimum tax (AMT).
If the AMT might come into play if application regulations are enacted, refer to previous discussion.
Additionally, the transfer for value rule could come into play, but you've seen in various dis-
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cussions how this can be avoided in many cases. When the rule does apply, the death proceeds
are income taxable to the extent they exceed the value of consideration paid plus premiums paid
following the transfer.
Income Taxation of Cash Surrender Value
If an insured key person leaves the business or retires from the business and the business wants
to take the policy's cash surrender value and terminate the policy, taxable income can result.
When the cash surrender value is greater than the cost basis-the amount the business invested n
the policy-the excess is taxed as income to the business. For example, suppose the policy is surrendered for its cash value of $8,000 and the cost basis is $7,000. The business must pay taxes on
$1,000 of the cash surrender value.
In determining the basis, the amount the business has paid into the policy is reduced by any
dividends the insurer paid during the life of the policy. In addition, if the business has taken a
policy loan that is still outstanding when the policy is surrendered, the loan amount is also immediately taxable, but only to the extent the cash surrender value exceeds the cost basis.
For an S corporation, each shareholder's portion of the cash surrender value has two effects: (1)
any gain over basis is income taxable to the shareholder and (2) the shareholder's basis in the
corporate stock is increased by the same amount.
Federal Estate Taxation
When the insured key person dies and the life Insurance policy proceeds are paid to the business, there are generally no federal estate tax consequences for the deceased as long as he or she
had no incidents of ownership in the policy. This is true because the business, not the key person,
is the owner and the beneficiary-there is no taxable benefit to the key person's estate.
However, in the case of a partnership, where the partnership entity receives the proceeds and
the key person is one of the partners, a portion of the proceeds will be included in determining
the value of the insured's partnership interest for estate tax purposes.
A similar situation occurs with corporations when the key person is one of the owners. That is,
based on the deceased owner's share of the stock, a portion of the proceeds will be included in
determining the value of the estate.
Chapter 5 Review Questions
1. All of the following could be considered key persons to a corporation EXCEPT:
A. chief financial officer.
B. sales manager.
C. president.
D. stock boy.
2. The beneficiary of a key person life insurance policy is the
A. business.
B. key person.
C. key person’s spouse.
D. key person’s estate.
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3. A corporation wants to maintain a key person life insurance policy on an employee who is not
an officer or shareholder of the corporation. She wants to sell the corporation an existing life
insurance policy she owns on her own life; in which case
A. this type of transfer is forbidden by law.
B. the transfer for value rule makes no exception for this particular type of transfer.
C. the statement is false: the death proceeds remain tax except Susan’s estate was the
original beneficiary
D. this is known as a Section 303 which has no tax-exempt features.
4. All of the following factors should be considered when placing a value on the loss of a key
person EXCEPT the
A. type of business.
B. economic climate.
C. business geographical location.
D. color of the key person’s car.
5. Business X pays the premiums for a key person life insurance policy on employee Kyle. The
result of premiums paid is:
A. a business deduction for X.
B. a business deduction for Kyle.
C. taxable income X.
D. no income taxation for X.
6. When an insured key person of a corporation, not a shareholder, dies generally there are:
A. no federal estate tax consequences.
B. federal estate taxes to be paid by the deceased employee’s estate.
C. income taxes to be paid by the corporation.
D. estate taxes to be paid by the corporation.
.
7. The owner of a key person life insurance policy is the
A. key person.
B. business.
C. directors.
D. stock boy.
8.
Key employee Martin leaves the employ of Stark Company, which had insured Martin under
a key person policy. Stark then decides to surrender the policy to the insurer for the cash surrender value. Which of the following tax consequences results?
A. Martin is taxed on the value of the premiums paid.
B. Stark is taxed on the full face amount of the policy.
C. Stark is taxed on the excess of the cash surrender value over Stark’s cost basis.
D. no tax consequences results.
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9.
The primary purpose of key person life insurance is to
A. prevent a valued employee from leaving the business.
B. protect the business against losses.
C. have cash available to cover expenses if the business owner becomes disabled.
D. provide funds to cover estate taxes.
10 The key person whose life is being insured must
A. pay the premiums.
B. own the policy.
C. agree to the insurance.
D. designate the beneficiary.
ANSWERS
1D 2A 3B 4D 5D 6A 7B 8C 9B 10C
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CHAPTER SIX - SPLIT DOLLAR LIFE INSURANCE
DEFINITION
Split-dollar life insurance is a plan under which the costs and the benefits of a life insurance
policy are split between two parties-usually an employer and a valued employee. The term splitdollar" refers to a way to pay for and share in the benefits of the insurance, not to a particular
type of life insurance policy.
Although this arrangement could be made between other parties, such as parents and children, a
corporation and a stockholder, a sole proprietor and an employee for a buyout agreement, the
most common usage is between an employer and an employee. The reasoning behind the employer's sharing costs with the employee for a life insurance policy is that the employer has greater financial assets and is in a position to help an employee meet life insurance needs.
RECENT TAX DEVELOPMENTS AND FUTURE OF SPLIT-DOLLAR
PLANS
Consult your insurance company for guidance on the use of collateral assignment and all forms of split-dollar arrangements.
Recent rules, and in particular the Sarbanes-Oxley Act, have prohibited several forms of Splitdollar plans, and, as stated later, at this point the only people that know from day to day as to the
legality of the split-dollar plan, are the insurance companies (and some regulators) who stay on
top of this ever-changing field. Still, split dollar assignments have been a powerful tool for solving many corporate problems through the medium of life insurance. Therefore, the following
text will describe the split-dollar assignments as they were prior to this seemingly excessive regulation but it must be mandatory that the insurer establish the rules and policies that can still be
legally sold, including some that are so new they are not mentioned in this text.
SPLIT DOLLAR CONCEPTS AND PLANS
No Discrimination Problems
Unlike tax-qualified employee benefits, which must meet stringent requirements of the Internal
Revenue Code, the Employee Retirement Income Security Act (ERISA), and other governmentimposed nondiscrimination requirements, split-dollar insurance plans may be provided discriminately. That is, the employer may select precisely which employees will be covered by splitdollar insurance. This allows special benefits to be made available-legally-for employees the
employer especially wants to reward. While split-dollar plans do not have the tax advantages of
qualified benefits, the tax consequences are not severe. Taxation is covered later.
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ADVANTAGES TO THE EMPLOYER
For the employer, there are at least these benefits to helping an employee secure life insurance
under a split-dollar plan:

Encouraging good employees to remain with the employer.

Attracting quality workers to the business.

Providing cost effective benefits only to especially valued employees, while legally
avoiding the nondiscrimination problems that can arise with other employee
benefits.

Offering additional low cost retirement benefits to selected employees.

Being guaranteed of a return on the employer's investment in the life insurance policy.
ADVANTAGES TO THE EMPLOYEE
Since split-dollar insurance is intended primarily to benefit an employee, this arrangement naturally offers numerous advantages to the employer as well:

More life insurance at a lower cost than the employee would be able to acquire if
he or she paid the full premium, rather than sharing the premium.

A "fringe benefit" designed to reward this employee specifically.

A source of funds that may be used after retirement if the employee lives.

A method to repay the employer's generosity with no out-of-pocket expense.
The Basic Split-Dollar
There are many ways to vary the details of split-dollar plans in order to meet different employer
and employee needs, but typically, the employer and the employee jointly pay the premiums for a
life insurance policy under which the employee is the insured. Permanent or cash value life insurance must be used because the cash values provide part of the mechanism that makes a splitdollar plan work.
Splitting the Premiums
In this method, the employer pays the part of each annual policy premium that equals the annual increase in cash values in the policy. The employee pays the balance of the annual premium.
For example, assume the annual increase in cash values for the first year is $200 and the annual
premium is $1,000. The employer pays $200 of the premium and the employee pays $800.
In the early years, the employee pays a substantial portion of the premium. However, as the
cash values grow, the employer will take over the larger share of the premium. For example,
suppose in a later year the annual increase in cash values is $700. Now the employer pays $700
and the employee pays only $300 of the $1,000 premium.
While the employee's burden appears high in the early years, many policies build cash values
quickly so the employee eventually pays no portion of the premium. In addition, the basic splitdollar arrangement can be altered to help employees who are unable to pay high premiums in the
early years.
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Splitting the Benefits
Both parties split the benefits as well. If the employee dies, the employer is generally entitled to
receive death proceeds from the policy equal to one of the following:
1. The cash value of the policy or
2. The amount of premiums the employer has paid.
The employee's beneficiary-named by the employee-receives the balance of the death benefit.
The employee is always entitled to name his or her own personal beneficiary. Furthermore,
split-dollar policies are typically written so that the personal beneficiary may be changed only
with the written consent of the insured employee.
Of course, the employee might not die (this situation is discussed later).
A concern that is sometimes expressed about split-dollar insurance is that, as the employer
takes over larger amounts of premium payments, the employer becomes entitled to a larger share
of the death benefit. Correspondingly, then, the employee's beneficiaries will receive a smaller
death benefit, especially if the policy has been in effect for a long period. One way to offset this
problem is to use a participating policy that pays dividends, which may then be used to add to the
death benefit that will be paid to the employee's survivors.
Split-Dollar Policy Ownership
Split-dollar Insurance may be set up using one of two basic forms of policy ownership-the endorsement method or the collateral assignment method.
Endorsement Method
Under the endorsement method, the employer owns the policy on the life of the insured employee. As owner, the employer is responsible for paying the premiums, but under the basic splitdollar plan, the employee agrees to share in premium payment. As indicated above, the employee's share is the excess over the annual increase in the policy's cash values.
In return, the employer is named beneficiary for a portion of the death benefit and the employee
names a personal beneficiary for the balance of the death benefit. The employer's share is either
the cash values or an amount equal to premiums the employer has paid. The personal beneficiary's share is the remainder of the proceeds.
The "endorsement" concerns the employee's right to name a personal beneficiary because this
is, in fact, an endorsement attached to the policy granting the employee that right. Furthermore,
the endorsement limits the employer's rights as policy owner since one of those rights would
normally be to name the beneficiaries. However, the employer is forbidden, under the endorsement, from changing the employee's personal beneficiary unless the employee agrees to the
change.
Endorsement Method Variation
Some insurers allow a split-dollar endorsement arrangement to actually split the ownership of
the policy as well. While not exactly an equal ownership split, this type of arrangement allows
the employee to be named the owner of the amount of the death benefit over and above the policy's cash value. The employer still owns all other benefits and has all other ownership rights with
the exception, again, of the right to change the employee's personal beneficiary. The employee
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still must consent to any change the beneficiary designation.
Collateral Assignment Method
Using the collateral assignment method means the employee applies for and owns the life insurance policy on his or her own life. As owner, the employee is responsible for paying the premiums. However, a separate agreement is written in which the employer agrees to share in the
premiums. Again, the amount the employer pays each year is the same as the annual increase in
the policy's cash values. The employee pays the balance of the premium.
The agreement gives the employer the right to recoup from the death proceeds the premiums
the employer paid. The employee assigns the policy as collateral for the premium payments,
which are considered a “loan” form the employer. Typically, no interest is paid on the “loan,”
although provisions could be made for the employer to eventually receive the equivalent of interest as well.
As owner of the policy, the employee names his or her own personal beneficiary. Under the
collateral assignment method, the employer is not considered a policy beneficiary, but is, instead,
the collateral assignee and, thus, is entitled to the specified share of the death proceeds.
Choosing the Best Method
Whether to use the endorsement or the collateral assignment method depends largely on the requirements of the people involved. If one of the employer's goals is to be able to borrow the cash
values for business purposes, the endorsement method should be used since the business/employer is the policy owner under this method. As owner of the policy, the employer has
all loan rights associated with the cash values. This is not the case with a collaterally assigned
policy, which the employee owns.
Using an Existing Key Person Policy
The endorsement method is more convenient when the employer wants to use an existing key
person policy for the split-dollar arrangement. The employer already owns the policy and some
simple adjustments can be made to share the premium costs and to allow the key person to name
a personal beneficiary for his or her share of the policy proceeds.
FUNDING DEFERRED COMPENSATION
Split-dollar insurance is sometimes used to provide informal funding for non-qualified deferred
compensation plans, which are discussed in a later chapter. Basically, these plans involve an
agreement between an employee and employer to defer a portion of the employee's compensation
until sometime in the future-generally after the employee retires. A split-dollar plan can be used
for this purpose because the cash values will grow over the life of the policy, building up a nice
sum of money to be paid later. At the employee's retirement, the employer may surrender the
policy for its cash value and use the cash value to pay the deferred compensation to the employee. If this is the purpose, the endorsement method, where the employer owns the policy, is required because the deferred compensation must come from the employer's funds.
If the collateral assignment split-dollar arrangement is used for funding a deferred compensation plan, the employee would at some point be required to transfer ownership to the employer,
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which could result in a transfer for value rule violation. This is a problem when the employee is
a non-owner, such as an employee who is not a stockholder or officer of a corporation.
Using an Existing Personal Policy
If the employee to be covered already owns a life insurance policy on his or her life, this policy
could be used in the split-dollar plan. In this case, the collateral assignment method would be
simplest to implement since the employee already owns the policy. However, this assumes the
employer has no particular reason, such as those mentioned above, for owning the policy.
SPLIT-DOLLAR VARIATIONS
In response to differing client needs, many insurance companies have adjusted, altered and refined the details of split-dollar life insurance plans over the years. Today, many variations of the
basic split-dollar plan exist. Each version has unique twists that make the plan more appealing to
customers with certain requirements. The insurers are the logical place to go for information as
to what is legally available and how their plans might make available additional adaptations.
Employer Pays All
The simplest variation to the split-dollar plan occurs when the employer pays the entire premium. In other words, although the employer and the employee still share the policy benefits, the
employer is willing to pay the entire premium with no contribution from the employee.
This is one way an employer may further reward a loyal employee, especially when the employee may be unable to make high premium payments in the early years of the policy. The only
"cost" to the employee is being required to pay taxes on the economic benefit received. This taxation is required regardless of how the plan is set up. Basically, an economic benefit refers to
anything of financial value an individual receives. The tax code provides a specific way to determine the taxable value of premium payments made on someone's behalf.
Level Employee Contribution (Averaging)
Another option is designed to solve the problem of very high employee contributions during
the early years by providing for level employee contributions or averaging. This type of arrangement results in the employee making a lower contribution that remains constant over the
years of the policy. One way to accomplish this is for the business to determine the total costs to
the employee for the plan over a certain number of years-possibly until the employee's anticipated retirement date. T his amount is then divided by the number of years involved, arriving at a
level premium contribution the employee will make annually.
For example, suppose total employee costs would be $30,000 over a 20-year period. Instead of
paying higher early premiums and lower premiums in later years, the employee pays $30,000 for
20 years = $1,500 level annual premium
A common variation results in both the employer and the employee paying level premiums
over a specified period. Suppose again the policy is anticipated to be in force for 20 years. The
employer agrees to pay an annual premium equal to 1/20th of the cash value that the insurer
guarantees will be available in the 20th year and the employee pays the balance of the premium.
Let's say the guaranteed cash value for a certain policy in the 20th year is $55,000. The total annual premium to be split between the employer and the employee is $3,650. The employer's an-
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nual premium contribution is 1/20th of $55,000 —$55,000 / 20 = $2,750 (employer's share of
annual premium)
Determining the employee's share of the $3,650 annual premium is then a simple matter of subtraction such as Total annual premium
$3,650. Minus employer's share — 2,750
Employee's share— $ 950
This arrangement does not change the basic operation of the split-dollar death benefit. That is,
in the early years, the employee's share of the death proceeds is greater than the employer's. As
the years pass, the employer's share (based on cash values) becomes greater and the employee's
share becomes smaller. Another option available under certain policies to boost the employee's
share of the death benefit is the fifth dividend option.
Using the Fifth Dividend Option
You know that participating life insurance policies pay dividends and the insured person has an
option about how to receive them. The so-called fifth dividend option involves using dividends
to purchase one-year term insurance in an amount equal to the policy's increasing cash value.
As each one-year term passes, the dividends purchase a new one-year policy equal to the increased cash value at that time. Any excess dividends reduce the amount of premium the employee must pay so there is the double benefit of keeping the death benefit higher while reducing
the employee's share of the premium.
Eventually, the dividend might not be adequate to cover the term insurance because the amount
of insurance is increasing (along with the cash values) and the employee is growing older, which
results in higher insurance rates. At that point, the employee's portion of the death benefit could
become smaller, but still remain higher than it would have been without using the dividends to
purchase more insurance. Still, the benefits in the early years of premium payment generally offset this disadvantage.
Other Dividend Options
Another way to improve the employee's share of the death benefit in later years is to leave the
policy's dividends to accumulate at interest in the easy years when the dividend might not be adequate to purchase one-year term insurance. The accumulated interest is added to the death benefit, again maintaining a higher share for the employee without compromising the employer's
share.
Alternatively, the dividends could be used to purchase small amounts of paid-up life insurance, rather than term insurance. This option, too, would result in an additional death benefit for
the employee's beneficiaries.
Both of these options for using dividends, notice, have no effect on the employer's portion of
the death benefit. Only the employee's beneficiaries receive additional proceeds.
Taxable Death Benefit Received
During the plan participant's lifetime, the insured is deemed to receive a current benefit because
of the life insurance provided by the plan, such current benefit value is subject to taxation and
must be included in the participant's income each year, but the amount that is included in income
is usually much less than the actual life insurance premium.
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Only the cost of the pure amount at risk is currently taxable, which is determined by simply
subtracting the cash value of the policy at the end of the year from the policy fact amount. Example: Face amount $100,000, cash value $25,000, therefore the pure amount at risk is $75,000.
The value of this pure amount at risk ($75,000 in this case) is determined by applying the lesser
of the Table 2001 rates (such rates provided by the IRS) and the insurer's published rates for oneyear term insurance policies available to all standard risks to this amount. Note: It would serve
no particular purpose to show these rates, which start at age 31 through ages 90.
To illustrate how it works, if the plan participant is age 35, according to the table at age 35 the
premium is $.99 (per thousand)—multiplying $.99 by 75 gives $74.25 for that year. Each dollar
that the plan participant actually contributes on an after-tax basis to the plan will reduce the reportable economic benefit by an equal dollar.
As time goes by, the rate-per-thousand will grow, but in a whole life policy the amount of risk
will decrease as the cash value increases, however, if the insurer that issued the policy has a oneyear term policy that has lower premiums than the IRS rates (incidentally, are referred to as "Table 2001 rates"—those lower rates may be used. The total amount of the current reportable economic benefit that is recognized by the plan participant becomes their cost basis in the plan. An
amount equal to this cost basis may be received by the plan participant tax free.
Death Benefits
The employer pays the part of each year's premium that at least equals the increase in the cash
value. The employee may pay the remainder of the premium, or the employer may pay the entire
premium. When the increase in cash value equals or exceeds the yearly premium, the employer
pays the entire premium. If the employee dies while in the service of the employer, a beneficiary
chosen by the employee receives the difference between the face value and the amount paid to
the employer (the cash value or the total of all premiums paid by the employer-whichever is
greater). Thus, during employment, the employee's share of the death benefit decreases. I f the
employee leaves the employer, the latter has the option of surrendering the policy in exchange for
return of all premiums, or selling the policy to the employee for the amount of its cash value.
There are two types of split dollar life insurance policies: (1) Endorsement-the employer owns
all policy privileges; the employee's only rights are to choose beneficiaries and to select the manner in which the death benefit is paid. (2) Collateral-the employee owns the policy. The employer's contributions toward the premiums are viewed as a series of interest-free loans, which equal
the yearly increase in the cash value of the policy. The employee assigns the policy to the employer as collateral for these loans. When the employee dies, the loans are paid from the face
value of the policy. Any remaining proceeds are paid to the beneficiary. See Dictionary of Insurance Terms. Also, IRS Publ. 525
Bonus Plans
Under a single bonus plan, the employer pays the entire premium, but does on a different basis. To understand the purpose of a bonus plan, you must first remember that the premiums the
employer is paying for split-dollar life insurance are not tax deductible to the employer because
the employer eventually receives a tax-free benefit—a portion of the death proceeds. Under a
single bonus plan, the employer pays part of the premium amount to the employee as a bonus,
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which is tax deductible for the employer. The employee then uses this bonus to pay his or her
share of the premium. While the employee must pay taxes on the bonus, remember that he or she
will pay taxes anyway, on the economic benefit received if the employer pays the entire premium. The primary difference in these arrangements is that the employer gets a tax deduction for
the bonus, but not for premium payments. The amount of the bonus is often the same as the cost
determined under the Table 2001 as described above.
Optionally, the employer may fund the premium with a double bonus plan. By paying the employee a bonus equal to twice the Table 2001 costs, the employer provides money to offset the
employee's taxes. Double bonus plans were especially popular when the individual income tax
rates were much higher, so, for example, an employee in the 50% tax bracket could use the double bonus to pay taxes on the bonus.
Time Value of Money Factor
In a basic split-dollar plan, no importance is placed on the time value of money in determining
the return to the employer from the death proceeds. The employer receives a portion equal to
cash values or premiums paid over the years. There is no recognition that the money spent by the
employer could have received interest or been used for some other purpose that would have resulted in a gain for the employer if it had been used elsewhere.
However, the split-dollar plan may be arranged to recognize and benefit the employer for the
time value of money. When the death proceeds or the cash surrender value is taken from the policy, the employer receives not only the return of investment, but also an amount equal to what a
certain rate of interest would have provided over the years. To implement this arrangement, the
agreement between the employer and the employee must specify what the rate of interest is and
whether it is simple or compounded.
Equity Split-Dollar
As stated previously, in the basic split dollar plan, the employer's portion of the death benefit is
equal to either the cash surrender value of the policy or the amount of premiums the employer
has paid. Under the so-called equity split-dollar arrangement, the employer agrees to receive a
return only of premiums it has paid during the policy period. Any excess equity in the cash values, over and above premiums the employer has paid, belongs to the employee. If the employee
dies, the business recovers its premiums and the employee's personal beneficiary receives the
death benefit plus any excess cash values. The excess cash values are essentially combined with
the death benefit so the tax consequences remain the same as they would be for the face amount
death benefit alone.
If the employee lives and the policy are surrendered for its cash values, the employee receives
the excess equity, while the employer recoups the premiums it paid.
Reverse Split-Dollar
As its name implies, a reverse split-dollar plan reverses the functions and benefits of the basic
plans we've discussed. The goal of reverse split-dollar plans is to provide the employee with
considerable cash for future use, and not so much for life insurance protection.
In this case, the employer pays for the life insurance costs and the employee pays for the cash
value increases-exactly the reverse of basic plans. The employer’s portion of each annual premi-
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um is based on the rates discussed previously and the employee pays the balance. Again, this is
the reverse of basic split-dollar arrangements. Of course, this could be combined with an "employer pays all or some other arrangement under which the employee pays nothing out-of pocket
for premiums.
If the employee dies, the employer, who essentially has key person life insurance on the employee's life, receives the death benefit. Depending on the particular arrangement, the employer
may receive the full death benefit or the death benefit minus any premiums the employee had
paid prior to death. These premiums would then be returned to the employee's personal beneficiary.
If the employee lives, which is the hope behind reverse split-dollar plans, the employer receives
a return of premiums it has paid, and the remaining cash surrender value goes to the employee.
This can provide a substantial amount of cash for the employee to use for retirement or other
purposes as desired.
Reverse split-dollar plans became more popular with the advent of universal and variable life
insurance policies, which provide the opportunity for greater growth than traditional whole life
policies with lower interest rates. Some practitioners believe reverse split-dollar plans provide
entirely too much tax benefit to the employee to continue unscathed by the IRS. This is true because the cash value build-up is currently treated like any other life insurance policy even though
reverse split-dollar plans can provide significant benefits for which the employee may pay little
or nothing in taxes. Currently, however, these plans can provide an important benefit for selected employees with minimal tax consequences.
The collateral assignment method of ownership is used with a reverse split-dollar plan, since
this gives the employee full control over the policy's cash values, assigning only the agreed-upon
portion of benefits to the employer.
The split-dollar arrangements presented above represent those that are most commonly used.
The insurers with whom you do business might offer other “creative splitting” options from
which your clients may choose.
TAX CONSEQUENCES
Because split-dollar is a method for providing life insurance, the taxation rules you've learned
for life insurance generally apply.
Premium Deductibility
As is true for any other life insurance policy, premium paid are not deductible for anyone who
has an interest in or is beneficiary of the policy. Thus, employers may not deduct their share of
the premiums for split-dollar life insurance because employers are either the beneficiaries or the
collateral assignees of the policy. Likewise, the portion of premiums the employees pay is not
deductible since the employees or their survivors will benefit.
Economic Benefit
Earlier we mentioned that employees are taxed on the amount of economic benefit they receive
as the result of their employers paying premiums for them. The IRS has ruled that an economic
benefit is taxable income and that a life insurance premium that pays for insurance proceeds pay-
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able to the employee and/or an employee's personal beneficiary is such a benefit. The value of the
economic benefit under a split-dollar plan, determined on an annual basis, is the one-year term
insurance cost minus the portion of the premium paid by the employee.
The basis for determining the cost of one-year term insurance is either:
1. The government's Table 2001 rates or
2. The insurance company's own standard one-year term rates.
Generally, standard rates from the insurer issuing the policy are lower than the government's
Table 2001. Therefore, where available, these rates generally would produce a lower taxable
economic benefit for the employee.
Annual Cash Value Increases
Regardless of whether the employer or the employee owns the split-dollar life insurance and
has the right to receive its cash values, the annual increases in cash values typically are not taxed
during the year of increase. The exception is when the cash values help trigger an alternative
minimum tax (AMT) for a corporation, whatever that might be as discussed earlier.
Cash Surrender Values
Taxation may occur when the employee lives, rather than dies, and at some point the employee, the employer or, usually, both (depending on the arrangement) will receive the life insurance
policy cash surrender value. In the final section of this chapter, we'll deal with the taxation that
occurs in the specific circumstances under which the cash values are paid. The general treatment
follows.
If the employer receives no more than an amount equal to premiums it has paid, the employer
has no taxable income from its portion of the cash values. If the arrangement includes payment
of some rate of interest to account for the time value of the employer's money, the employer pays
income taxes on the gain over premiums paid.
The employee pays taxes on the difference between the portion of the cash surrender values the
employee receives and the amount he or she paid during the policy period.
Death Benefits
When the covered employee dies, the split-dollar insurance death benefits generally are not
taxable, either to the employer or to the employee's personal beneficiary. The only situations under which the death benefits might be taxed are:
1. The death benefits fail to qualify as life insurance proceeds under the tests provided by the
IRS.
2. The transfer for value rule applies, causing the death proceeds to lose their tax-exempt nature.
3. The proceeds play a role in triggering the alternative minimum tax for the employer.
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FUTURE OF SPLIT-DOLLAR PLANS
There have been three events (at least) over the past few years that have directly affected the
tax treatment and even the legality of some split-dollar arrangements.
The IRS released final split-dollar regulations in TD9092, which clarifies that any money paid
by an employer in a split-dollar arrangement that benefits the employee is going to be treated either as a taxable benefit to the employee or a loan to the employer.
Secondly, the passage of HR 3763 – also known as the Sarbanes-Oxley Act of 2002, the corporate ethics bill that among other things forbids loans from public companies to executives. One
form of split-dollar arrangement (the collateral assignment method) is based on the premise of
the employer "loaning money on the employer's behalf.
Also, Treasury Notice 2002-50 targets certain types of split-dollar arrangements (such as the
reverse split-dollar) in which artificially high current term rates are used to reduce or avoid taxes.
The sale of life insurance under these split-dollar plans generally ceased as insurers and clients
awaited the IRS promulgation of final regulations. Now that the final regulated have been published, it is likely that insurers and clients will need to fully evaluate the impact, especially in the
light of Sarbanes-Oxley, before the split-dollar plans again assume a prominent place. The 64
dollar question will be, of course, of the public's perceived value of split-dollar plans in the new
regulatory environment—which, as we have seen with estate taxation, et al may be uncertain and
liquid for some time to come.
The Corporate Responsibility Act of 2002 (the Sarbanes-Oxley Act or HR 3763) bans public
companies from making certain personal loans to executives. Collateral assignment split-dollar
is premised on the idea of company loans to the insured policy owner/employee. Since the target
of the act are the highest paid corporate executives, passage of this law has halted the sale of this
form of split-dollar for many insurance companies while they sort out what the new law really
means to split-dollar.
Consult your insurance company for guidance on the use of collateral
assignment and all forms of split-dollar arrangements
FEDERAL ESTATE TAXATION
Under these ownership arrangements, if they are still applicable and available, the death proceeds paid to the employee's personal beneficiary would be included in the deceased employee's
estate and subject to federal estate taxation, but death benefits are not included in the estate if
the individual avoids the incidents of ownership described previously. However, even when the
employer owns the policy under the endorsement method, the employee has the right to name a
personal beneficiary under a split-dollar plan. This results in an incident of ownership, subjecting the proceeds to estate taxation. Some practitioners suggest that this can be avoided by giving
the right to name or change the personal beneficiary to the beneficiary, rather than to the employee. This excludes the insured from having any rights under the policy that may be construed as
incidents of ownership.
And, of course, under the collateral assignment method, the employee owns the policy—
obviously an incident of ownership. Only the amount of the death benefit payable to the personal
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beneficiary is included in the estate—the portion paid to the employer is not included.
It is also possible to avoid incidents of ownership under a collateral assignment arrangement.
The employee-insured's personal beneficiary could apply for and own the split-dollar life insurance policy on the employee's life. This beneficiary, then, would have the separate agreement
with the employer, assigning the appropriate portion of the death benefit to the employer upon
the employee's death.
The IRS has not been entirely consistent in ruling on the federal estate taxation of split-dollar
life insurance policy proceeds. In one situation, a policy on a 50% shareholder resulted in the
portion of the death benefit payable to a personal beneficiary being included in the estate because
the shareholder had the right to name the beneficiary. On the other hand, the IRS ruled under a
reverse split-dollar endorsement arrangement that all of the proceeds were to be included in the
estate-both the employer's and the personal beneficiary's shares. However, the estate was also
allowed a deduction for the portion paid to the employer.
In the case of a corporation's controlling stockholder, where the corporation owns the policy
and the stockholder had no incidents of ownership, the personal beneficiary's portion of the death
benefit generally is includable in the estate. This inclusion results from the attribution rules that
attribute incidents of ownership by the corporation to a majority stockholder for proceeds payable
to someone other than the corporation itself.
The IRS and the tax courts have issued a number of rulings on this issue that are not always
consistent, to say the least. A client establishing a split-dollar plan should always consult with tax
attorneys to ensure, as far as possible, that the desired outcomes occur.
Terminating the Split-Dollar Plan
A split-dollar plan terminates, of course, if the employee dies. If the employee lives, however,
there are other reasons for terminating the plan. The employee might leave the company's employ. The employee might retire. There is even a point at which the costs associated with the Table 2001 rates make continuing the arrangement less attractive than in earlier years. Whatever the
reason for terminating the plan, there are various ways to distribute the surrender values.
Rollout
A split-dollar rollout involves taking a loan from the policy's cash values in order for the employer to recoup premiums paid, then transferring full ownership of the policy to the employee.
Under the endorsement method, where the employer owns the policy, the employer takes the policy loan. Typically, then, the employer would sell the policy to the employee-insured for the difference between the cash surrender value (prior to the loan) and the amount of the loan. In this
case, the employee, as the new policy owner, then becomes responsible for paying interest due on
the loan. Some employers are willing to pay the employee a bonus to offset the amount of the
interest payments.
Under a collateral assignment arrangement, where the employee already owns the policy, the
employee would borrow from the policy's cash values in order to reimburse the employer's costs.
In turn, the employer is no longer a collateral assignee. All rights belong to the employee alone.
(Note: This effective arrangement is one that has come under fire from the regulators, perhaps
more than other aspects of split-dollar funding, because of the "corporate responsibility" regulations,)
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In either case, the insured can now pay future premiums from remaining cash values, from dividends, or both. Furthermore, because the employee now owns the policy outright, there is no
taxable income resulting from the economic benefit formerly provided by the employer's share of
premium payments. However, the employee will pay income taxes on any amount of cash value
that exceeds the employee's contributions to this point.
Interestingly, if the total cash values accumulated in the policy at the time of rollout exceed the
amount of premiums the employer has contributed, the IRS has ruled that the employer has a taxable gain even though the employer recovers no more than the premiums actually paid. For example, assume the employer has contributed premiums totaling $20,000 and the policy's cash
value is $30,000 in the year of the rollout. This is a $10,000 taxable gain to the employer even if
the employer takes a loan of only $20,000 to recoup its costs. However, the employer may also
take a deduction equal to the amount of income on which the employee is required to pay taxes.
Spinout
An alternate way to terminate the policy is called a spinout, under which the employer simply
transfers all ownership rights to the employee without taking a policy loan. In effect, all premium
contributions the employer has made and the cash values in the policy are a bonus paid to the
employee.
A spinout results in taxable income for the employee to the extent cash values exceed the
amount the employee has personally paid into the plan. The employer is then entitled to take a
tax deduction for an equal amount. The deduction is permitted under a section of the tax code
that permits such deductions as a business expense when the employer's contribution qualifies as
bonus compensation.
Conversion to Key Person Insurance
At termination, split-dollar plans have sometimes been converted to key person insurance,
with the employer gaining all ownership rights. Special care must be taken, however, to avoid
transfer for value problems and resultant loss of tax exemption for the death proceeds. The only
really safe circumstances under which a conversion of this sort can occur are when the insured
under the split-dollar plan is an officer or shareholder. In this case, the proceeds retain the tax
exemption.
Chapter 6 Review Questions
1. Under a basic split-dollar life insurance plan
A. the employer pays the premium.
B. the employee pays the premiums.
C. both the employer and employee pay the premiums.
D. permanent insurance cannot be used.
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2. Split-dollar insurance plans
A. may be provided discriminately.
B. must meet the requirements of the IRS.
C. must meet the requirements of ERISA.
D. must be provided on a non-discriminating basis.
3. The ownership arrangement under which a split-dollar policy is owned by the insured
employee is the
A.. collateral assignment method.
B. endorsement method.
C. splitting the benefit method.
D. deferred compensation method.
4. A common premium-splitting arrangement is for one party to pay the portion of the premium
equaling the annual increase in policy cash values. Under an unmodified plan, this party is
typically the
A. employee.
B. employer.
C. employee’s spouse.
D. stock boy.
5. If the purpose of a split-dollar plan is to eventually fund deferred compensation for the
employee, the ownership method should be the _________ arrangement.
A. collateral assignment .
B. employer pays all.
C. the fifth dividend option.
D. endorsement.
6. What variation on the split-dollar plan results in both the employer paying the premium and
the employer receiving a partial tax deduction?
A. the employee & the employer pay equal shares of the premiums.
B. the employee pays the full premium.
C. bonus plan.
D. averaging.
7. What type of split-dollar feature operates to maintain a higher level of death proceeds payable
to the employee’s beneficiary than the basic split-dollar arrangement?
.
A. Table 2001 rates.
B. double bonus plan.
C. level employee contribution.
D. fifth dividend option.
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8. The split-dollar that gives the policy’s cash values to the employee and the death benefit to
the employer is called _______ split-dollar.
A. equity.
B. reverse.
C. mutual.
D. time value of money.
9. If no other tax complications come into play, the death benefits paid from a split-dollar plan
are
A. taxable to the employer and the employee’s beneficiary.
B. taxable to the employee’s beneficiary only.
C. taxable to the employer’s beneficiary only.
D. not taxable.
10. In terminating a split-dollar plan while the employee is alive:
A. there are various ways to distribute the surrender values.
B. the employer must pay all outstanding premiums when due.
C. the employee receives nothing.
D. the insurance company pays the face value of the policy equally to the employer and the
employee.
ANSWERS
1C 2A 3A 4B 5D 6C 7D 8B 9D 10A
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CHAPTER SEVEN - NONQUALIFIED DEFERRED COMPENSATION
NONQUALIFIED VERSUS QUALIFIED BENEFITS
Many businesses today provide their employees with qualified benefits of various types. "Qualified" refers to plans established to provide employee benefits that qualify for special tax treatment according to the tax code. While this text does not address the specific requirements of
qualified plans, we have briefly mentioned that employers must deal with issues of nondiscrimination, funding limits and the requirements of the Employee Retirement income Security Act
(ERISA). While there are significant benefits for both employers and employees in providing
and receiving qualified benefits, employers have a great deal more flexibility in the use of nonqualified benefits.
Nonqualified benefits are simply those that do not meet the legal requirements for receiving
special tax advantages. Key person insurance and split-dollar life insurance, for example, are
nonqualified benefits. Besides avoiding the possibility of tax law violations and significant reporting requirements, the use of nonqualified arrangements allows employers to legally discriminate among employees in order to provide special "rewards" to those who are most valuable to
the business.
Even when an employer has some type of qualified plan in place for all employees on a nondiscriminatory basis, the employer might want to provide additional benefits to key people. Nonqualified plans allow the employer to do so, as you've already seen in the key person and split
dollar discussions.
In this chapter, we'll explore still another such benefit, commonly known as nonqualified deferred compensation. Like the other benefits we've discussed, deferred compensation plans can
assist the employer in recruiting, hiring and retaining valuable employees. Although not "qualified," these plans do have some attractive tax features for both employers and employees if the
plans follow certain rules. Furthermore, the limits on compensation that may be considered for
qualified pension plan contribution purposes as imposed by OBRA '93 have made nonqualified
deferred compensation arrangements even more attractive for key employees.
What Is Deferred Compensation?
The term-deferred compensation is descriptive: Some part of the compensation that an employee would otherwise be entitled to receive is deferred until a future date. There are two basic reasons an employee would defer compensation:
1. To allow an individual with current high income to defer part of taxable income to the future, hoping the income tax effects will be less severe.
2. To allow an individual to amass a greater amount of retirement income by having part of
current compensation deferred until retirement.
The financial situation of any given individual determines which reason is primary and which
is secondary. However, for the very highly compensated, reducing current income taxation is
generally the impetus. Individuals with more modest current incomes are more likely, on the
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other hand, to find the increased retirement income possibilities a greater incentive for deferring
income.
Whatever the primary goal, the actual mechanics of deferring compensation can take different
forms.
Some practitioners believe all parties involved should very carefully weigh the value of deferred compensation arrangements in light of many economic uncertainties. First of all, Congress
constantly tinkers with tax laws in order to close loopholes and find methods to raise additional
taxes. Secondly, no one can predict positively what will occur in the distant future with economic factors such as inflation and interest rates. However, there are significant differences of opinion since others in the benefits field believe OBRA '93 has improved the market for nonqualified
deferred compensation plans. You'll see that there are some risks associated with deferring compensation, regardless of the tax and economic climates. However, deferred compensation arrangements currently provide benefits that are attractive to employers and employees alike. Most
importantly from your viewpoint, you can offer a way to reduce the financial risks inherent in
deferred compensation arrangements through life insurance funding.
Deferral Methods
Other terms associated with deferred compensation (and sometimes used as synonyms) are salary reduction and salary continuation plans. Both are methods for deferring compensation into
the future.
Salary Reduction Plans
A salary reduction form of deferral is sometimes called "pure" deferred compensation, presumably because it most accurately reflects the deferral of current compensation. Under such a plan,
the employee typically agrees to have his or her salary reduced currently in order to defer part of
compensation until a future date. Instead of actually taking a reduction in current salary, the employee could alternatively agree to a "reduction" by means of giving up bonuses or pay raises the
employee would otherwise receive.
Let's look at an example of how salary reduction works in its most straightforward form the
employee allows the employer to reduce the amount of current salary actually paid. Employee
Chastain has just been hired by ABC Corporation at an annual salary of $250,000. ABC has offered and Chastain has accepted an arrangement under which Chastain will defer receiving 20%
of his annual salary until he retires. For Chastain's first year of employment, he will defer 20% of
$250,000 or $50,000. His taxable income from ABC, then, will be $200,000 instead of
$250,000.
Even if the salary reduction doesn't result in a lower tax bracket, at these rates the dollar tax
savings can still be significant.
Future Federal Tax Savings
Of course, no one knows what individual federal income tax rates will be in the future, but one
goal of deferred compensation plans is to pay out the deferred compensation in such a way that
the tax bite is smaller. Typically, the compensation that was deferred will be paid in installments
to the employee, rather than in a lump sum, since one large payment could trigger the highest tax
rate.
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SALARY CONTINUATION PLAN
A second type of deferred compensation plan is salary continuation. Unlike salary reduction
methods, the employee's salary is not reduced currently. Instead, the employer agrees to continue
paying the employee a salary in the future, generally after retirement from the business (Deferred
Compensation Agreement, "DCA"). Normally, the salary continued will not be equal to the full
current salary or the salary just before retirement, but will be some agreed-upon percentageperhaps up to 50%. The amount is not a legal issue, but one that must satisfy the employer, the
employee and, in the case of a corporation, the board of directors. Furthermore, you'll learn that
the IRS has some strong opinions about what represents "reasonable compensation” for an executive. Whether or not compensation is considered reasonable can affect the tax outcomes of deferred compensation plans.
For either of the deferral methods the basic principles are essentially the same from the employer's viewpoint. The employer wants to provide a special reward for an important employee
and eventually gain a tax advantage for the business by doing so. Additionally, employers sometimes like these plans because the business is expected to be in a better financial position to pay
the additional compensation in the future, rather than currently.
Employees, too, may benefit in essentially the same way regardless of which type of deferral is
used. Current taxable income is reduced and extra retirement income will be available in the future. Furthermore, many employers provide not only for retirement income, but also write the
agreement to allow benefits to pay benefits to the employee's survivors if the employee dies before receiving any or all of the deferred compensation.
Top-Hats
The “top-hat” plan is the most common approach for an ERISA exemption. A DCA that is “unfunded and is maintained by an employer primarily … for a select group of management or highly compensated employees” is exempted from most Title I requirements. The Department of Labor takes the position (that the word “primarily” modifies the type of benefit being provided under the plan and not the participants, meaning that a top-hat plan may not cover any employees
other than management or highly compensated employees.
A top-hat plan is, however, subject to reporting and disclosure provisions. Labor Regulations
allows for an abbreviated compliance procedure. Failure to take advantage of this procedure will
require an employer to file an Annual Return/Report of Employee Benefit Plan, with requisite
penalties for noncompliance.
An unfunded top-hat plan for ERISA purposes generally conforms to an unfunded plan for tax
purposes, as discussed below. Determining what constitutes a “select group of management or
highly compensated employees” is more problematic. The Department of Labor (DOL) has formulated no definitive standard, but has indicated that the requisite top-hat group should be limited to individuals who, by virtue of their position or compensation level, have the ability to affect or substantially influence the design and operation of the DCA. Some tax advisors and courts
have equated highly compensated employees for ERISA purposes with highly compensated employees under the IRC (section 414(q)) definition, even though the preamble to the section
414(q) regulation states that the definition should not be extrapolated for ERISA purposes.
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Even though the SEC has not formally clarified when DCAs are subject to security registration
requirements, as long as the plan is a true top-hat plan, concerns about registration of the plan as
a security should be mitigated under the private sale exemption. The SEC has issued a number of
“no-action” letters with regard to DCAs.
Excess Benefit Plan-A Subspecies
A variation on deferred compensation plans is the excess benefit plan, which is not exactly the
same as a traditional deferred compensation plan, even though their purposes are similar-to provide additional retirement income.
Excess benefit plan ERISA section 3(36) defines an excess benefit plan as a DCA maintained by
an employer to provide benefits for certain employees in excess of the IRC section 415 limitations for qualified plans. Irrespective of whether the plan is funded or non-funded, ERISA’s participation and vesting standards are not applicable. If the plan is funded, however, many other
Title I requirements are applicable. A supplemental DCA that is structured (as is commonly the
case) to make up for a limitation on qualified plan benefits due to the constraints of both section
415 and 401(a)(17) may not qualify as an ERISA excess benefit plan.
The primary difference is those excess benefit plans, if properly developed, need not meet any
of the ERISA requirements that cause so many compliance problems for employers. While nonqualified deferred compensation plans are generally exempt from ERISA requirements, employers must be very careful to ensure the plans do not fail in some way that requires the employer to
meet ERISA rules.
Excess benefit plans are designed specifically to provide additional benefits for certain employees beyond the dollar limits imposed on qualified pension and profit-sharing plans. For example,
under one type of qualified plan, the employee's annual benefit after retirement may be no more
than $118,800 (in 1994, but adjusted annually for inflation). Thus, an employer who wants to
pay, in 1994, a retirement benefit of $150,000 annually to a valued executive is simply not permitted to do so legally under a qualified plan. An excess benefit plan, on the other hand, can be
used to provide the difference of $31,200 to equal the desired benefit.
Though excess benefit plans are generally subject to the same taxation rules as deferred compensation plans, excess benefit plans differ from deferred compensation plans in:
1. Their stated purpose, which is to provide benefits over and above qualified plan limits (rather than to defer income for tax purposes) and
2. Their exemption from all ERISA considerations provided the plan is put together correctly.
Funding Deferred Compensation Plans-or Not...
The parties to a deferred compensation agreement have an option about whether the plan will
be funded or unfunded. A funded plan is one for which the employer has established, specifically for the employee involved, an account to receive funds that will pay the deferred compensation
in the future. This account could be in the form of an irrevocable trust, an escrow account or
some other means that removes the funds from availability to the employer or the employer's
creditors. When a deferred compensation plan is funded, the employee can be fairly secure in the
knowledge that money backs up the employer's promise to pay in the future. Unfortunately,
there's a price to pay for this security-taxation.
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Disadvantages of Funded Plans
When a deferred compensation plan is formally funded, the tax code requires the employee to
be taxed on the employer's contributions when the employee's right to receive the funds becomes
non-forfeitable or substantially vested. To be substantially vested, the employee must have a
right to transfer the funds without concern about a substantial risk of or forfeiture. In other
words, if the employee has an absolute right to the funds, they become immediately taxable
whether or not the employee actually receives them. Numerous tax rulings and court cases have
addressed the issue of what represents a substantial risk of forfeiture, but this is generally determined on a case-by-case basis since whether such a risk exists is, apparently, not easy to decide.
Constructive Receipt
The rule that controls taxation based on the employee's right to receive funds is called the doctrine of constructive receipt, which holds that taxation will occur currently if an individual
could have received a monetary benefit, whether or not the individual actually did receive it.
Generally, amounts are considered constructively received if they are credited to the individual's
account or set aside in some way specifically for that individual. In other words, if the money is
available to the individual on demand, the money is constructively received and, therefore,
taxable currently.
The constructive receipt doctrine requires a taxpayer to currently include in gross income compensation that the taxpayer does not actually possess but that was under his dominion and control
and that could have been readily obtained without incurring any substantial penalty or restriction.
The IRS had often but unsuccessfully attempted to invoke the constructive receipt doctrine in
the context of a DCA. In Revenue Ruling 60-31, the IRS finally conceded that “a mere promise
to pay [a DCA benefit], not represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts and disbursement method.” A DCA
payable only out of the employer’s general assets will not result in a taxable event to the employee until payment is received.
The key to avoiding application of the constructive receipt doctrine is to contractually enter into the DCA before the deferred income is earned. As noted above, this requirement has been
codified in the new IRC section 409A.
The IRS will not issue advance rulings on the tax consequences of a controlling shareholder/employee participating in a DCA. When the controlling shareholder’s participation is as an
employee (rather than a shareholder), the courts, with acknowledgement from the IRS, have respected the DCA arrangement.
A simple example is the interest paid on a bank savings account. The bank credits the interest
to the account and the interest is taxed in the same year. The account holder might not take or use
the interest, but because he or she has an unreserved right to do so, the interest is taxed.
Also, to avoid constructive receipt, there must be substantial limitations imposed on the individual's right to access the funds. For another easy example, consider a bank certificate of deposit
(CD). A taxpayer has a two-year CD on which the bank pays interest periodically during the two
years. While the individual may take the money, including the interest, out of the CD before the
two-year period ends, there is a substantial penalty for doing so. Because this is considered a sub-
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stantial limitation on access to the funds, taxation of the interest does not occur currently as long
as the funds are left on deposit. In this case, the funds are not constructively received. At the end
of the two-year period, the interest becomes available without restrictions to the taxpayer, who at
that time must pay taxes on it.
These same general rules apply to deferred compensation arrangements; substantial limitations
must be in place to restrict the employee's access to the funds. Otherwise, the funds will be considered constructively received and immediately taxable. The IRS describes methods that can be
used to avoid constructive receipt under deferred compensation plans. The deferral agreement
between the employer and the employee should include provisions that:
1. The deferral being made by the employee is irrevocable. Once the employee agrees to a
salary reduction or the employee agrees to pay salary continuation, the decision may not
be revoked.
2.
The choice to defer income is being made before the employee actually earns the compensation to be deferred. If, however, the compensation has already been earned when the
agreement is entered into, the deferred compensation plan must include non-forfeiture
provisions that place the employee at substantial risk of losing the benefits.
3.
The agreement must include a specific period during which the compensation will be deferred before the employee is eligible to receive it. The period could be expressed, for example, as 15 years or until retirement or termination of employment.
Economic Benefit Doctrine
Whether or not the employee receives a taxable economic benefit is also a concern with a funded deferred compensation plan. As stated earlier, an economic benefit does not necessarily mean
the employee receives cash only that the individual receives something that has an economic value. If the employer's contributions are (1) dedicated solely for the employee's benefits, (2) are
irrevocable and (3) are available to the employee without limitations, the IRS says the employee
has received an economic benefit. Again, then, the funds become immediately taxable as being
constructively received.
The economic benefit doctrine would currently tax the value of property transferred by an employer to fund a DCA to the extent that the property transferred was legally set aside from the
claims of creditors of the employer (e.g., under a secular trust or escrow arrangement) for the
benefit of the employee under the DCA. This would be true even though the benefited employee
has no current actual or constructive access to the money or property funding the trust.
A number of “informal funding” techniques have developed that do not invoke the economic
benefit doctrine. The employer’s obligation may be financed through life insurance or annuity
contracts. The policy must be the sole property of the employer and constitute a general asset
subject to creditor claims.
The "Rabbi Trust"
Several trust formats may be used for the informal funding and accepted by the IRS, but the
primary trust that explicitly seems to have the approval of the IRS is called the Rabbi Trust, and
this is discussed later in the "Trusts" section.
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Protection from Employer's Creditors
Another problem with funded plans is that they often protect the deferred compensation from
the employer's general creditors since the funds are deposited strictly for the use of the employee
in a trust or escrow account. In other words, the employee is not at risk of losing the funds in the
event the employer experiences financial problems that cause creditors to demand immediate repayment. This protection for the employee has caused problems with the substantial risk of forfeiture requirement necessary to avoid immediate taxation.
An employee may designate a nonbinding preference regarding the investment of employer assets used to finance a DCA, but the employee remains an unsecured creditor of the employer.
The unsecured contractual guarantee of a third party has been found not to result in a currently
taxable economic benefit. Examples of this, (found in PLRs 9040050 and 8741078, Berry v.
United States, 760 F. 2d 85 (4th Cir. 1985)), would be a guarantee by a parent of a subsidiary’s
deferred compensation promise, or by the team owner of the employer-team’s promise to pay a
ballplayer’s deferred compensation.
ERISA Requirements
In addition to the possibility that the employee will have to pay taxes on the funds before they
are actually received, there is yet another disadvantage to a funded deferred comp plan. Funding
causes the plan to fall under the regulation of the Employee Retirement Income Security Act
(ERISA), which requires special fiduciary and vesting considerations and considerably more detailed reporting to the government. These requirements cause the nonqualified plan to be treated
much like a qualified plan but without the tax advantages. Generally, this is one of the problems
employers are attempting to avoid when they offer nonqualified benefits.
A DCA (other than a true excess benefit plan) formally funded by a trust or other funding vehicle must comply with minimum coverage, participation, and other burdensome Title I ERISA
requirements.
ERISA Exemption for Unfunded Plans
On the other hand, the tax code allows deferred compensation plans to be generally exempt
from ERISA requirements provided the plans are both:
1. Unfunded and
2. The major purpose is to provide deferred compensation for a selected group of management
personnel and/or highly compensated employees.
When the plan meets these conditions, the only ERISA requirements with which the employer
must comply are notifying the Department of Labor that the plan exists and providing some basic
information about the plan.
UNFUNDED PLANS
For the reasons described above, most deferred compensation plans are unfunded, which
means no formal method is used to set aside the money specifically to pay deferred benefits. Under an unfunded plan, one of two situations exists: (1) literally no fund exists to receive the deferred compensation or (2) a fund exists, but remains completely available to the employer's
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creditors, rather than being earmarked specifically for the employee.
Under either of these circumstances, with no funding guaranteed, it seems the employee has no
security whatsoever about whether the deferred benefits will be available in the future. Indeed,
with an unfunded deferred compensation plan there is a risk that the employer will either be unable or unwilling to pay the promised benefits when the time comes. Of course, the employee has
a contractual agreement with the employer, but, like any other contract, it is only as secure as
whatever backs it up. Therefore, employees are not likely to agree to an unfunded deferred compensation agreement with employers whose businesses do not have a solid financial base.
Assuming, however, that the employer is financially solvent, there is a way to provide a measure of security for the employee without the formal funding that causes tax havoc. The tax laws
permit a deferred compensation plan to be considered unfunded even when the plan is informally
funded, thereby avoiding current taxation. Informal funding may occur in various ways, the most
important of which—from your perspective—is through life insurance. Informal funding is the
entree for the life insurance agent. The rest of this section, therefore, concentrates on unfunded
plans that are informally funded through life insurance.
LIFE INSURANCE FOR INFORMAL FUNDING
A recent publication started a brief but succinct informational on informal funding as:
“A number of 'informal funding' techniques have developed that do not invoke the economic
benefit doctrine. The employer’s obligation may be financed through life insurance or annuity
contracts. The policy must be the sole property of the employer and constitute a general asset
subject to creditor claims."
Life insurance is the single most optimum solution to securing deferred compensation for the
employee on an unfunded basis. When other methods are used, such as interest on investments,
and the employee dies before the funds have grown adequately, the employer may be unable to
fulfill its obligation. The result is that the employee's survivors receive little or nothing of the deferred compensation that the employee “earned”. On the other hand, with life insurance on the
employee's life payable to the employer, the employee's death results in an immediate payment of
death proceeds to the employer, who may then use the proceeds to fulfill the deferred compensation agreement by paying benefits to the insured's estate or survivors.
Plan Is Not "Funded" by Policy
It is generally accepted by the IRS that a deferred compensation plan informally funded by life
insurance doesn’t cause a plan to be considered funded for purposes of taxation, provided all of
these conditions exist:
1. The employee has no interest or rights in the policy under which the employee is the insured
person.
2. The policy is the sole property of the employer, who is both owner and beneficiary.
3. The policy's values remain, like any other business asset, subject to claims of the employer's general creditors.
Therefore, the life insurance policy may not be payable to the personal beneficiaries of the insured, the employer must be the beneficiary in order to avoid current taxation. This status also
ensures that the insured employee is not taxable on any economic benefit received as the result of
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premium payments the employer makes.
Benefits of Life Insurance for the Employer
For the employer, a life insurance policy purchased to informally fund the deferred compensation can provide additional benefits. During the period the policy is in force, the cash values
grow without current taxation, just as any cash value life insurance policy does. The employer,
as policy owner, may borrow from the cash values.
Furthermore, employers are relieved of the burden of finding other means to eventually pay the
deferred compensation. Employers have the assurance that as long as they pay the policy premiums, the insurance will be available to pay the benefits promised in the future. The cash values
and the death benefit are guaranteed to be paid, unlike some investment vehicles, which are riskier.
A number of other benefits are available to the employer when the deferred compensation is finally paid, as discussed later.
TRUSTS
A trust is a legal instrument that in order to be effective, must follow certain legal requirements. Obviously, when an individual or business uses a trust to accomplish its purpose(s), an
attorney must be involved. A trust is an arrangement under which one person or institution holds
legal title to real or personal property for the benefit of another person or persons. This arrangement nearly always takes the form of a written document which sets out the rights and responsibilities of all parties. A trust is a valuable instrument used to hold property for the benefits of
other persons, now or in the future, and often avoid some taxes that otherwise would have to be
paid.
Irrevocable Trust
An irrevocable trust may not be changed or revoked after it is created, and its usual purpose is
to remove property and its future income and appreciation from the estate of the creator of the
trust. An irrevocable trust can also be used to protect assets given to the beneficiary's creditors.
Property placed in an irrevocable trust will not be removed from the estate if the owner retains
certain interests or powers in the trust, such as a provision that the person will receive the income
from the trust for the rest of their life. Further, gift taxes will apply when the owner relinquishes
ownership of the property to the extent that control over the property has been relinquished.
Revocable or Living Trust
A revocable trust (or living trust) is created during the individual's lifetime and it may be
amended or revoked at any time. The trust document provides instructions as to how the assets
under the trust are to be managed at anytime. However, since the trust is set up so that the ownership of the property can be altered or changed, at any time and for any reason, the person has
not committed himself to anything, and any income and deductions attributable to the property in
the trust will be taxed as individual income. However, the person will not be liable for any gift
tax when the assets are contributed to the trust.
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Present Interest Trust
Congress enacted special rules that allow a method of making gifts to minors that qualify for
the annual exclusion. A gift to such qualifying trust established for an individual under the age
of 21 will be considered as a gift of a present interest and qualifies for the $12,000 annual gift tax
exclusion. The trust must stipulate that the gift property and its income may be expended for the
benefit of the beneficiary before reaching age 21 and to the extent not being expended, will pass
to the beneficiary upon reaching age 21. If the child dies prior to reaching age 21, the funds must
be payable under a general power of appointment.
Crummey Trust and the Totten Trust have been discussed early in the section on gift taxes.
THE RABBI TRUST
One of the most popular means used in recent years to informally provide an unfunded deferred
compensation plan is a so-called Rabbi Trust. The terminology comes from the first such IRSapproved trust, which happened to be established for a rabbi. Revenue Procedure 92-64 further
clarified the acceptable rules for Rabbi Trusts along with a model trust document and the required features to avoid constructive receipt of income to the employee.
An example of the use of a Rabbi Trust is where an employee receives compensation, the taxation of which is deferrable as a non-qualified deferred compensation plan.
The Rabbi trust may also be used when one business purchases another business but wants to
set aside part of the purchase price and defer its payment as well as the taxability to the payee
upon the satisfaction of conditions to which both parties agree.
A non-qualified deferred compensation plan is where current income of an employee is deferred but not taxable to the employee. The employer, however, sets aside the assets in a separate
trust for the employee's future. Ordinarily, this would cause current inclusion into gross income
even though the employer has yet to reduce the money to income because of the economic benefit theory doctrine. So the IRS allowed by private letter ruling that the trust would not result in
income according to Section 83(a) of the Code if the assets of the trust were to the reach of the
employer's general creditors. This is because until the employee is vested, he is under a substantial risk of forfeiture and under the Code and accompanying regulations, as such is not subject to
current inclusion into gross income.
All non-qualified deferred-compensation plans must involve substantial risk of forfeiture or
other methods of avoiding constructive receipt, such as conditioning payment upon performance
of future conditions or service. The unique feature of the Rabbi trust is that the money placed in
it is protected from changes of heart of the employer. Once placed in the trust, the money cannot
be revoked by decisions of the employer. As long as the financial position of the employer is
sound, the money is relatively protected.
Acquiring a Business
When one business purchases another business, the purchasing business may want to set aside
part of the purchase price and defer its payment to the payee upon the satisfaction of conditions
to which both parties agree. A Rabbi trust may be used in this situation to defer the taxability to
the payee of the deferred payments of the purchase price.
For the Rabbi trust to be successfully applied, there must be real risk of forfeiture upon the
failure by the payee to fulfill the agreed upon conditions. If the condition is not impossible to
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fail, then constructive receipt may overcome the successful applications of the Rabbi trust.
Impact
The Rabbi trust allows the deferment of compensation whether employment income or the purchase price of a business acquisition and the absence of this would result in the taxability to the
payee of the compensation not yet received by the payee. This would serve as a disincentive for
deferring such payments.
By establishing such a trust, the employer provides some security for the employee because the
trust generally is irrevocable the employer cannot dismantle it at will. Furthermore, the trust
must be completely inaccessible to the employer's owners or management, now and forever, to
qualify for this purpose. The trustee, who may not be the employer, is responsible for eventually
paying the deferred compensation to the employee from the trust.
However, the trust secures the tax deferral on contributions for deferred compensation because
the funds remain subject to claims of the employer's general creditors if the employer becomes
insolvent or bankrupt. This means the trust could be depleted if it is raided by creditors of which
the employee is now considered one, by the way. Nevertheless, the fact that such an informal
funding method is available is much more attractive to employees. The trust eliminates the possibility that the employer might refuse to pay the deferred income, although the risk remains that
the employer will be unable to use the trust for that purpose if the funds have been depleted by
other creditors.
IRS Model Rabbi Trust
Because Rabbi Trusts have become so widely used, in 1992 the IRS developed a "model"
Rabbi Trust document for use as a guide in drawing up the trust to informally fund nonqualified
deferred compensation plans. If the trust is developed based on the model, the problems associated with funded plans should be eliminated.
The model includes all provisions required to establish an approved trust except one: that investment possibilities the trustee may pursue. Investment powers must be spelled out by the individuals involved in the trust agreement and the agreement must provide some discretionary
powers to the trustee.
Somewhat contradictorily, the IRS requires the language of the model to be used verbatim,
while at the same time allowing deviation as long as the different language is "not inconsistent"
with the model language. In addition, the model suggests several alternatives for certain provisions, allowing the parties to select the one that meets their needs.
Life Insurance in a Rabbi Trust
Life insurance policies may be used to provide the funds in a Rabbi Trust. The model provided
by the IRS places three conditions on the trustee's powers when life insurance is used. The trustee
may not:
1. Name any person other than the trust as beneficiary of the life insurance proceeds. (Remember that a "person" could be an unnatural person, such as a corporation, as opposed to a natural person, which is a human being—generally speaking...)
2. Assign the life insurance policy to any other person except a successor trustee (in the event
the trustee resigns or is removed).
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3. Lend to any person any amounts the trustee borrowed from the policy. However, one of the
optional provisions in the model trust document permits the trustee to lend these amounts to
the employer, so this arrangement could be included if desired.
Secular Trusts
The topic of a Rabbi Trust raises questions about other types of trusts to informally fund deferred compensation agreements. One type is called a secular trust, but it does not accomplish
the same tax deferral as a Rabbi Trust. We mention it here essentially to warn you and your clients away from a secular trust when the employee's tax benefits are important factor in a deferred
compensation arrangement, as they usually are.
Some employers have sought to allay employee fears about default in the event of bankruptcy
by funding the non-qualified deferred compensation plan with a secular trust. A secular trust is an
irrevocable trust created to fund non-qualified deferred compensation liabilities. Unlike a Rabbi
Trust, a secular trust places funds outside the reach of creditors. Therefore, unless provisions are
inserted creating a substantial risk of forfeiture, the employee is currently taxable as a result of
contributions to the trust. Correspondingly, the employer is able to deduct contributions to the
trust as they are made. Because the employee is taxed immediately on deferred amounts, future
payouts of the principal amounts will be tax-free.
Since the employee has an interest in the trust, the secular trust is considered "funded" for
ERISA purposes. In addition, because the employee has a vested interest in the trust, it will not
become property of the company's creditors during a bankruptcy situation. This protects employees from an employer's bankruptcy because the secular trust represents an irrevocable transfer of
assets that cannot be reached by an employer's creditors. Unfortunately, because of that stipulation, amounts set aside in a secular trust are taxable to the employees in the year the amounts are
placed in the trust. Thus, employees must pay current taxes on amounts set aside in a secular
trust, even though they do not receive this money until retirement.
A secular trust can be beneficial to the employee who objects to risking forfeiture of deferred
amounts. These amounts are, after all, part of the employee's current compensation. It may make
little sense to defer that compensation if its ultimate receipt is subject to new risks. To take care
of the tax cost, the plan may provide for immediate distribution from the trust of sufficient funds
to cover the employee's tax costs. Some companies gross up the deferred amounts to cover all or
part of the tax costs.
Secular trusts are interesting and agents working in the business area should be at least familiar
with the term, however rarely have such trusts been implemented. While the benefit security aspects of a secular trust are attractive, the cost is substantial. To offset to the effects of adverse
taxation, many companies make "gross up" payments to their executives. These costs are often
material, and may need to be disclosed in the company's proxy report. For that reason, they tend
not to be popular with shareholders. The trust's earnings are potentially subject to double taxation: once at the trust level, and again when distributed to the employee.
Springing Trusts
Another method to protect employee interests is a springing trust. A springing trust is the consequence of an unfunded non-qualified deferred compensation plan containing a provision that, if
some event such as a change in ownership or effective control of the company occurs, the com-
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pany is required to establish a Rabbi Trust to hold the deferred amounts. A variation of the
springing trust is the "rabbicular trust".
Rabbicular Trusts
More sophisticated planners seeking the best of both worlds have developed a hybrid, the "rabbicular trust," under which a Rabbi Trust converts to a secular trust (and becomes taxable) upon
the occurrence of an event signaling financial difficulty for the employer (short of bankruptcy),
such as a stipulated decline in debt-equity ratios, net worth, gross sales, earnings per share, etc.,
and when the event occurs, the trust becomes a Secular trust and the executive is given the right
to withdraw benefits.
The rabbicular trust can protect against:

Change of control or management: An unfriendly takeover will not affect the assets in the trust. Rabbi Trusts are frequently written with a trigger that requires full
funding of designated non-qualified benefit programs upon a change of control, as
defined within the document. This protects participating executives from a change
of heart due to a hostile takeover, for instance.

Change of heart: management's reluctance to pay benefits. The employer cannot
access assets in the trust, once committed.

Change of financial condition: may include situations such as a change in the corporate net worth, net income or price per share. Other conditions might include a
specified change in financial ratios or the loss of a particular client or customer.
In addition to these changes, a "call" is another tool that executives might wish to consider in
order to help protect their investments. A call allows the employee to receive their investments at
any time. For example, if you, as the investor, feel that your non-qualified deferred compensation
is at risk, you may than collect your compensation immediately. However, there is a downside to
a call. Typically, the executive will incur a penalty upon exercising a call of a benefit. The penalty may be a percentage of the total compensation withdrawn.
The objective is to (1) protect the assets from the claims of the employer's creditors if events
which make insolvency likely, and (2) to take advantage of the tax deferral and ERISA exemptions until that time. However, federal bankruptcy laws permit the bankruptcy Trustee to reclaim
any transfer made within ninety (90) days of the employer's bankruptcy (or within one (1) year
for transfers to insiders). A rabbicular trust must be designed very carefully to ensure that it accomplishes the desired tax deferral without compromising the security of the benefit.
Haircuts
Another mechanism for avoiding loss of deferred amounts on bankruptcy is called a "haircut
provision." Here the executive is given the right to an immediate payout of the deferred
amounts, subject to forfeiture of part of the deferrals. It is generally recommended that the "haircut" involve a forfeiture of at least ten percent of the executive's deferred account. (The Internal
Revenue Service has not issued any rulings on the effect of "haircut provisions".) Frequently,
non-qualified deferred compensation plans that include "haircuts" also provide that the executive
cannot participate in the non-qualified deferred compensation plan in the future, once a "haircut"
withdrawal has occurred.
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"Haircuts" have a built-in public relations disadvantage. If key executives start to exercise
withdrawal privileges at a time when the company is under siege, other employees as well as
shareholders and suppliers may assume that the prospects for its survival are slim.
While these trusts may have "cute" names, the Secular trusts are the ones that are the most
used, so the discussion that follows will address the Rabbi and Security trusts primarily. As one
financial planner has noted recently, there is a lot of talk about these trusts, but that is all it is,
just talk.
Secular Trusts (Continued)
Briefly, a secular trust provides formal funding in an irrevocable trust. The trust funds are protected from the employer's general creditors. The trust is established for the benefit of the employee. The employee is taxable on contributions to the trust in which the employee is substantially vested. According to the IRS, substantial vesting occurs if the employee's interest is either
transferable or not subject to a substantial risk of forfeiture. You can see that it is likely the employee will pay current taxes on employer contributions to a secular trust.
The IRS has published some opinions about secular trusts-opinions that have been challenged
or criticized by tax practitioners as inconsistent and even incorrect. The uncertainty about the
IRS's position on taxation of secular trusts, coupled with the general current taxability of contributions to the employee, has resulted in less interest in using secular trusts than in using Rabbi
Trusts for deferred compensation plans.
Components of the Plan and the Contractual Agreement
A deferred compensation plan involves a contractual agreement between the employer and
the employee. This contract is based on a formal plan the employer has designed in conjunction
with attorneys, tax authorities, the employee and the insurance agent (if life insurance policies
provide the informal funding). We will look at the components that are included in a typical plan
design, as well as the provisions generally included in the contract between the employer and the
employee.
Many elements of a deferred compensation plan that appear in the plan design document will
also appear in the contract between the employer and the employee, while others will not. For
example, whatever the formal plan stipulates as the event that triggers payment of the deferred
compensation will show up in the contract as well. On the other hand, eligibility information included in the plan design, such as salary minimums or job descriptions, will probably not appear
in the contract with the employee.
Eligibility Requirements
The primary eligibility requirement is based on the tax code provision that the plan must have
been developed for a specific group of management personnel or highly compensated employees.
Beyond that, there are no legal guidelines for eligibility. However, the employer must be careful
not to include an extremely broad group of employees. If the group is not selective enough, the
IRS can decide the deferred compensation plan is just another employee retirement plan that is
subject to the dollar limits and complex regulations that govern such plans.
For this reason, eligibility should be greatly restricted or not specifically defined in the plan at
all. For example, a restrictive provision could define the positions that make an individual eligi-
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ble, such as all employees at the executive vice president level and above. Sometimes, minimum
salaries are used, but the employer must be careful to tie salaries to an inflation index. Otherwise, employees at lower salary levels when the plan is introduced could eventually be included
inadvertently.
Some employers prefer not to define eligibility at all, instead using a provision that permits the
employer to select participants on a case-by-case basis. If the employer is a corporation, for example, the plan could indicate that a committee will nominate potential participants who must
then be approved by the board of directors.
Service Requirements
The plan design might include service requirements related to the future payment of deferred
compensation. For instance, the employer could require that an executive be employed with the
company for 10 or 15 years before retirement in order to receive the deferred compensation benefits. To retain flexibility, however, the employer might also include provisions for valuable employees who have shorter tenures with the business.
For example, the company's situation in the future-unknowable at the time the plan is designed
could call for hiring a high-powered executive to turn around a faltering division in the business.
This could be a highly experienced person who wants to retire in five years, but who is willing to
join the company for that period. In order to gain the person's services, the employer could use
this alternate provision to offer deferred compensation even though the executive will not be with
the company long enough to fulfill the 10- or 15-year service period that otherwise applies. Flexibility such as this can be important in order not to constrain the employer's ability to respond to
unpredictable economic needs.
Retirement Age
A provision that is sometimes tied to or coordinated with service requirements is the retirement age at which deferred compensation benefits are payable. Some employers want to encourage or at least allow employees to retire at a younger age than the employees might otherwise
choose. The plan can provide that the employee will receive the full-deferred compensation benefit even if he or she retires at, perhaps, age 62, as long as the service requirements have been
met.
Another provision could indicate that, if the employee retires even earlier, say age 59, the benefit will be reduced slightly until another age is reached. For example, an employee's benefit will
be reduced by 3% per year until the employee reaches age 62, at which time the employer begins
paying the full-deferred compensation amount. Employers often tie provisions such as these to
the normal retirement age of basic pension plans that are provided for all employees.
Income Replacement Goals
The income replacement goals of the employer and the employee can be stipulated in the plan.
A typical amount that would be paid to a retired executive under a deferred compensation plan is
about 50% of current earnings. Remember that the deferred compensation is generally considered
a supplement to other retirement income. Fifty percent is an amount that is likely to be approved
by a corporation's board of directors or others involved in the decision. In addition, the employer
must be aware of the IRS position about "unreasonable compensation," which essentially is that
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the company may take a tax deduction only to the extent that compensation is "reasonable." The
tax code defines reasonable compensation as:
"Such amount as would ordinarily be paid for like services by like enterprises under like
circumstances."
If the IRS decides compensation is not reasonable, a portion of the payment will not be tax deductible. Furthermore, in the case of a corporation, unreasonable compensation paid to an employee who is also a stockholder will be taxed as a dividend and, therefore, not only not deductible, but doubly taxed to both the corporation and the stockholder.
Compensation Base
Because future benefits to be paid under a deferred compensation plan are generally tied to the
employee's compensation base, the plan should provide a means to establish that link. A commonly used method is to determine the average compensation over a stipulated period that includes the highest earning years-which are usually the last years before retirement.
For example, the plan could specify that the base compensation is determined by averaging
gross pay for the five years of highest compensation during the last 10 years the individual is employed before retiring.
It's beneficial for the employee to be allowed consideration for the highest earning years since
compensation includes bonuses and other incentives the employee has received. If bonuses are
smaller in some years, those years can be ignored for purposes of determining the compensation
base in order to boost the average.
To average the five years of highest earnings, the income for those years is totaled and divided by five:
Then, if the plan provides for a benefit equal to 50% of usual compensation, the employee will
receive 50% of the average compensation:
$455,600 x .50 = $227,800
This, then, is the annual deferred compensation benefit the employee will receive upon retiring.
DEFINED BENEFIT vs. DEFINED CONTRIBUTION PLANS
The approach to paying the deferred compensation can be based on either a defined benefit
method or a defined contribution method. (These, by the way, are the same choices available under qualified plans.) The terminology is fairly descriptive in that under a defined benefit plan, the
plan identifies or defines the benefit that will ultimately be paid. A defined contribution plan
identifies or defines the contribution that will be made during the deferral period.
Defined Benefit
When a defined benefit plan is selected, the benefit might be specified as either of the following:
1. A flat dollar amount (which may or may not be indexed for inflation) or
2. A formula (which is generally similar to the averaging method described previously, that is,
the average of the five years of highest earnings during the last 10 years of employment).
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The defined benefit might also take into consideration the number of years of service the particular employee gives. For example, a certain additional amount could be added for each year of
service, thus rewarding further an employee who not only met a 15-year service requirement, but
actually was with the employer for 20 years.
Another feature of a defined benefit plan is that the benefit to be paid can be offset by other retirement benefits the individual is entitled to, such as Social Security and/or benefits from a company sponsored retirement plan for which all employees are eligible. As an example, the plan
could stipulate that the employee will receive from all sources no more than 70% of average
earnings. For simplicity, let’s say the employee’s average earnings are $100,000, which restricts
retirement income to $70,000 per year. The employee receives:
From Social Security:
From all other retirement income sources
Total before deferred comp is paid:
Maximum permitted:
Less other benefits:
Defined benefit to be paid from deferred comp:
$18,000
27,000
$45,000
$ 70,000
45,000
$35,000
Another advantage of a defined benefit plan is that it can more directly reward the individual’s
performance. Obviously, the higher the earnings on which the benefit will be based, the higher
the benefit will be.
Salary continuation (versus reduction) plans often use the defined benefit approach since the
two complement each other, while salary reductions and defined contribution methods are also
complementary as you’ll see.
Defined Contribution/Money Purchase
As the name implies, a defined contribution plan indicates the amount of the contribution that
will be made annually. Defined contribution plans are also called money purchase plans. Because the amount contributed can be the same as the amount of the employee’s salary reduction,
theses arrangements work well together.
The contribution that is stipulated in the plan document is the amount of the employee has
agreed to have deferred. This probably will be indicated as a percentage of each year’s salary,
allowing the amount to increase as the employee’s compensation increases. The amount might
be actually placed in an account for the employee (within the rules for funded versus unfunded
plans) or the contribution might simply be an accounting entry to designate the employee is entitled to this amount. If the money is actually set aside, remember that for nonqualified deferred
compensation to work properly, the funding must be informal, such as through life insurance or a
Rabbi Trust (which might or might not include life insurance).
Where there is no actual funding under a defined contribution plan, the employee does not have
the advantage of earning income on the deferred funds. To offset this disadvantage, the employer
sometimes stipulates a certain rate of interest that will be paid as if it had actually accrued. With
a life insurance policy, of course, the employee can indirectly earn income through the cash val-
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ues that build during the deferral period if the employer chooses to use the earnings for that purpose.
Forfeiture Provisions
To protect the employer and provide another reason for the employee to stay with the company,
the plan probably includes forfeiture provisions. These provisions require the employee to give
up all or part of the deferred compensation if certain events occur before the employee retires.
The most common events used to trigger forfeitures are:
1. The employee is terminated by the company with cause," which generally means for a serious work or legal violation of some type (frequent absences from work, sexual harassment
and embezzlement are examples).
2. The employee leaves voluntarily and goes to work for a competitor of the company providing the deferred compensation arrangement or competes personally as a self-employed person.
Vesting
The plan could include somewhat more lenient provisions when termination occurs under other
circumstances. For example, it is possible that the employee, the employer or both could decide
in the future that the employment relationship is no longer satisfactory. The plan might provide
for gradual vesting of the deferred compensation for the employee so he or she will still receive a
percentage of the benefits if employment terminates after a certain number of years.
Unlike qualified retirement plans, under which specific vesting schedules apply, nonqualified
deferred compensation plans require no vesting at all. Therefore, an employer who decides to
include such a provision may design any vesting schedule desired-or none.
EVENTS TRIGGERING BENEFITS
Retirement
The primary purpose for benefits paid under a deferred compensation plan is to provide retirement income. Therefore, the usual trigger is the employee's retirement according to the plan
provisions. In addition, the plan may be written to pay benefits from the deferred compensation
plan in the event of death as well.
Death
There is always the possibility the employee will die, either before receiving any of the deferred
compensation or after receiving only a portion of it. Many plans allow the payment of death
benefits to the employee's survivors or estate, before and/or after the employee retires. Remember that, if the plan is informally funded by life insurance, the employer owns and is the beneficiary of the policy, so no direct death benefits would be paid to the employee's survivors from the
policy. However, the employer might choose to use a portion of the death proceeds from the policy to pay a death benefit to the survivors. This is another advantage of using life insurance; the
proceeds are available exactly when they are needed.
One disadvantage of such a death benefit is that it is taxed to the person who receives it as or-
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dinary income, rather than being received income tax free as benefits paid directly from life insurance policies generally are. However, the tax code does allow the first $5,000 of any death
benefits paid by an employer to the employee's survivors to be excluded from income taxation
under most circumstances. We'll talk more about the details of the $5,000 death benefit exclusion later. We'll also discuss the payment of periodic death benefits to survivors in the section of
this chapter that covers the payout of deferred compensation.
Payment Methods
The most commonly used deferred compensation payment method is monthly installments. Alternately, the employer could make annual payments or pay the entire amount in one lump sum.
Lump-sum payments, however, are rare. First, they require the employer to provide a very large
sum at once, which can be difficult under unfunded plans. Second, the employee must pay taxes
on that very large amount in a single tax year. Furthermore, if the employee has a great deal of
control about the form in which payments may be received-such as an option to take either a
lump sum or installments, constructive receipt becomes an issue.
It is very important for all parties and their tax consultants to consider carefully how the payments will be made in order to arrive at the optimum tax benefits for all involved.
Other Provisions
In addition to the above, various other provisions may be included, depending on the particular
plan.
Naturally, all parties to the agreement are identified by name and respective positions, the
employee, the employer or company, and the trustee, if any.
It's also typical to include an acknowledgment that the parties to the agreement have no right
to assign, transfer, exchange or sell any benefits provided under the plan.
Some plans allow the employee to take a so-called hardship withdrawal in the event of an
"unforeseeable emergency" as the IRS defines it. The definition that must be included in the plan
to satisfy the IRS is essentially the following:
An unanticipated emergency caused by an event beyond the individual's control and
which would cause severe financial hardship if the individual were not permitted to make
the withdrawal.
The employee must be limited to withdrawing the amount needed to take care of the emergency. Except for these special restrictions, an employee taking a hardship withdrawal could have
constructive receipt problems and be taxed on the entire amount of deferred compensation. Under this provision, the only taxable amount would be the withdrawn amount.
Another provision stipulates that successors to the parties to the agreement are bound by the
agreement. This includes successor companies in the event the employer is sold or reorganizes
under a different form of ownership or name. Successors of the employee, who are also bound,
include beneficiaries, heirs and the executor of the employee's estate.
The agreement should also acknowledge compliance with the laws of the state in which the
employer is doing business and in which the employee resides.
When the employer is incorporated, the agreement may include a resolution by the board of directors, agreeing to honor the deferred compensation arrangement.
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If funding is provided, there should be a provision describing the form in which it will occur.
Even for an unfunded plan, if life insurance policies and/or a Rabbi Trust are established, the
agreement should cite and identify those documents as well.
The trust itself, where used, is established with a separate trust document that cross-references
the deferred compensation agreement. The trust document and all others, of course, require the
services of attorneys and tax accounts as well as the insurance agent when insurance is included.
Finally, the agreement will include any other conditions, provisions and benefits that may be
negotiated between the parties. The deferred compensation plan and the agreement between the
employer and employee are complex legal documents that require careful consideration and
preparation by competent legal and tax experts.
Paying the Benefits-Methods and Tax Issues
There are additional tax factors that come into play when the deferred compensation benefits
are paid to the employee or, if the employee dies, to his or her heirs. There are also certain tax
complications that can occur with a deferred compensation plan.
EMPLOYER'S OPTIONS WITH AN INSURANCE-FUNDED PLAN
When life insurance has been used for informal funding, the employer has a number of options
when the employee retires and becomes eligible to receive the benefits. If funds to provide the
compensation to the employee are available from a source other than the life insurance policy,
the employer needs not use the policy's cash values unless desired. For example, the employer
might have made certain investments that have resulted in sufficient funds to pay the promised
benefits. Remember that there is no requirement for the life insurance policy to be used to make
the payments, especially if the plan is legally considered unfunded. Instead, the employer may
choose to keep the policy in force. If the retired employee dies, the policy will still pay the death
benefit to the employer.
Let's assume, however, that the employer does want to make use of the life insurance to pay the
employee's deferred compensation. There are two basic options:
Policy Surrender
The employer surrenders the policy for its cash value, which the employer uses to pay the
employee's benefits. The policy no longer exists in this case. The disadvantage is that the employer also gives up the opportunity to receive the death benefit, which would be paid income tax
free to the employer when the retired employee dies. Thus, the employer does not recoup funds to
offset the premium payments made during the years the employee was working.
Policy Loan
Alternately, the employer could take a policy loan from the cash values and uses the loaned
amount to pay the deferred benefits. The employer must pay interest on the loan, of course, but
the rate of interest for insurance policy cash values is often considerably less than interest rates in
the marketplace. So, if the employer would otherwise be required to borrow funds to pay the
benefits, this could be an economic option. Furthermore, interest is typically deductible as a
business expense when a life insurance policy is owned by a business.
There is one potential drawback to the policy loan option. The tax code limits the amount of
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deductible interest when the policy covers the life of an officer, employee or any other person
who has a financial interest in the employer's trade or business. If the aggregate indebtedness for
any one of these persons is greater than $50,000, only the interest on the first $50,000 of debt is
deductible. Notice, if the employer has loans from policies on the lives of two employees retired
at the same time, the limit is on $50,000 of indebtedness for each individual. However, especially
if the employer has sources of funding for the deferred compensation in addition to the insurance,
this interest limitation may not be a significant factor. The employer could borrow up to $50,000
on the policy and use other sources to make up the funding difference.
Generally, employers borrowing from cash values borrow only as much as necessary in any
one-year to meet current needs. This keeps the interest amount lower than, for example, borrowing all cash values when the full amount is not needed to pay the deferred benefits. The employer continues to pay interest until (1) the loan is repaid, (2) the policy is surrendered or (3) the employee dies and the death benefit is paid. Any outstanding loan amounts, of course, are deducted
from the death benefit.
Employee Receives Retirement Benefits
The original goal of any deferred compensation plan is, of course, that the employee will live to
receive retirement benefits. At this point, Uncle Sam demands his due from the employee, while
finally providing a tax benefit to the employer.
Employee Taxable Income
Payments from deferred compensation arrangements are taxable to the employee as current income in the year received—included with all other income, deferred compensation benefits are
taxed at the individual’s regular individual tax rate. The employee may or may not be in a lower
marginal tax bracket when the benefits are paid. While the possibility of a lower bracket after
retirement is one of the potential tax benefits of deferred compensation arrangements, this is not
necessarily what actually happens, so the employee should be mentally prepared to pay taxes at
the same rate (or even a higher rate) as before retirement.
Taxes are one of the primary reasons deferred compensation benefits are usually paid in installments, rather than in one lump sum. Payment of a large amount in a single tax year could
significantly increase the tax burden. It is a rare situation where the employer even offers the
employee an option to receive the funds in this manner. Furthermore, if the employee does have
an option to receive the entire amount at once, constructive receipt again becomes an issue.
Remember that if someone has an unrestricted right to receive the funds, they become immediately taxable, whether or not the individual actually receives them.
Employee Withholding
Because the IRS defines deferred compensation payments as wages, the payments are subject
to withholding taxes just as if the employee had received the money before retiring. Taxes that
will be withheld from each payment, therefore, include:
1. Regular income tax withholding
2. Social Security withholding or FICA (Federal Insurance Contributions Act).
3. FUTA (Federal Unemployment Tax Act).
Deferred compensation benefits paid in 1994 and later years are subject to withholding for at
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least the HI portion of the tax.
Deferred compensation payments might be subject to withholding on the old age, survivors and
disability insurance (OASDI) portion, depending on other taxable income. If income for the year
equals or exceeds the OASDI taxable wage base, some or all of the payment may be subject to
withholding. FUTA withholding is similar to FICA withholding, but with a lesser amount.
Employer’s Tax Deduction
Now that the employee has begun receiving the deferred compensation, the employer is finally
entitled to a tax deduction for its payments to the employee. The tax code allows the deduction
only when the deferred compensation is included in the employee’s taxable income. Therefore,
the amount deductible is not the full deferred amount at once (assuming no lump-sum payment to
the employee), but only the amount the employer actually pays in each of the employee's taxable
years.
Furthermore, the deduction is limited to what the IRS considers "reasonable compensation," an
issue we've already discussed. The IRS has demonstrated over the years that it is inclined to
scrutinize, for issues of reasonableness, deferred compensation payments made to a controlling
stockholder of a corporation more carefully than any other such payment. The reason behind this
scrutiny is to determine whether excessive compensation actually represents a dividend that has
not been paid-and therefore has not been doubly taxed as dividends normally are. Because of this
concern, deferred compensation plans for controlling stockholders should be very carefully monitored by the company's tax and legal experts beginning with the preparation of the plan and contract and continuing with reviews during the deferral period. Minority stockholders and nonowner employees, on the other hand, are not as likely to be subjected to IRS challenges on the
issue of reasonable compensation in the absence of any blatantly excessive compensation.
Death Benefits
Deferred compensation agreements commonly provide for the payment of death benefits to the
employee's survivors whether death occurs before or after the employee retires. If the agreement
is funded by an employer-owned life insurance policy, the employee's death triggers payment of
the proceeds to the employer. The employer receives the death proceeds income tax free and
may then use the funds to pay the agreed-upon benefit to the employee's heirs if desired. However, there is no requirement that the employer actually use the proceeds for this purpose. That is,
any death benefit payable could come from any source of funds available to the employer.
Remember, though, even if the employer actually uses the life insurance funds, the heirs do not
receive life insurance proceeds as defined by law. They are simply receiving "compensation"
provided for under the deferred compensation agreement. Therefore, the heirs must pay income
taxes on any death benefit the employer pays.
$5,000 Death Benefit Exclusion
Although the survivors must pay income taxes, a portion of the death benefit may be excluded,
using the $5,000 death benefit exclusion. As indicated earlier, an employee's estate or beneficiary may receive up to $5,000 as a death benefit from the employer income tax free. Amounts
over $5,000 are taxed when received as ordinary income.
This $5,000 exclusion is the maximum exclusion allowed for anyone employee. Thus, for example if the employer pays more than one death benefit on an employee's life, the $5,000 limit
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still applies. Let's suppose the employer pays a death benefit of $25,000 to the deceased employee's spouse and another $25,000 to the employee's adult child. In this case, the spouse and the
child must share the $5,000 exclusion proportionately to their shares of the death benefit. Since
each receives one-half of the death benefit in this scenario, each may take one-half of the exclusion or $2,500. Both the spouse and the child will then pay current income taxes on the balance
of the death benefits they received-$22,500 each in this case, as shown here:
Spouse
Child
Death benefit from employer
$25,000
$25,000
Shared exclusion
2,500
2,500
Taxable income
$22,500
$22,500
If there were three beneficiaries, each could take one-third of the exclusion. If there were four,
each would be entitled to one-fourth of the exclusion, and so forth, depending on the number of
people receiving death benefits from that single employee's death.
Other restrictions apply to using this death benefit exclusion. The exclusion may not be used
when any of the following situations exist.
Finally, the $5,000 death benefit exclusion may be used by the survivors of employees of corporations, partnerships and sole proprietorships. However, proprietors and partners themselves
are not eligible for the exclusion. These restrictions apply to nonqualified deferred compensation
plans and other nonqualified arrangements, but not to qualified retirement plans.
Income in Respect of a Decedent
When payment of death benefits results from a contractual agreement, such as the deferred
compensation agreement, the benefits are considered income in respect of a decedent— a consideration that affects federal estate taxation. Income in respect of a decedent must be included
in the income of one of the following:
 The decedent's estate, if the estate receives it.
 The beneficiary, if the right to income is passed directly to the beneficiary and the beneficiary receives it.
 Any person to whom the estate properly distributes the right to receive it.
Under the tax code, income in respect of a decedent refers to compensation the deceased person earned but did not receive before death. This type of income must be included in the deceased's estate even though it was actually paid to someone else, such as a spouse or other survivor. To the extent that any estate taxes paid are attributable to income in respect of a decedent,
the person who received the death benefits may take a personal income tax deduction.
The deferred compensation agreement may stipulate that death benefits, if any, will be paid in
any one of several ways. Although a lump-sum death benefit is permitted, most employers prefer
not to use it, opting instead for installment payments that more closely resemble the payout
method used when the employee lives. Often, the employer agrees to pay a stipulated percentage
less than 100% of the amount the employee was receiving or would have received while living.
Here are some examples of how the agreement could stipulate that death benefit installments
will be paid by the employer:

Monthly or annual benefits paid for the lifetime of the surviving spouse.
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
Monthly or annual benefits paid for a stipulated period, such as 10 years, following
the employee's death.

Monthly or annual benefits paid to each of the employee's children until each child
reaches age 21 or some other specified age.
Other methods could be negotiated between the employer and the employee when the agreement is developed. In all cases, except where the $5,000 exclusion applies, the benefits are taxable as current income to the recipients.
Death Benefit Only (DBO) Plans
One variation of the deferred compensation arrangement, a death benefit only (DBO) plan, is
used primarily to avoid including any funds in the employee's estate, subject to estate taxation. A
DBO is designed to provide no income to the employee; instead, payments are not made from the
deferred compensation plan until the employee dies, and then the payment is a death benefit paid
to survivors.
A DBO works to avoid estate inclusion only if the employee has no right to receive any of the
funds at any time. For example, if the plan attempts to qualify as a DBO plan, but provides that
the employee may receive the funds, let's say after reaching age 75, the IRS will disqualify the
plan as a DBO. Likewise, any other provisions that guarantee the employee any right to the
funds if the employee does not die will result in the funds being included in the estate whether or
not the employee ever actually receives them.
When a DBO is properly developed and the funds are paid to the beneficiaries, the death benefits are treated as described previously. That is, the benefits are current taxable income to the
beneficiaries and may be eligible for the $5,000 exclusion. The employer may take a tax deduction for the DBO amounts as they are paid to the beneficiaries.
Additional Tax Issues
In addition to the tax issues discussed in various contexts in this chapter, other tax effects will
occur or may arise, depending on the circumstances of the particular situation.
Employer Premiums and Proceeds
When the employer uses a life insurance to informally fund a deferred compensation plan, the
premiums are not deductible as a business expense. On the other hand, the employer receives the
death proceeds free of income taxation. This treatment is the same as life insurance where the
business is both the owner and beneficiary of a policy covering an employee's life.
The one income taxation concern is that payment of the life insurance proceeds to the business
will trigger or increase the possibility of triggering the alternative minimum tax (AMT).
Accumulated Earnings Tax
For corporations, the buildup of life insurance cash values and or the amassing of premiums
technically could trigger the accumulated earnings tax discussed earlier in the course. Even if
the employer uses some means other than life insurance to accumulate funds to meet a deferred
compensation agreement, the accumulations may come into question. However, several tax rulings appear to support the contention that these accumulations represent a reasonable need of the
business, which is the standard required to avoid the tax.
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Controlling Shareholders
In addition to other potential problems involving controlling shareholders, there is the additional problem of whether or not such an individual can avoid the non-forfeitable rights requirements. Even when a deferred compensation agreement with a controlling stockholder specifically
limits these rights, the IRS must be further convinced. At issue is whether or not, because the individual has control over the corporation, he or she also has control over whether the restrictions
remain in place or are removed. If the controlling stockholder can remove the restrictions the
deferred funds would be deemed constructively received and taxable currently. While this issue
can't be ignored-since the IRS pointedly watches for it-past court rulings have so far not considered a controlling interest alone as evidence of a non-forfeitable right to the funds. When a controlling stockholder is involved, therefore, legal advice and monitoring become even more important in order to retain the tax benefits of deferral.
Third-Party Guarantees
In relation to a deferred compensation plan, third-party guarantees refer to arrangements
whereby an employee acquires from a third party (not the employer) some type of assurance that
the benefits will be paid. The potential problem with third-party guarantees is whether or not the
IRS will decide the plan is funded, the employee has non-forfeitable rights, and therefore, the deferred compensation has been constructively received.
In one actual case, a parent company was the third-party guarantor for a deferred compensation
agreement between one of its subsidiaries and the subsidiary's employee. The tax ruling on this
case left the tax deferral intact.
Another form of third-party guarantee available is insurance that indemnifies the employee if
the employer fails to provide the deferred benefit, discussed in more detail elsewhere in this text.
Again, the IRS has not required the deferred income to be taxed currently simply because an individual purchased this type of insurance. This is true even if the employer reimburses the employee for the premium payments, as long as the employer did not purchase and does not own the
policy. However, the employer-reimbursed premium is includable in the employee's personal
income for tax purposes.
Estate Taxes of Deferred Compensation
The only way to completely avoid estate taxation of deferred compensation is through a carefully prepared death benefit only (DBO) plan as described previously, with only the survivors
(not the employee) receiving any part of the deferred income. Remember that the plan must be
written to deny the employee any right to the funds at any time. As long as the employee holds
no interest in the death benefits, the benefits cannot be included in the estate.
Deferred compensation payments are included in the employee's estate under other circumstances. If the employee has begun receiving the income before dying and the deferral agreement
requires the employer to continue payments to survivors, a certain amount is included in the estate. The amount, determined as of the date of death, is the present value of the payments that
remain to be paid under the contract. For example, suppose 10 annual payments remain under an
agreement to pay benefits for 15 years. Only the value of the remaining 10 payments is included
in the estate.
Now let's assume the employee died during deferral before receiving any benefits. The present
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value of all future payments would be included in the estate, provided the employee had the right
to receive those payments in the future after he or she was no longer employed. On the other
hand, if the employee had no enforceable right to receive future payments, nothing is included in
the estate.
While many of the major tax concerns associated with nonqualified deferred compensation
plans have been discussed, any individual situation can trigger additional tax issues.
Section 457 Deferred Compensation
Everything discussed so far has been about plans between private businesses and employees.
The tax code regulates somewhat differently nonqualified deferred compensation plans for state
and local government employees and employees of certain tax-exempt entities. These plans are
generally referred to as Section 457 plans for the applicable section of the tax code.
OVERALL LIMIT ON DEFERRALS
Elective Deferrals
If an employee is covered by certain amount of retirement plans, he may choose to have part of
his compensation contributed by the employer to a retirement fund, rather than being paid directly to the employee. This amount that is set aside—elective deferral—is treated as an employer
contribution to a qualified plan. An elective deferral, other than a designated Roth contribution,
is not included in wages subject to income tax at the time contributed, but it is included in wages
that are subject to Social Security and Medicare taxes. Elective deferrals include elective contributions to the following retirement plans: (Note: These plans are, for the most part, retirement
plans and are not within the scope of this text.)
1. Cash or deferred arrangements (Section 401(k) plans).
2. Salary reduction simplified employee pension plans (SARSEP).
3. Savings incentive match plans for employees (SIMPLE plans)
4. Tax-sheltered annuity plans (403(b) plans).
5. Section 501(c) (18) (D) plans.
6. Section 457 plans.
For 2007, one should not have deferred more than a total of $15,500 of contributions to (1), (2)
and (4) above. The limit for SIMPLE plans is $10,500. The limit for (5) is the lesser of $7,000
or 25% of your compensation. The limit for Section 457 plans is the lesser of your includible
compensation or $15,500.
Note: "Qualified plans" has been defined earlier in this text, refers to whether participating employees may defer taxation on their employer's contributions.
ROTH 401(k) PLANS
While this text does not thoroughly cover retirement plans, Roth 401(k) plan contributions
should be addressed as there have been recent changes. Employers with section 401(k) and section 403(b) plans can create qualified Roth contribution programs so that the employee may elect
to have part of all of his elective deferrals to the plan designated as after tax Roth contributions.
IF the employer's plans allow it, the employee may designate part of all of his 401(k) contributions as "Roth 401(k)" contributions, wherein his contributions are nondeductible. However, all
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of the income to the plan will be tax-free to the employee when it is distributed if the employee
has 5 years of participation and distribution after age 59 ½, death, disability6, or for up to
$10,000 for a first home purchase.
Taken together, deferrals to all of these plans, including the Section 457 plan, must total a deferral of no more than the limits described. If the employer contributes to any of these plans on
behalf of the employee, the employer's contributions are also included in meeting the limits.
Other Requirements and Restrictions
Under Section 457, employees elect to defer compensation monthly, and they must elect to do
so before the beginning of the month. The plans may be available to all employees or only to selected individuals at the employer's option.
Section 457 plans must be unfunded, remaining the property of the employer and subject to the
employer's general creditors.
These plans must meet specific rules for distribution of the funds. Specifically, no funds may
be distributed to the employee until:
1. The employee's separation from service or
2. The calendar year in which the employee reaches age 7 or
3. An unforeseeable emergency occurs (one that is beyond the employee's control and will
cause a financial hardship if the employee is not allowed to receive a distribution).
Life insurance may be used under Section 457 plans. As long as the employer both owns and is
the beneficiary of the policy, the employee is not taxed on the economic benefit of premiums
paid.
Like other deferred compensation plans, the employee has taxable income only when the benefits are paid. Likewise, distributions are subject to withholding taxes for Social Security and
FUTA, with one exception. Section 457 payments for employees of a state or a political subdivision of a state are not subject to FUTA taxes.
If any of the Section 457 requirements are violated, the plan becomes "ineligible" and the plan
participants are taxed immediately.
As with any retirement plan, there are many other features that will need to be addressed if one
is to work in this particular market.
Chapter 7 Review Questions
1. The form of deferred compensation that does NOT require the employee to directly give up a
portion of current compensation is called:
A. salary reduction.
B. salary continuation.
C. pure deferred compensation.
D. hybrid deferred compensation.
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2. When there is no substantial risk of forfeiture, an employee will be taxed currently on contributions to a deferred compensation plan-even if the employee does not actually receive the
fund because of the doctrine of:
A. constructive receipt.
B. secular vesting.
C. top-hat plans.
D. fraud.
3. Protection from an employer's general creditors is provided under a deferred compensation
plan that is:
A. funded.
B. unfunded.
C. secured .
D. unsecured.
4. ______ is the single most optimum solution to securing deferred compensation for the
employee on an unfunded basis.
A. common stock.
B. real estate.
C. life insurance.
D. a certificate of deposit.
5. What trust has the IRS approved for tax-deferred informal funding of deferred compensation
plans and has even developed a model for use by employers?
A. revocable trust.
B. irrevocable trust.
C. secular trust.
D. Rabbi Trust.
6. The type of plan that specifies the amount the employer will pay into the deferred
compensation plan is:
A. defined benefit plan.
B. defined contribution plan.
C. secular trust plan.
D. compensation accumulation plan.
7. The primary purpose of a deferred compensation plan is to:
A. secure a tax deduction for the employer.
B. provide taxable income to the employee upon employment termination.
C. provide retirement income.
D. maintain employee loyalty.
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8. If a deferred compensation plan is informally funded by life insurance the _______ owns the
policy and the _______ is the beneficiary of the policy.
A. employer, employer.
B. employer, employee.
C. employee, employee.
D. employee, employer.
9. Payments from a deferred compensation arrangement are taxable to the _____ as current
income in the year ________.
A. employer, paid.
B. employer, received.
C. employee, paid.
D. employee, received.
10. Upon the death of an employee for whom compensation has been deferred, if an employer
pays the employee’s survivors a death benefit, the death benefit is:
A. fully taxable.
B. not taxable.
C. taxable to the extent it exceeds the published IRS requirements.
D. taxable to the extent it exceeds $50,000 per beneficiary.
Answers
1B 2A 3A 4C 5D 6B 7C 8A 9D 10C
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CHAPTER EIGHT - OTHER EXECUTIVE PROTECTION
INTRODUCTION
This chapter presents other uses for insurance products to provide business executives with
special benefits and protection with particular attention to Section 162 executive bonus plans
covering life insurance needs and Indemnification insurance as a third party guarantee for executives in unfunded deferred compensation plans.
SECTION 162 EXECUTIVE BONUS PLANS
A Section 162 executive bonus plan is yet another means available to employers who want to
provide nonqualified benefits to selected employees on a legally discriminatory basis. Section
162 refers to the part of the tax code allowing employers to take a tax deduction for their contributions to the plan. These plans can be used to provide bonuses in the form of funds to pay for
life insurance and/or disability income insurance for executives. Under this type of agreement,
the employee purchases a cash rich life insurance policy and names himself as owner. This may
be a single insured or a joint insured policy.
It must be noted that large compensation packages in the form of a bonus have come under fire
from the government with the result that there has been recent (Feb. 2008) Revenue rulings covering the amount of the bonus and the drafting of compensation arrangements with senior officers. The general principle is still effective, so it will be discussed first, with the recent restrictions following.
The employer pays the premiums to the life insurance company which is fully deductible by the
employer and considered compensation to the employee. The premiums are considered taxable
income to the employee, so often the corporation with "double bonus" the employee.
The tax advantages under these rules include tax-free accumulation of funds, tax-free income
through loans and withdrawals and tax-free transfer at death.
If the employee is a stockholder of the company and is/her tax bracket is less than the corporate
tax bracket, this plan is very attractive to the employee-stockholder who wishes to withdraw
profits from the corporation. There are many producers who insist that this plan works best with
stockholders of "C" or "S" corporations.
The benefits usually include the life insurance policy death benefits as well as cash value accumulations that can be used as a retirement income supplement. With this type of executive
bonus plan, the business can use tax deductible company funds to selectively provide valued
benefits to key people. These plans can be effective tools to attract and keep key executives.
The bonus plans are rather simple in design, although they should always either be prepared by
an attorney, or reviewed by an attorney or tax advisor. Basically, the company provides the key
executive with a bonus that is taxable as income to the recipient. Usually, the bonus is a deductible business expense for the company.
The key employee may choose to use the bonus to purchase a whole life or universal life insurance policy (some producers prefer the newer interest-sensitive universal life policies) that builds
cash value that grows on a tax deferred basis. Any cash value accumulation will grow tax deferred and may be accessed by the employee income tax-free through withdrawals and policy
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loans. (See new restrictions below) The cash value of the policy can be used to supplement retirement income or for most other financial need.
If the key executive dies, in most cases the heirs will receive the death benefit proceeds from
the life insurance policy, tax free.
There are some variations such as the double bonus plan where in the company will provide the
key executive with a large enough bonus to cover the life insurance premiums as well as the income taxes incurred by the executive on the bonus, and which can be used to eliminate any expense for the key executive.
There is also a "controlled" bonus where the company wants to retain some measure of control
over the bonus. The company and the executive enter into an agreement which includes a vesting schedule on the cash value growth of the policy. This can be considered as "golden handcuffs" as it allows a company to limit the availability of the cash value benefits until the executive has fulfilled the terms of the agreement, whereupon the executive is "vested." Once the executive is vested, he gains total control of the policy's cash value.
ADVANTAGES OF THE PLAN
This plan has several advantages; in particular, the company can choose the key employees
they wish to reward. These payments can be a fully deductible expense to the company. The key
employee may name the beneficiary of the entire death benefit of the life insurance policy.
Unless there is some sort of restricted or controlled executive bonus, the key executive will
have immediate access to policy cash value and may access that cash value without income tax
through policy loans and withdrawals. Executive bonus plans are not usually subject to "qualified plan limits." (Again, please refer to recent IRS rulings.)
DISADVANTAGES OF THE PLAN
There is a disadvantage to the company inasmuch as they are unable to fully recover its costs
from the death benefit since the key executive names the policy beneficiary.
The company has very little control of the policy. Even if the controlled executive bonus is utilized, it only restricts the key employee's access to the policy's cash value. And, obviously, one
of the disadvantages is that the bonus is never recovered by the company even if the key employee leaves the company prior to vesting.
For the key employee, he must include any bonus in his taxable income, plus, without proper
estate and/or financial planning, the insurance policy's death benefit will be includable in his taxable estate.
And perhaps the most practical disadvantage is that establishing such a plan is not as easy as
taking a life insurance application. Just to mention a few of the tasks that might appear:

A net worth of the business must be made if the executive is also a shareholder.

It always involves independent tax and legal advisors, even is "sample" 162 Bonus
plan language is used (available on the internet).

The buy-sell agreement must be worked out and sample language must be drawn
up. Often a cross-purchase plan can be used for these agreements, but not always.

Individual applications must be obtained and both must be medically-underwritten.
This is still life insurance and those insured must be insurable. It might be very
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wise to question the applicant's thoroughly prior to a lot of money being spent on
legal and tax expenses. There are many yellow pads and uncompleted forms in
trash cans because one of the principals forgot to mention he had a heart problem or
was taking Prozac, etc.

Once the underwriting is completed and the offer from the client is received, bonus
checks to the principals will be made by the corporation under the authority of the
prepared Board Resolution. The executives then issue the checks to pay the premiums.
The process of a Board Resolution would include a bonus check being issued to each of the
stockholders (if that is what is needed) and then each involved stockholder writing a check for
the respective insurance premium.
This is not insurmountable but it is a lot of work if the policy is going to be for a small amount.
In those situations where the client is a large company and the policy is large, it works well,
thank you.
Restricted Access
By including a restricted access provision in the agreement, the employer can limit the conditions under which the employee may use the policy's cash values. These conditions would also
become part of the life insurance policy itself by means of an endorsement. The restrictions tend
to make an executive bonus plan resemble split-dollar and deferred compensation plans, under
which the employer retains certain rights by virtue of limiting the employee's rights. A major difference remains in that the employer's contributions in the form of bonuses are still currently deductible and the employee is still currently taxable on the bonuses.
Restricted access can be accomplished by various means. The employer might include a vesting schedule that requires the executive to remain employed for a certain period before any cash
values become available. The longer the employee remains, the greater the amount vested until
the employee eventually has access to 100% of cash values. The restriction may either require
the employee to completely forfeit unvested amounts or allow these amounts to be paid after a
period of time has passed.
For example, suppose an executive who is only 70% vested leaves the employer, whereas five
more years of employment would have resulted in 100% vesting. The employer may require five
years to pass, and then release the remainder of the cash values to become the employee's unrestricted property. On the other hand, the agreement might require the employee to use the cash
values to pay back the bonuses if the employee leaves prior to a stipulated date.
RECENT RULING FOR EXECUTIVE BONUS PLANS & DEFERRED
COMPENSATION
In Revenue Ruling 2008-13 (Feb. 21, 2008), the Internal Revenue Service (IRS) added an additional layer of complexity to drafting compensation arrangements for senior executives - an area
of the law that already has been subjected to unprecedented changes as the result of Internal Revenue Code (IRC) Section 409A. The ruling adopts a new interpretation of IRC Section 162(m),
which Congress enacted in 1993 to limit the amount publicly-traded companies and their affiliates can deduct for compensation paid to their highest-ranking executives. Rev. Rul. 2008-13
expands the scope of Section 162(m) so that an executive's performance-based compensation under a performance plan that: satisfies all the criteria of Section 162(m) will be non-deductible
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solely because the executive also is covered by a severance provision that takes his or her targeted performance bonus into account in calculating severance pay.
Background
Section I62 (m) denies a deduction to any publicly held corporation for compensation in excess
of $1 million per year paid to a "covered employee,” A "covered employee" is the chief executive
officer of the corporation and any other employee whose compensation must be disclosed because he or she is one of the four highest compensated employees of the registrant (not counting
the CEO).
Some types of compensation do not count against the $1 million limit, including compensation
payable "solely on account of the attainment of one or more performance goals," provided that
the adoption and implementation of the performance bonus plan satisfy certain requirements related to corporate governance and shareholder consent. These goals are set forth in Treasury
Regulation § 1.162-27:
"Compensation does not satisfy [this requirement] if the facts and circumstances indicate that,
the employee would receive all or part of the compensation regardless of whether the performance goal is attained [including circumstances where] the payment of compensation under a
grant or award is only nominally or partially contingent on attaining a performance goal...
Compensation does not fail to be qualified performance-based compensation merely because
the plan allows the compensation to be payable upon death, disability, or change of ownership
or control, although compensation actually paid on account of those events prior to the attainment of the performance goal would not satisfy the requirements of this paragraph (e)(2)."
On January 25, 2008, the IRS issued a Private Letter Ruling that relied in part on this regulation to hold that a corporation could not deduct a performance bonus paid to an executive after
the attainment of the pre-established performance criteria because the executive's employment
agreement provided that if he were terminated without cause or even for good reason, pending
performance bonus targets would be deemed satisfied and the executive would be paid the target
bonus, Priv. Ltr. Rul. 200804004 (Jan. 25, 2008).
Rev. Rul. 2008-13
The Private Letter Ruling came as a surprise to many, and there were almost immediate calls
for its withdrawal and clarification. Rev. Rul. 2008-13 was in part a response to these requests.
However, the Revenue Ruling neither withdrew nor clarified the reasoning of the Private Letter
Ruling. Instead, it adopted the holding of the Private Letter Ruling, and further expanded the circumstances under which compensation will not be considered performance-based compensation
to which the $1 million limit under Section 162(m) does not apply. Under this ruling, compensation payable to a covered employee following the attainment of properly established performance criteria will count against the $1 million deduction limit if compensation would otherwise
be paid upon the executive's involuntary termination without cause, voluntary termination for
good reason, or retirement, whether or not the goal had been attained.
This establishes unequivocally that compensation counts against the $1 million deduction limit,
even if it is paid because of the attainment of a properly-established performance goal to an executive who has not terminated employment, if the compensation is otherwise payable either in
the event of attaining performance criteria or under any alternative scenario when the perfor-
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mance criteria is not met other than the alternatives specifically mentioned in the Treas. Reg. §
I.162-27(e)(2)(v), i.e., death, disability, or a change in control.
It is important to note that this regulations provides for a facts-and-circumstances determination of whether compensation is payable for a reason other than attainment of a performance
goal. The regulation instructs that this facts-and-circumstances determination "is made taking
into account all plans, arrangements, and agreements that provide for compensation to the employee." It seems to follow that (as in Priv. Ltr, Rul. 200804004), if an executive employment
agreement or senior executive severance plan provides for payment of a performance-based bonus target upon a voluntary or involuntary termination of employment, the holdings in Rev. Rul.
2008-13 would be applicable to any compensation paid under the performance plan, even if the
performance plan itself complied in all respects with Section 162(m).
Thus the practical implications of Rev. Rul. 2008-13 are even more far-reaching than its holdings suggest. Rev, Rul, 2008-13 should be taken into account in drafting any executive employment agreement or executive severance arrangement for a public company or for any company
that might become a public company at any time during the term of the employment agreement
or severance plan. Similarly, in the context of an acquisition by a publicly-traded company, the
prospective new owner may need to consider whether any of the target's surviving employment
agreements or other executive arrangements unexpectedly might trigger the disallowance of deductions for performance-based pay to senior executives of the combined enterprise.
Temporary Transition Relief under Rev. Rul. 2008-13
Perhaps in recognition that many existing performance bonus plans and executive deferred
compensation arrangements unexpectedly would trigger disallowance of deductions under Section 162(run) if Rev. Rul. 2008-13 were applicable immediately, the ruling provides some limited transition relief, including a "grandfathering" exception. The holdings in Rev. Rul. 2008-13
will not be applied to disallow an otherwise allowable deduction for compensation payable under
a plan with a performance period that begins on or before January 1, 2009. In addition, the
holdings in Rev. Rul. 2008-13 will not be applied to compensation payable under the terms of an
employment: contract as in effect on February 21, 2008, without regard to any future renewals or
extensions (including renewals or extensions that occur automatically under the terms of the contract without: action on the part of the employer or employee).
Using a Secular Trust
One way to restrict access is through a secular trust, which we discussed briefly in the previous chapter. This irrevocable trust, which in this case is established by the employee, not the employer, owns the life insurance policy. The IRS has not issued any specific rulings on the use of
life insurance policies in secular trusts, but so far the use of the trust has not allowed the employee to escape current taxation on the bonuses that fund the insurance that makes up the trust.
Likewise, the employer has been allowed to take the deduction for bonuses as compensation even
when the trust is used.
One concern with a secular trust-and possibly with any other severe restrictions on the employee's access to the cash values is that the IRS could decide this represents a substantial risk of forfeiture as described earlier. In this case, the employer would not be allowed to take the tax deduction. The employee would not be currently taxed on the bonus in this case either.
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Indemnification Insurance
The previous chapter briefly mentioned insurance used to provide a third-party guarantee or
protection for an executive who has forgone current compensation under an unfunded deferred
compensation plan. This coverage is called indemnification insurance or executive indemnification insurance.
The policy pays a benefit to the insured executive in the event the employer either refuses or is
financially unable to pay the deferred compensation benefits when due. The policy benefits are
intended to equal the deferred compensation benefits the employee would have received had the
employer not defaulted. These benefits are taxable income, just as the deferred compensation
benefits would be taxable if they had been paid as agreed.
An IRS ruling indicates that the existence of such insurance does not cause a deferred compensation plan to become taxable currently as long as the other requirements for these plans (as discussed in earlier) are met. The employee must own the indemnification insurance and be the person who benefits from it. The employee pays the premiums, which are not tax deductible-the
general rule for insurance premiums paid by individuals.
The IRS even allows the employer to reimburse the employee for the insurance premiums as
long as the employer receives no benefit from the policy and has no other legal interest in the insurance. If the employer does pay the premiums, their value is taxable income on which the employee must pay current taxes.
One drawback to executive indemnification insurance is that employees who need the coverage
the most are probably the least likely to be able to get it. That is, if the financial soundness of a
business is in question, the insurance company is not likely to take the risk. Of course, an executive who believes the employer's financial future is uncertain should probably not agree to a deferred compensation arrangement in any event. Executives will find the insurance a more viable
purchase to protect against the more remote risks, such as unforeseeable economic downturns or
an unpredictable decision by the employer to refuse to pay the deferred compensation benefits.
Conclusion
The business insurance issues and product solutions you've learned about in this text have addressed two key areas:
1. Business continuation in the event of an owner's death or disability.
2. Benefits that may be provided for selected employees rather than to all employees, avoiding
the costs and administrative headaches associated with benefits that must meet nondiscrimination standards.
One must be very much aware, of course, that tax-qualified employee benefits are also a significant issue for many businesses. Employers often provide group life and health insurance for all
employees, as well as pension, profit sharing or other retirement programs.
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Chapter 8 Review Questions
1. A Section 162 executive bonus plan is a means available to employers to provide nonqualified
benefits to employees on:
A. a discriminatory basis.
B. a nondiscriminatory basis.
C. an all inclusive basis.
D. a tax free basis.
2. With a traditional executive bonus life insurance plan the ______ owns the policy.
A. employer.
B. employee.
C. employee’s estate.
D. employer’s general creditors.
3. The death benefit’s proceeds of policies provided under Section 162 are paid to the ______
beneficiaries’ income ________.
A. employer’s, taxable.
B. employer’s, tax-free.
C. employee’s, taxable.
D. employee’s, tax-free.
4. Who is entitled to a tax deduction for a Section 162 bonus paid for life insurance? The
A. employer.
B. employee.
C. trustee.
D. rabbi.
5.
With a section 162 executive bonus life insurance plan the _____ is the insured and the
_____
is the beneficiary.
A. employer, employer.
B. employer, employee.
C. employee, someone other than the employee.
D. employee, someone other than the employer.
6.
The death benefits paid under a Section 162 executive bonus life insurance plan are included
in the estate because the
A. employer paid the premiums.
B. employer owned the policy.
C. employee had incidents of ownership.
D. employer was the beneficiary.
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7. If the employer pays the premiums under an executive bonus life insurance plan the value is
A. non-deductible by the employee.
B. non-deductible by the employer.
C. not taxable to the employee.
D. taxable to the employee.
8. With a traditional executive bonus life insurance plan the employer
A. owns the policy.
B. can barrow from the policy.
C. can surrender the policy for its cash value.
D. pays the employee a bonus intended to fund life insurance premiums.
9. Tax treatment of restricted access plans remain open to ________ interpretation.
A. the insurance commissioner
B. I.R.S.
C. the employer’s
D. SEC
10. A secular trust
A. is an irrevocable trust.
B. leaves unlimited access to the employee.
C. is established by the employer.
D. prevents the employer from receiving a tax deduction.
Answers
1A 2B 3D 4A 5D 6C 7D 8D 9B 10A
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CHAPTER NINE - ETHICAL ISSUES
PROFESSIONALISM
It is no accident that this chapter concerning ethical issues begins with the subject of professionalism. While acting in a professional manner involves more than attention to ethics, it is difficult to imagine that a person who does not take ethical issues seriously could ever become a
genuine professional. Consider briefly some of the attributes that characterize professionalism in
the life and health insurance business.
KNOWLEDGE AND SKILLS
It may seem almost too obvious to mention, but an agent must have appropriate insurance
knowledge to act professionally. The knowledge you acquire to start selling insurance is just the
beginning of a lifetime of self-development to stay abreast of new products and evolving issues
in the insurance business. Expanding knowledge is essential for professionals who help people
manage the financial decisions that profoundly affect their future well being.
Along with increasing knowledge, you must develop the skills to use what you learn in a way
that benefits both you and your clients. For example: it is not enough simply to know the features
of every product you can sell. You must also know for whom each product is most appropriate,
how a product does or does not meet the financial objectives of a particular client, because to sell
an unsuitable product can be a greater travesty than not selling any product at all if the results are
detrimental to the client.
PROFESSIONAL DESIGNATIONS
Insurance agents often seek educational opportunities that lead to one or more professional designations conferred by recognized educators in financial service fields.
Chartered Life Underwriter (CLU)
One such well-known designation is that of Chartered Life Underwriter (CLU) awarded by the
American College in Bryn Mawr, Pennsylvania. To reach the CLU designation, agents undertake
in-depth study over a period of time of a wide range of topics directly related to the insurance
industry. Each topic is followed by an examination and when all exams are successfully completed, along with specified experience requirements, the designation is awarded.
Chartered Financial Consultant (ChFC)
The American College also has a program of study that leads to the Chartered Financial Consultant (ChFC) designation. Similar to the CLU designation in course and experience requirements, the ChFC focuses less on life insurance company operations and more on the myriad of
financial planning considerations such as investments, retirement and estate plans. Successful
exam results coupled with the appropriate experience lead to the designation.
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Certified Financial Planner (CFP)
Agents interested in financial planning have another option, the Certified Financial Planner
(CFP) is a designation offered by the College of Financial Planning in Denver. The requirements are similar to the American College designation, along with the necessity for successfully
completing the stipulated exams and having the required experience.
CLIENT-FOCUSED
Professionalism also means being client-focused, or putting the client's needs first. Unquestionably, one reason you have chosen the insurance business for your career is that you want to
pursue opportunities that will reward you financially in relation to your achievements. That's fine; obviously, you must think of your own financial needs. What we mean here by putting the
client's needs first involves the decisions you make when (not if!) you're faced with the temptation to go for the bigger commissioned item when the smaller commissioned item fits your client's needs just a little bit better.
Don't be fooled into thinking that the temptation to sell policies under less than optimum conditions will never present itself. You are almost certainly going to be faced with tough choices
sooner or later and the thought will probably cross your mind that you really can justify promoting the product that will give you the better commission. This is not at all an insulting statement;
rather it is an acknowledgment that we are all human beings subject to tough decisions that can
become tougher when our own financial security is a consideration. Being aware that you will,
sometime, be placed in such a position can help you recognize the situation when it occurs, deal
with it, and resolve it by focusing on the client. Interestingly, agents generally find those putting
clients' needs ahead of their own results in greater rewards and more business for themselves.
AN INDUSTRY REPRESENTATIVE
As a life insurance agent, you become a representative of the entire insurance industry. In
their own minds, people do business with other people, not with companies. In effect, you become 'the insurance industry to many people because they will judge the insurance business by
their relationship with you. To your clients, since you represent the insurance company, your
professionalism reflects how people view the insurance business.
Because you represent the insurance business, it is also important to respect your competitors
and convey that respect to clients when they broach the subject of the competition. Never be disparaging about others in the insurance business, even if you believe it is warranted. Instead, illustrate how you your product and your companies can meet the client's needs. This parallels the
idea of staying client-focused. You don't need to disparage the competition in order to defend
your products and practices if you can honestly and objectively show clients what you can do for
them.
IN THE BUSINESS OF SERVICE
Insurance is essentially a service business. Yes, you sell a product, but think about the nature
of the product, especially in comparison to other consumer products, a car, for example. When a
consumer buys a car there is an instant gratification. The consumer drives the car off the lot, can
touch it, smell it and show it to other people has instant use of it and will continue to use it at his
or her convenience. The benefits are tangible, obvious and immediate. Now consider an insur-
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ance policy. Yes, the buyer has it in his or her possession, can touch it, smell it, and talk about
its benefits, but, quite frankly, from a consumer point of view, so what? The primary benefit is
generally not immediate (most people hope-especially for life insurance) and there is nothing
tangible to show for the money spent. For life insurance, the tangible benefit-whether it is used
for the cash value or payment of a benefit is available only in the future. As a result, the most
important current benefit of an insurance policy is the service an agent provides.
Insurance buyers sometimes complain that, while they receive a great deal of attention from insurance agents who are trying to make a sale, they feel essentially abandoned after the sale is
made. This is an unfortunate signal that agents have forgotten about service. Here are some important services an insurance agent should always perform:
Follow up with the client before the second premium is due. Because clients who allow a
policy to lapse often do so by not paying the second premium, it is important to provide service
early to reduce the chances of termination. Call clients to answer any questions they might
have about the policy or about how to pay the next premium, showing your interest before the
premium is due.
Review client needs on a regular basis. Don't let more than a year go by without contacting
your existing clients about reviewing their current needs. People's lives change. They get married and divorced. They have children. Their income increases. Business needs change, too.
Owners and employees alike come and go. Business income and values increase and decrease.
Life changes can generate needs for new or different products. If you don't take the initiative,
clients think you don't care about them. Aside from serving the client's needs, remember that if
you don't look after your clients someone else might earn the business that could have been
yours.
Assistance to beneficiaries When an insured dies is almost inevitable for life agents. Helping
people through the claims process or answering questions and generally being available are
services they will appreciate and remember. You will have the personal satisfaction of knowing
you have helped people during one of the most difficult experiences of their lives.
Assist claimants in filing insurance claims. No matter how thoroughly you have explained
how the insurance works, insured’s often forget or become confused when they actually need to
file a claim. You can help by answering questions, talking a claimant through the process over
the telephone or even visiting in person to help organize bills and fill out the claim forms. If
claimants don't understand which costs are covered, you can review the coverage and show
them how to use the policy and claim forms for future claims. If necessary, you can help claimants reach the right person in the claims department to discuss a claim. As you can see, a claim
can offer numerous opportunities for you to provide small services that have high value for
your clients.
These services as well as the other factors included in this section about professionalism all
have a common objective, serving the client well, and that is at the heart of ethical behavior.
FIDUCIARY RESPONSIBILITIES
Insurance involves a high degree of public trust. One part of that trust has to do with the fiduciary responsibilities of insurance companies and their agents. T he term “fiduciary” refers to the
holding of something of value for another, which is what the insurer does on behalf of insured’s.
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This term and its related responsibilities also apply to agents since they advise the public about
financial matters, suggest solutions that cause members of the public to spend money, and collect
money from clients when they purchase insurance. This fiduciary position requires agents to be
very careful and completely ethical in insurance transactions. You must satisfy yourself that you
have asked for and received accurate information about the prospective insured's financial situation before you recommend any product. When recommending a certain benefit amount for any
type of insurance policy, be able to show the applicant what factors you considered.
Clearly and honestly explain details, such as how cash values accumulate, what they mean,
what is guaranteed and what is not. Be able to explain the tax effects of such things as policy
ownership, dividends, and early withdrawal of cash values, death benefit installment payments
and similar items. Describe accurately and completely any special policy features.
When you receive premium payments from clients, you must not use that money for anything
else, even temporarily. Premium payments must not be placed in a bank account belonging to
the agent, the agent's business or any other person or entity unless authorized by the agent's insurance company. Some insurers may authorize agents to place premiums in their own accounts,
retaining commissions and sending the balance to the insurance company. This practice allows
agents to both receive their own commissions and pay commissions to their hired agents promptly.
AGENCY AUTHORITY
The insurance business operates largely on the basis of sales by agents who have been given
authority by the insurer to act on the insurance company's behalf in securing clients. This concept
of agency authority, sometimes called the powers of agency, again emphasizes the high levels of
trust and ethics necessary in the insurance business. The authority or power an insurer grants to
its agents is legally spelled out in the contractual agreement between the insurance company and
agents. Under common law, the insurance company is responsible for its agents' actions under the
authority the insurer grants to the agent. The legal waters become somewhat muddied, however,
by the concepts of actual, implied and apparent authority.
ACTUAL OR EXPRESS AUTHORITY
Actual authority refers to the authority or power that is really and clearly given to the agent by
virtue of the agency contract. It is sometimes referred to as express authority because it is expressly stated in the contract. For example, the contract might grant authority to represent the
insurer in the states of Oregon and Washington, to submit insurance applications on the company's form, to collect and submit premium payments, and similar actions.
IMPLIED AUTHORITY
Often, a contractual arrangement that gives actual authority carries with it some additional implied authority, therefore, implied powers are a subcategory of sorts of the express powers. For
example, if the contract gives the agent authority to collect premiums and forward them to the
insurance company without further qualification, it is implied that the agent may collect premiums in any form, cash, personal check, money order or any other negotiable form. The insurer
could not then reject a personal check as payment of a first premium on the basis that a certified
check was required. On the other hand, agents must be careful not to assume any authority is
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implied other than that included in the agency contract. Agents can unwittingly bind the insurer
to commitments it did not intend to make and at the same time deceive the applicant or insured,
knowingly or unwittingly, but illegally in either event.
APPARENT AUTHORITY
As opposed to actual authority, which occurs because of a contractual agreement between the
principal (the insurance company in this case) and the agent, apparent authority involves the
perspective of a third party. Simplistically stated, apparent authority is any power ascribed to the
agent because it appears to a reasonable third party that the agent does have that authority from
the insurance company. Like implied power, apparent authority can be binding upon the principal, the insurance company, if the third person had no reason to think the agent did not have the
apparent power to act on the insurer's behalf.
In all cases involving the insurance agent's authority, agents and insurers should have a clearly
defined set of limitations under which agents can obligate insurers. It is also important for agents
to act in such a way that there is no ambiguity that will confuse third parties such as applicants,
insured’s or policy owners.
CONSUMER PROTECTION AND ETHICS
Like all businesses, the insurance industry is subject to laws designed to protect consumers
from unethical or illegal practices. Insurers, their employees and agents must abide by the general consumer protection statutes that apply to all businesses as well as any consumer laws specifically directed toward the insurance business. Most consumer protection laws include a list of
deceptive or otherwise illegal practices that specify, without being all inclusive, certain forbidden
actions. Insurers and other businesses are expected to follow not only the letter of these laws, but
also the spirit. In this section, we will discuss regulations that apply directly to the business of
insurance.
Unfair Trade Practices
Most states have adopted regulations recommended by the National Association of Insurance
Commissioners (NAIC) regarding unfair trade practices in the insurance business. NAIC developed a model law to help states comply with a portion of the federal McCarran Ferguson Act,
which gives states primacy over the federal government in regulating insurance matters. The
practices listed below are included in NAIC's model.
UNFAIR DISCRIMINATION
In the context of Insurance, unfair discrimination refers to:
1.
Refusing to issue or renew, or canceling or declining a policy because of someone's
(1) sex-or sexual preference in a few states: (2) marital status: (3) handicapped condition.
2.
Limiting the availability of benefits or modifying benefits, rates, terms, conditions
or types of coverage based upon any of the three items mentioned previously, unless
any restrictions or modifications are based upon strict actuarial principles.
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REBATING
In most states, it is illegal for insurance agents to be involved in rebating, which is offering or
giving something of value, other than the insurance policy itself, to an individual as an inducement to buy insurance. A rebate could take many different forms, from a return of part of the
premium to splitting the agent's commission to receiving cash or a valuable gift. It is also illegal
for the insurance buyer to accept a rebate.
ILLEGAL POLICY REPLACEMENT
In some cases, a policy owner can benefit from replacing one insurance policy with another, but
in many cases the policy owner stands to lose a great deal by replacement. An agent, who convinces a consumer to drop one policy in order to buy another, without clearly explaining any disadvantages and/or by misrepresenting facts to the policy owner's detriment, is guilty of illegal
policy replacement.
Policy replacement is illegal when an agent uses deception in order to gain the sale for his or
her own benefit without regard for the policy owner. Some potentially negative consequences for
life insurance policy owners are the loss of significant cash values, the inability to get the same
amount or type of coverage for the same premium rate, payment of new sales commissions and
administrative fees, and reinstatement of the contestable and suicide exclusion periods.
Agents must be extremely diligent in making appropriate policy comparisons in order to ensure
that purchasing a new policy benefits the insured and that the replacement is legal. In some
states, policy comparisons must be made in writing, signed by the applicant as an acknowledgment of having received the written information, and copies must be left with the applicant. Additionally, agents may be required to notify both the new insurer and the insurer of the older policy that replacement is being considered.
MISREPRESENTATION AND FRAUD
Agents who are guilty of illegally replacing a policy often do so by engaging in misrepresentation and fraud and these practices are also forbidden under any other circumstances. Misrepresentation and fraud go hand-in-hand since agent misrepresentations are assumed to occur for the
purpose of defrauding the applicant or insured (and in some cases the insurer). Specifically,
agents may not misrepresent facts to consumers about the policy being offered or about the financial condition of the insurance company that issues the policy. Misrepresentation can occur
orally or in writing, including any type of general advertising, or during personal contacts.
Misrepresentation can also occur by virtue of an agent's failure to tell consumers something
they should know in regard to the life insurance sale or the policy. By omitting information that
should be disclosed whether intentionally or unintentionally, agents may find themselves liable
for subsequent damage to the insured. For example: suppose an agent tells a client that he may
skip premiums for a universal life insurance policy, but does not tell the client that doing so when
there is little cash value can ultimately result in lapsing the policy. Then, when the insurance
company notifies the client that his policy is about to lapse, the client does not have the cash to
pay the premium and, therefore, loses the policy. T he client can claim that the agent is legally
liable for his loss of the policy because the agent failed to disclose the potential for insufficient
cash values to cover premium costs. This is an example of misrepresentation by omission for
which agents may be held liable.
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DEFAMATION
Another form of misrepresentation could occur in the defamation of competitors by an agent.
Because you are a representative of the insurance business, you should avoid showing disrespect
for your competition. In addition, you must avoid going beyond disrespect to participate in this
illegal act. Defamation is making false or malicious statements for the purpose of harming another's reputation. This is an issue in consumer's rights because defamatory comments might be
made in the context of convincing someone to buy one company's policy rather than the policy
sold by another insurer or agent.
BOYCOTT, COERCION AND INTIMIDATION
Acts or agreements that use boycott, coercion or intimidation for the purpose of creating a
monopoly or unreasonable restraints in the insurance business are also unfair trade practices.
These three actions cover a great many possible illegal practices that could be directed toward the
consumer or toward other insurers or agents.
ADVERTISING
Each state insurance commissioner is responsible for monitoring insurer advertising practices.
In general, insurance advertising must be truthful and it must neither deceive nor mislead the average consumer. Most states follow the National Association for Insurance Commissioner's advertising standards, which include very specific practices to be followed or avoided.
MISUSE OF FUNDS
The discussion about agents' fiduciary responsibilities indicated that misuse of funds, such as
premiums, is illegal. In fact, one of the unfair trade practices involves failing to remit premiums
to insurers or to refund premiums to applicants or to deliver claim monies. Agents have a limited
amount of time during which they must forward funds to the proper places or face losing their
licenses. Remember, monies intended for premiums or any use aside from the agent's own legal
use may not be commingled with the agent's own funds unless the insurer authorizes the agent to
retain commissions from premium payments and send the balance to the insurer.
Another unfair trade practice addresses unfair claim practices, forbidden when a claim is made
against a policy. These are discussed in the following section.
UNFAIR CLAIM PRACTICES
Although technically part of unfair trade practices statutes, unfair claim practices are presented separately because they are specifically related to what occurs after a policy is in force, when
an insured files a claim. For life insurance policies, this is a once-in-a lifetime act.
Again, the National Association of Insurance Commissioners has produced a model that is used
in whole or in part by all states. A few states have modified the exact language and/or dropped or
added specific items. Following is a paraphrased summary of prohibitions frequently found in
states' unfair claim practices laws, which apply to all types of insurance transactions.
1. Misrepresenting pertinent facts or provisions about the particular coverage.
2. Falling to acknowledge and act promptly after receiving communications about a claim.
3. Falling to adopt and implement reasonable standards for promptly investigating claims.
4. Refusing to pay claims without conducting a reasonable investigation.
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5.
Falling to affirm or deny coverage within a reasonable time after receiving proof of loss
statements.
6. When liability has become reasonably clear, not attempting to settle claims promptly,
fairly and equitably.
7. Attempting to settle claims for less than a reasonable person would have expected by reference to written or printed advertising that accompanied or was made part of an application.
8. Making claim payments without including a statement that sets forth the coverage under
which payments are being made.
9. Attempting to compel claimants to accept settlements or compromises less than an
amount awarded in arbitration by describing an insurer policy of appealing arbitration
awards in favor of insured’s or claimants.
10. Delaying investigations or claim payments by requiring an insured, claimant or physician
to submit a preliminary claim report and a subsequent formal proof of loss form, both of
which contain substantially the same information.
11. Failing to promptly settle claims where liability is reasonably clear under one portion of a
policy in order to influence settlements under other coverage’s in the policy.
12. Failing to promptly provide a reasonable explanation of the factual or legal basis in the insurance policy for denying the claim or for offering a compromise settlement.
13. Attempting to settle claims based upon an application for insurance that was altered without knowledge or consent of the insured.
14. Failing to adopt and implement reasonable standards for processing and paying claims
once the obligation to pay has been established.
15. Failing to expeditiously honor drafts given to settle claims.
Because states have discretion to use any or all of NAIC's model and may adapt the wording
and add or delete items, it is important for you to learn exactly what is included in the unfair
claim practice statutes where you do business.
DELIVERING THE POLICY
Delivering a new insurance policy gives agents the opportunity to reinforce the purchaser's
good decision in buying the policy and to review the policy's features. This is a very important
time because if an individual is going to drop an insurance policy, he or she usually does so very
early in the life of the policy. In addition, in the rare cases where the first premium was not paid
with the application, it is the agent's responsibility to collect the premium along with a statement
from the insured person that he or she is still insurable.
POLICY SUMMARY
Insurers usually must provide a policy summary along with the policy itself. Agents may use
the summary to highlight certain features of the policy and point out how the insured may contact
the agent or company, and then review other important features they might wish to emphasize. A
policy summary is likely to be a single sheet providing basic information such as:
 The insured's name.
 The policy owner's name, when different from the insured.
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
The name of the type of insurance purchased (as opposed to a special name the particular insurer has assigned to the policy).
 The names of any types of riders attached to the policy.
 The policy form number, which is the legal designation under which the policy was
filed with the state insurance department.
 The policy number (account number) the insurer assigns to the individual insured
and his or her particular policy.
 The effective date of the policy and any riders.
 The total annual premium and usually other modal premiums.
 The life insurance policy loan interest rate.
 Any benefit options selected by the insured or other owner of the policy.
Taking time to review the policy summary and the policy itself helps cement the developing relationship with a new client, while explaining features of the policy that are of particular interest
to the client. For example, agents should explain items that affect the client on an ongoing basis,
such as how the grace period works, any non-forfeiture provisions, how dividends are paid when
applicable, how to file a claim for benefits, and similar information. This is also an opportunity
to practice and demonstrate the professional knowledge and skills that are so important in the
insurance business.
PROTECTION FOR THE INSURANCE PROFESSIONAL
People such as insurance agents, physicians or attorneys who offer professional services to the
public are expected to perform at a level somewhat above common standards. For example, if
you give poor advice to a friend about what to do for a toothache, but you are not a dentist, you
are held to a lower standard than if a dentist gave bad advice. The same is true of a nonprofessional giving advice about financial matters, such as insurance. On the other hand, the public
holds professionals responsible for performing at a much higher level of expertise and if those
professionals make mistakes, as all humans do occasionally, they are held legally liable for those
mistakes.
ERRORS AND OMISSIONS (E&O) INSURANCE
Insurance agents can protect themselves against the possibility of being found legally liable for
costly mistakes with Errors and Omissions (E&O) insurance. E&O insurance for agents is similar
to malpractice insurance or professional liability insurance for doctors and lawyers. Obviously,
it's preferable to avoid the mistakes that might lead to a lawsuit, but again, errors occur and the
cost of E&O insurance is small compared to the potential cost of a liability lawsuit settled out of
your pocket.
Most mistakes can be avoided if you know and follow the law; communicate with your clients
informing and listening; and stay up to date with changes in the insurance business and legal environment. Earlier in this chapter, we mentioned how an agent may become legally liable for loss
to a client by omitting information that should have been given to a client. Agents have most often had liability problems because they failed to do one of three things: (1) Match the coverage
with the client's needs; (2) Suggest and acquire adequate insurance; (3) Maintain the client's coverage by allowing a policy to lapse without the client knowing it.
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While E&O insurance does not protect an agent who willfully, knowingly or fraudulently causes harm to an insured, the coverage is invaluable for handling the legal consequences of inadvertent mistakes.
A Final Word
We hope you have seen the "thread" of ethics woven throughout this chapter as we discussed
the professional characteristics of agents as well as rules and regulations that guide the life insurance business.
An important point about ethics is that, while ethical behaviors can be taught and unethical behaviors can be punished, whether or not someone chooses to act ethically is, finally, a choice.
And while penalties may apply for violating the letter of the law, in fact, it is the spirit of the law
that most closely reflects ethical actions.
Similarly, it is the spirit with which an agent approaches the insurance business that inspires
ethical integrity.
Chapter 9 Review Questions
1. Professionalism means
A. financial security for the agent.
B. client’s needs first.
C. the bigger the commission the better the client’s needs are met.
D. promoting a product to produce commission.
2. Insurance is a
A. tangible product business.
B. commodity business.
C. gamble.
D. service business.
3. Responsibilities of insurance agents that involve making recommendations, selling financial
products, and holding money are called _______ responsibilities.
A. consumer
B. actual
C. E & O
D. fiduciary
4. The type of authority that is granted in an agency contract is called
A. actual.
B. imposed.
C. implied.
D. apparent.
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5. The unfair trade practice of refusing to issue an insurance policy solely because of someone’s
marital status is known as
A. coercion.
B. intimidation.
C. unfair discrimination.
D. misrepresentation.
6. Advertising for an insurance company is monitored by the
A. IRS.
B. federal government.
C. state insurance commissioner.
D. life underwriters.
7. Insurance agents can protect themselves against the possibility of being found legally liable
for mistakes through
A. product liability insurance.
B. malpractice insurance.
C. professionalism.
D. Errors and Omissions (E & O) insurance.
8. All of the following are professional designation EXCEPT
A. CLU-Chartered Life Underwriter.
B. ChFC-Chartered Financial Consultant.
C. CFP-Certified Financial Planner.
D. COA-Commission Oriented Agent.
9. The Agent receives authority from the _________to act on the insurance company’s behalf.
A. department of insurance.
B. insurer.
C. client.
D. NAIC.
10. An agent who convinces a customer to drop one policy in order to buy another, without
clearly explaining any disadvantages, is guilty of
A. illegal policy replacement.
B. rebating.
C. unfair discrimination.
D. defamation.
ANSWERS
1B 2D 3D 4A 5C 6C 7D 8D 9B 10A
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