Key Exec Plans

Key Person

Executive Bonus

162 Bonus Plans

Split Dollar

Buy Sell

  • What is ‘Key Person Insurance’  KeyManVideo

    A life insurance policy that a company purchases on a key executive’s life. The company is the beneficiary of the plan and pays the insurance policy premiums. This type of life insurance is also known as “key man insurance,” “key woman insurance” or “business life insurance.”

    Key person insurance is needed if the sudden loss of a key executive would have a large negative effect on the company’s operations. The payout provided from the death of the executive essentially buys the company time to find a new person or to implement other strategies to save the business.

    In a small business, the key person is usually the owner, the founders or perhaps a key employee or two. The main qualifying point would be if the person’s absence would sink the company. If this is the case, key person insurance is definitely worth consideration.

    How Key Person Insurance Works

    For key person insurance policies, a company purchases a life insurance policy on its key employee(s), pays the premiums and is the beneficiary of the policy. In the event of death, the company receives the insurance payoff. These funds can be used for expenses until it can find a replacement person, pay off debts, distribute money to investors, pay severance to employees and close the business down in an orderly manner. In a tragic situation, key person insurance gives the company some options other than immediate bankruptcy.

    To determine if a business needs this kind of coverage, company executives must consider who is irreplaceable in the short term. In many small businesses, it’s the owner who does most things – keeping books, managing employees and handling key customers, etc. Without this person, the business would come to a stop.

    How much insurance is needed depends on the business, but in general, a business should buy whatever they can afford. Companies should ask for quotes on $100,000, $250,000, $500,000, $750,000 and $1 million policies, and compare the costs of each.

    Categories of Loss Covered by Key Person Insurance

    1. Losses related to an extended period when a key person is unable to work, but has not died.

    2. Insurance to protect profits…for example, offsetting lost income from lost sales, losses resulting from the delay or cancellation of any business project in which a key person was involved.

    3. Insurance designed to protect shareholders or partnership interests. Typically, this insurance enables shareholder or partnership interests to be purchased by existing shareholders or partners.

    4. Insurance for anyone involved in guaranteeing business loans or banking facilities. The value of insurance coverage is arranged to equal the value of the guarantee.

  • The word bonus is important to executives. In certain professions, a year-end bonus may be as large as or larger than an executive’s annual salary. Regardless of whether the bonus an executive receives is a blockbuster or something more modest, it sends a message:

    “You are responsible for the success of this organization, and this organization believes that you should participate in its rewards”.

    No matter where the executive is in the hierarchy, this message is a powerful incentive to do an even better job next year.

    Executive bonus plans are often referred to as Section 162 Plans because this section of the Internal Revenue Code states that an employer may deduct all ordinary and necessary business expenses including a reasonable allowance for salaries or other compensation for personal services actually rendered. (Section 162 establishes limits on the amount of compensation that may be deducted by employers as a business expense — generally speaking, $1 million). Section 162 provides the legal basis for the income tax deduction of bonuses and other compensation that is paid.

    An executive bonus plan is an arrangement under which an employer pays the premiums on a permanent, cash value life insurance policy. Although the employer pays the premiums, the executive — not the employer — owns the life insurance policy. The basic executive bonus plan is simplicity itself. It is in the application of the plan that some complexity enters the arrangement.

    The need for an executive bonus plan often arises out of an employer’s desire to add a certain extra incentive to its executive compensation. Sometimes this is coupled with the employer’s desire to provide death protection for its executives, give its executives an opportunity to make contributions and give itself a current income tax deduction. The executive bonus plan does all of those things.

    Although the emphasis in an executive bonus plan is on death benefits, the policy’s cash value also may provide additional retirement income for an executive. That income may supplement an existing qualified retirement plan or represent the only retirement program offered by the employer-not an uncommon situation in young companies in which sufficient, stable earnings may not be available. Even if a qualified plan is installed, the employer may wish to single out one or more key executives for special treatment, reflecting their contribution to the enterprise.

    In an executive bonus plan, the employer pays an executive a bonus — all of part of which is in the form of a premium payment on a permanent life insurance policy.

    Although an employer may design the bonus arrangement in almost any fashion, including agreeing to pay an annual premium amount without regard to business results, the maximum business benefit often is obtained by tying the granting of a bonus to the executive’s achievement of particular benchmarks.

    What this means is that if the executive doesn’t perform well, he or she receives little or no bonus. Making such a bonus arrangement work in the business requires that the employer identify the results that it wants to reward.

    For example.

    Let’s assume that the employer’s objective is to achieve sales growth of 20 percent—from an existing $10 million to $12 million—for the current year and it looks to its Sales Vice President to make that growth happen.

    The employer could provide no bonus for achieving the first $10 million of sales, 1/2 percent bonus for the next $1 million and 1 percent for every additional $1 million of sales in excess of $11 million.

    A similar approach can be used in areas other than sales.  For example, the bonus for the Production Vice President may be based on a 10 percent increase in output that meets existing quality control standards.

    The bonus, if based on the meeting of some goal or objective, should be based on criteria that:

    are achievable;

    stretch the individual and his or her area of responsibility; and

    are within the executive’s control.

    It would make no sense and would be counterproductive to base the sales officer’s bonus on production or the production manager’s bonus on sales.

    When we discuss bonus design later in this course, we will look at formulas, flat amounts and combination approaches that help businesses to achieve results that they may never have thought possible. The key to making the bonus arrangement attractive to the employer usually lies in determining the objective that the employer wants to achieve and providing a bonus for it.

    The board of directors of a company should authorize major expenditures that may be outside of the routine, day-to-day expenses incurred by the business. Management compensation adjustments, such as executive bonuses, are such major expenditures.

    In order to authorize an executive bonus plan, the board of directors should pass a written authorization. The authorization should:

    identify the specific executives who will participate;

    state that the bonus is intended as additional compensation to each named executive;

    state that the bonus will be used to purchase individual, permanent, cash value life insurance (unless the key executive is uninsurable);

    establish that each participating executive is a member of the select group of corporate management (so that the favorable ERISA provisions will apply); and define the claims procedure.

    The resolution should define the claims procedures to meet plan document requirements for ERISA. According to ERISA requirements, the procedure must call for providing written notice in the event of a claim denial and an opportunity for a beneficiary to receive a full hearing. Because of the nature and operation of an executive bonus plan, the claims procedure requirement is somewhat academic. In other words, an insured bonus plan should be established only for the select group in order to avoid ERISA reporting and disclosure requirements.

    Corporate counsel should draft the board resolution. Even if the financial professional recommending and installing the plan is an attorney, he or she should resist the impulse to prepare any documents used to authorize or install the plan. A separation of these activities helps to avoid any appearance of a conflict of interest.

    Although other financial vehicles may be used to fund an executive bonus plan, life insurance provides a substantial number of benefits and tax advantages that make it particularly suitable. Any type of individual, permanent life insurance policy may be used as the funding vehicle in an executive bonus plan. Certain policy types may work better in plans whose bonus amount may vary from year to year. In many cases, the most desirable product is a universal life insurance policy. While the individual policy used may provide for cash value growth on a declared-rate, equity indexed or variable basis depending on the particular executive’s investment risk tolerance, the use of universal life insurance more easily adapts to:

    variations in premium deposits; and tax-advantaged access to cash value through withdrawals.

  • Section 162 of the Internal Revenue Code is the section that states that an employer may deduct certain expenses-including salary and other compensation-that are ordinary and necessary business expenses.  It is in reference to this Code section that certain nonqualified plans, known as executive bonus plans, are sometimes referred to as Section 162 Plans.  In its simplest form, an executive bonus plan is one in which an employer pays the premiums on a permanent life insurance policy owned by an employee. 

    The Need

    Employers often seek additional incentives to motivate their executives, and an executive bonus plan provides that facility. In addition, the life insurance policy that provides the vehicle for the plan enables executives to make additional premium contributions.
    In addition to providing death benefits, the cash value in the policy may provide supplemental income at retirement.  While the supplemental retirement income may be in addition to a qualified retirement plan, it may also be the only retirement plan that the employer offers-at least at the current stage of its development.  As in all nonqualified plans, the executive bonus plan may simply be used by the employer to provide special treatment to a key executive in compensation for his or her contribution to the success of the company.

    The Bonus

    The employer’s bonus in an executive bonus plan is accounted for as salary to the executive.  As such, it is deductible to the employer (within the limits of reasonable compensation) and taxable to the executive.  It is important to keep in mind that the premium payment made by the employer is deductible only because it is compensation, not because it is a nonqualified plan contribution.
    The employer sponsoring an executive bonus plan may design it any way it chooses.  Although it is not required, many employers try to tie bonus payments to the executive’s meeting of pre-determined corporate goals.  As a result, if the executive performs poorly he or she receives no bonus.  If the benchmarks are met, the bonus can be substantial.  
    Not surprisingly, the bonus arrangement works most effectively when the business clearly identifies the results it will reward.  The most effective goals are ones that:
    Can be achieved within the period being measured
    Cause the executive to stretch his or her talents,  and
    Are under the control of the executive
    We will consider formulas, flat amounts and combination approaches that can be used in an executive bonus plan to help businesses achieve the results they are looking for when we examine how to design a bonus, later in this chapter.  

    The Board Resolution        

    Adjustments to management compensation are major expenditures.  For that reason, establishing an executive bonus plan should be preceded by a resolution from the board of directors authorizing it.
    To authorize the plan, the board should pass a written authorization that will:  
    Identify the plan participants by name
    Clearly state the bonus is additional compensation that will purchase individual, permanent life insurance, and
    Identify each participant as a member of a select group of corporate managers
    The attorney for the employer should draft the board resolution. 
    A life insurance policy is not the only financial vehicle that can fund an executive bonus plan.  However, life insurance offers several benefits that may make it especially attractive.  
    Although any kind of permanent life insurance will generally work in an executive bonus plan, some policy types work better than others.  Because of the flexibility that it brings to the plan, the most desirable life insurance product to use in funding an executive bonus plan may be a universal life insurance policy.  Universal life insurance easily facilitates:
    Bonus differences from year to year (making flexible premiums important), and
    Access to cash value on a FIFO basis
    In all executive bonus plan cases, the executive owns the policy and names the death benefit beneficiary.
  •  

    Split-dollar life insurance isn’t an insurance product or a reason to buy life insurance. Split-dollar is a strategy that allows the sharing of the cost and benefit of a permanent life insurance policy. Any kind of permanent life insurance policy that builds a cash value can be used.

    Because split dollar plans offer tax advantages, these plans are highly regulated by the IRS and are therefore more “involved” than simpler strategies such as executive bonus plans. This is also the reason that the tax laws governing split dollar plans have undergone changes in recent years (2003) and remain under careful watch by lawyers and advanced market insurance practitioners.

    What Is Split Dollar?

    Most split-dollar life insurance plans are used in business settings between an employer and employee (or corporation and shareholder). However, plans can also be set up between individuals (sometimes called private split-dollar) or by means of an irrevocable life insurance trust (ILIT). This article primarily discusses arrangements between employers and employees; however, many of the rules are similar for all plans.

    In a split-dollar plan, an employer and employee execute a written agreement that outlines how they will share the premium cost, cash value and death benefit of a permanent life insurance policy. Split-dollar plans are frequently used by employers to provide supplemental benefits for executives and/or to help retain key employees. The agreement outlines what the employee needs to accomplish, how long the plan will stay in effect and how the plan will be terminated. It also includes provisions that restrict or end benefits if the employee decides to terminate employment or does not achieve agreed-upon performance metrics.

    Since split-dollar plans are not subject to any ERISA rules, there is quite a bit of latitude in how an agreement can be written. However, agreements do need to adhere to specific tax and legal requirements. Thus a qualified attorney and/or tax advisor should be consulted when drawing up the legal documents. Split dollar plans also require record keeping and annual tax reporting. Generally the owner of the policy, with some exceptions, is also the owner for tax purposes. Limitations also exist on the usefulness of split-dollar plans depending on the how the business is structured (for example as an S Corporation, C Corporation, etc.) and whether plan participants are also owners of the business.

    Split-dollar plans have been around for many years. In 2003, the IRS published a series of new regulations that govern all split-dollar plans. The regulations outlined two different acceptable split-dollar arrangements: economic benefit and loan. The new regulations also removed some of the prior tax benefits, but split-dollar plans still offer some advantages including:

    • Term insurance, based on the IRS’ interim table of one-year term premiums for $1,000 of life insurance protection (Table 2001 rates), which may be at a lower cost than the actual cost of the coverage, particularly if the employee has health issues or is rated.
    • The ability to use corporate dollars to pay for personal life insurance which can leverage the benefit, especially if the corporation is in a lower tax bracket than the employee is.
    • Low interest rates if the applicable federal rate (AFR), when the plan is implemented, is below current market interest rates. Plans with loans can maintain the interest rate in effect when the plan was adopted, even if interest rates rise in the future.
    • The ability to help minimize gift and estate taxes.

    Under the economic benefit arrangement the employer is the owner of the policy, pays the premium and endorses or assigns certain rights and/or benefits to the employee. For example, the employee is allowed to designate beneficiaries who would receive a portion of the policy death benefit. The value of the economic benefit the employee receives is calculated each year. Term insurance is valued using the Table 2001 annual renewable term rates, and the policy cash value is any increase that occurred during the year. The employee must recognize the value of the economic benefit received as taxable income every year. However, if the employee makes a premium payment equal to the value of the term life insurance and/or cash value received, then there is no income tax due.

    A non-equity arrangement is when an employee’s only benefit is a portion of the term life insurance. In an equity split-dollar plan, the employee receives the term life insurance coverage and also has an interest in the policy cash value. Plans may allow the employee to borrow against or withdraw some portion of cash value.

    Split-dollar life insurance isn’t an insurance product or a reason to buy life insurance. Split-dollar is a strategy that allows the sharing of the cost and benefit of a permanent life insurance policy. Any kind of permanent life insurance policy that builds a cash value can be used.

    Most split-dollar life insurance plans are used in business settings between an employer and employee (or corporation and shareholder). However, plans can also be set up between individuals (sometimes called private split-dollar) or by means of an irrevocable life insurance trust (ILIT). This article primarily discusses arrangements between employers and employees; however, many of the rules are similar for all plans.

    In a split-dollar plan, an employer and employee execute a written agreement that outlines how they will share the premium cost, cash value and death benefit of a permanent life insurance policy. Split-dollar plans are frequently used by employers to provide supplemental benefits for executives and/or to help retain key employees. The agreement outlines what the employee needs to accomplish, how long the plan will stay in effect and how the plan will be terminated. It also includes provisions that restrict or end benefits if the employee decides to terminate employment or does not achieve agreed-upon performance metrics.

    Since split-dollar plans are not subject to any ERISA rules, there is quite a bit of latitude in how an agreement can be written. However, agreements do need to adhere to specific tax and legal requirements. Thus a qualified attorney and/or tax advisor should be consulted when drawing up the legal documents. Split dollar plans also require record keeping and annual tax reporting. Generally the owner of the policy, with some exceptions, is also the owner for tax purposes. Limitations also exist on the usefulness of split-dollar plans depending on the how the business is structured (for example as an S Corporation, C Corporation, etc.) and whether plan participants are also owners of the business.

    Closely Held Business

    When creating a split dollar plan for a closely held business, the first important question is how to classify an individual who is involved in ownership of the business AND who is benefiting from the policy.  A related question is the type of business entity that is concerned such as an c corporation, s corporation or an LLC, as the specific entity will typically have an impact on the tax ramifications.  The key question is whether the individual involved in the business is receiving benefits as a business owner (shareholder, partner/LLC member) OR as an employee.

    If an individual receives a life insurance benefit as an employee, that benefit will be taxed as regular income.  If the benefit is received as a shareholder/partner or LLC member, the benefit may be taxed as a dividend or return of capital. Because taxation rates for regular income are much higher than dividend tax rates, there can be big advantages in documenting the individual as a shareholder in a corporation.

    If the corporation is a “C Corporation“, the shareholder benefit will be taxed as a distribution to the same extent that the corporation has earnings; however these are the earnings of the corporation and not necessarily the shareholder individually.

    If the corporation is an “S Corporation” the benefit will also be taxed as a distribution; however, because the S corp is a pass through entity, earnings are reported on the shareholder’s personal tax returns and thus the benefits are realized as after tax income.

    Things get a bit more uncertain for split dollar arrangements involving partnerships and LLCs because the IRS rules are very unclear about how to classify the life insurance benefits.  The question seems to be whether it will be deemed a “guaranteed payment to a partner” rather than payment to an employee, which is likely in a partnership or LLC where the individual isn’t acting directly as an employee.

    History and Regulation

    Split-dollar plans have been around for many years. In 2003, the IRS published a series of new regulations that govern all split-dollar plans. The regulations outlined two different acceptable split-dollar arrangements: economic benefit and loan. The new regulations also removed some of the prior tax benefits, but split-dollar plans still offer some advantages including:

    • Term insurance, based on the IRS’ interim table of one-year term premiums for $1,000 of life insurance protection (Table 2001 rates), which may be at a lower cost than the actual cost of the coverage, particularly if the employee has health issues or is rated.
    • The ability to use corporate dollars to pay for personal life insurance which can leverage the benefit, especially if the corporation is in a lower tax bracket than the employee is.
    • Low interest rates if the applicable federal rate (AFR), when the plan is implemented, is below current market interest rates. Plans with loans can maintain the interest rate in effect when the plan was adopted, even if interest rates rise in the future.
    • The ability to help minimize gift and estate taxes.

    Economic Benefit Arrangement

    Under the economic benefit arrangement the employer is the owner of the policy, pays the premium and endorses or assigns certain rights and/or benefits to the employee. For example, the employee is allowed to designate beneficiaries who would receive a portion of the policy death benefit. The value of the economic benefit the employee receives is calculated each year. Term insurance is valued using the Table 2001 annual renewable term rates, and the policy cash value is any increase that occurred during the year. The employee must recognize the value of the economic benefit received as taxable income every year. However, if the employee makes a premium payment equal to the value of the term life insurance and/or cash value received, then there is no income tax due.

    A non-equity arrangement is when an employee’s only benefit is a portion of the term life insurance. In an equity split-dollar plan, the employee receives the term life insurance coverage and also has an interest in the policy cash value. Plans may allow the employee to borrow against or withdraw some portion of cash value.

    Loan Arrangement

    The loan arrangement is significantly more complicated than the economic benefit plan. Under the loan arrangement, the employee is the owner of the policy and the employer pays the premium. The employee gives an interest in the policy back to the employer through a collateral assignment. A collateral assignment places a restriction on the policy that limits what the employee can do without the employer’s consent. A typical collateral assignment would be for the employer to recover the loans made upon the employee’s death or at the termination of the agreement.

    The premium payments by the employer are treated as a loan to the employee. Technically each year the premium payment is treated as a separate loan. Loans can be structured as term or demand and must have an adequate interest rate based on the AFR. But the rate can be below current market interest rates. The interest rate on the loan varies, depending on how the arrangement is drafted and how long it will stay in force.

    Terminating Split-Dollar Plans

    Split-dollar plans are terminated at either the employee’s death or a future date included in the agreement (often retirement).

    At the premature death of the employee, depending on the arrangement, the employer recovers either the premiums paid, cash value or the amount owed in loans. When the repayment is made, the employer releases any restrictions on the policy and the employee’s named beneficiaries, which can include an ILIT, receive the remainder as a tax-free death benefit. (For related reading, see: Structure and Taxation of Split-Dollar Coverage.)

    If the employee fulfills the term and requirements of the agreement, all restrictions are released under the loan arrangement, or ownership of the policy is transferred to the employee under the economic benefit arrangement. Depending on how the agreement was drafted, the employer may recover all or a portion of the premiums paid or cash value. The employee now owns the insurance policy. The value of the policy is taxed to the employee as compensation and is deductible for the employer.

    The Bottom Line   Business Life & DI

    Split dollar plans can provide planning flexibility for a closely held business in a number of ways including:

    1. Providing financial incentive to a key employee
    2. Funding certain buyout arrangements
    3. Estate and business succession planning for the business owner

    To achieve the above benefits, a split dollar plan provides a way of paying for AND owning permanent life insurance by ALLOCATING the cost of premiums AND the benefits of the policy between the employer AND the employee.

    Like many non-qualified plans, split dollar arrangements can be a very useful tool for employers looking to provide additional benefits to key employees

  • A buy and sell agreement is a legally binding agreement used to reallocate a share of a business if an owner dies or leaves the business. Also known as a “buy-sell agreement,” a “buyout agreement,” a “business will” or a “business prenup,” buy and sell agreements are used by sole proprietorships, partnerships and closed corporations to divide the business share or interest of a proprietor, partner or shareholder.

    n a buy and sell agreement, the owner of the business interest being considered for reallocation must be deceased, disabled, retired or must have expressed interest in selling. The buy and sell agreement requires that the business share is sold to the company or the remaining members of the business according to a predetermined formula. Before the interest of a deceased partner can be sold to the company or remaining partners, the deceased’s estate must agree to sell. Without a buy and sell agreement in place, a business can face significant tax burden or other financial difficulties if an owner dies, retires, becomes disabled or otherwise leaves the business.

    In order to ensure the availability of funds in the event of a partner’s death, most parties will purchase life insurance policies on the other partners. In the event of a death, the proceeds from the life insurance policy are used to purchase a portion of the deceased’s business interest. It is important to note that when a sole proprietor dies, since there are no business partners, a key employee can be the buyer or successor.

    Buy and Sell Agreement: Who Needs Them?

    Buy and sell agreements are useful to individuals in a variety of scenarios, such as:

    • You want to establish a fair value of a share of a business in case a dispute erupts between owners, such as a case in which one wants to exit and sell out, and another wants to remain and buy out the exiting partner.
    • You are a co-owner of a business and want to place restrictions on other owners who may seek to sell their interests to another person or entity that may not have the best interests of the business or remaining partners in mind.
    • You want to stipulate that owners or their estates must sell their shares of a business back to the business so the remaining partners can keep control of the company when an owner dies, becomes incapacitated or exits for any other reason.
    • You want to stipulate that remaining owners must buy the interests of an exiting or deceased owner to ensure liquidity.