Insurance-Related Compensation (Portfolio 828)

Part of Tax

Tax Management Portfolio, Insurance-Related Compensation, No. 828-2nd, discusses how to use life insurance contracts to provide compensation and benefits for employees, especially, after the enactment of §409A.

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Tax Management Portfolio, Insurance-Related Compensation, No. 828-2nd, discusses how to use life insurance contracts to provide compensation and benefits for employees, especially, after the enactment of §409A. To assist practitioners with life insurance plans, this portfolio provides a primer on life insurance features and taxation, including an overview of the most common types of life insurance contracts and riders, and shows how these insurance products are frequently used in executive compensation. It also discusses group-term carve-out and group permanent plans, corporate-owned life insurance (COLI) and bank-owned life insurance (BOLI), executive legacy programs and business-owned investment insurance plans. It gives more extended treatment to bonus life insurance (including restricted access bonus plans), split-dollar life insurance, and to unsecured “promise-to-pay” nonqualified deferred compensation plans (including death-benefit-only plans) which use life insurance contracts primarily as the financing mechanism. Special design issues and problems are highlighted for each technique. All discussions consider the impact or potential impact of the application of §409A to the compensatory arrangement.
In addition, this portfolio discusses the impact of §101(j) on “employer-owned life insurance” (EOLI), which covers most insurance acquisitions on employees and directors by a business entity in the business environment. This portfolio also analyzes the federal income tax treatment of traditional group-term life insurance plans, with emphasis on the tax benefits provided to employees under §79, and examines the federal income tax treatment of retired lives reserve accounts under §§419 and 419A, and death benefit plans under §419(e) single employer plans. The portfolio further examines the gift and estate tax and ERISA implications of group-term life insurance.
Tax Management portfolios on related topics include 826 T.M., Life Insurance (Estates, Gifts & Trusts Series), 385 T.M., Deferred Compensation Arrangements, and 394 T.M., Employee Fringe Benefits.
This portfolio may be cited as Brody, Richey, and Baier, 828-2nd T.M., Insurance-Related Compensation.


Lawrence Brody, Esq.

Lawrence Brody, Wharton School of Finance (1964); Washington University School of Law (J.D. 1967); New York University School of Law (LL.M. 1968).

Louis R. Richey, JD

Louis R. Richey, Wabash College (B.A. 1969); Indiana University School of Law (J.D. 1973).

Richard C. Baier, JD, CLU, ChFC, FLMI

Richard C. Baier, Brigham Young University (B.A. 1973); Indiana University School of Law (J.D. 1977).

Table of Contents

Portfolio Description


Technical Advisors


Detailed Analysis

I. Introduction

A. Scope of the Portfolio

B. Selecting the Appropriate Benefit

1. In General

2. Factors Influencing the Executive Compensation Package

3. The Advisor's Role

II. A Life Insurance Primer

A. Definition of Life Insurance

1. Historical Perspective

2. Advising Clients About Life Insurance

3. Policy Risk Elements

a. Mortality Risk

b. Interest Rate/Investment Risk

c. Lapse Risk

d. Expense Risk

4. Life Insurance Tax Overview

a. Tax Policy

b. Income Tax

c. Estate, Gift and Generation-Skipping Tax

5. Defining Life Insurance for Tax Purposes

a. Pre-1985 Fixed- and Single-Premium Policies

b. Pre-1985 Flexible Premium Policies

c. Post-1984 Life Insurance Policies

(1) Cash Value Accumulation Test

(2) Guideline Premium and Cash Value Corridor Test

(a) Guideline Premium

(b) Cash Value Corridor

(3) Additional Considerations

(a) Computational Considerations

(b) Withdrawals Within First 15 Years

d. Modified Endowment Contracts

(1) In General

(2) What Is a Modified Endowment Contract?

(3) Withdrawals and Exchanges

(4) Correcting a Life Insurance Contract that Inadvertently Became a Modified Endowment Contract

6. Relationship Between Life Insurance and Annuities

B. Types of Life Insurance

1. Group Insurance

a. In General

b. Group-Term Carve-Out

2. Individual Life Insurance

a. In General

b. Purpose of the Insurance

c. What Kind of Life Insurance?

(1) Term Insurance

(2) Whole Life Insurance

(a) In General

(b) Executive Bonus Insurance

(c) Nonqualified Deferred Compensation Plans

(d) Split-Dollar Insurance

(3) Universal Life Insurance

(4) Indexed Universal Life Insurance

(5) Variable Life and Variable Universal Life Insurance

(6) Group Universal and Group Variable Universal Life Insurance

(7) Joint and Survivor Life Insurance

(8) First-to-Die Insurance

(9) Policy Riders

C. Policy Dividends

1. Definition

2. Dividend Options

3. Taxation of Dividends

D. Surrenders, Withdrawals, Sales and Exchanges

1. Surrenders, Withdrawals, Sales and Dividends

2. Policy Exchanges

E. Policy Loan Interest Deductions

1. Background

2. Taxation of Loan Proceeds

3. Policy Loan Interest

4. Interest Deductions in General

5. Policy Loan Interest Deduction

a. In General

b. Doorway of § 264

c. Interest Allocation Under § 163

6. Section 264

a. Single Premium Policies

b. Plan of Systematic Borrowing

c. $50,000 Loan Limit

d. Four-of-Seven Exception

e. $100 or Less Exception

f. Unforeseen Substantial Events Exception

g. Trade or Business Exception

7. Interest Expense Allocable to Unborrowed Policy Cash Values

8. Summary

F. Transfers for Valuable Consideration

1. In General

2. Exceptions

3. Basis Carryover Transfers

4. Personal Insurance Transfers

a. Transfers to a Spouse

b. Transfers Incident to a Divorce

c. Family Members Other than a Spouse

5. Buy-Sell Arrangements

a. Stock Redemption to Cross-Purchase

b. Transfer of Personally Owned Policies to Fund Cross-Purchase

c. Cross-Funding Through Beneficiary Designations

d. Transfer for Value at Death of Shareholder

e. Trusteed Cross-Purchase Arrangement

f. Cross-Purchase Using a Partnership

6. Transfer for Value in Split-Dollar Arrangements

a. Economic Benefit Regime Endorsement Split-Dollar

b. Loan Regime Collateral Assignment Split-Dollar

c. Split-Ownership

d. Reverse Split-Dollar

e. Beginning or Ending the Arrangement

7. Multiple Transfers

8. Conclusion

G. Corporate Alternative Minimum Tax

III. Employer-Owned/Corporate-Owned Life Insurance (EOLI or COLI)

A. In General

1. Background

2. Section 101(j) - Tax Consequences

a. Annual EOLI Reporting Requirements

b. Recordkeeping Requirements

c. IRS Guidance on § § 101(j) and 6039I

d. Summary

B. Executive Legacy Programs

1. Introduction

2. Establishing a Legacy Program

3. Tax Consequences

4. Summary of Benefits Under Executive Legacy Program

C. Broad-Based COLI ("Janitor" Life Insurance)

IV. Bonus Life Insurance Plans

Introductory Material

A. What Is a Bonus Plan?

B. When to Use a Bonus Plan

C. Income Taxation

1. Employer

2. Employee

a. Taxability of the Bonus and Possible § 409A Application

b. Receipt of Policy Proceeds

c. Deductibility of Interest on Policy Loans

D. Estate and Gift Taxation

1. Includibility in the Executive's Estate

2. Gift of Policy to Third-Party Owner

E. Miscellaneous Considerations

1. ERISA Requirements

a. Reporting and Disclosure Requirements

b. Participation, Funding and Vesting Requirements

c. Fiduciary Requirements

d. Claims Procedure

2. FICA/FUTA Requirements

3. Community Property Considerations

4. Restricted-Access Bonus Plans

F. Documentation of the Plan

V. Insurance-Financed Deferred Compensation, Including "Death Benefit Only" Plans

A. Introduction

1. An Overview of Unsecured and Unfunded Employer Nonaccount Balance and Defined Contribution Account Balance Plans and Employee Defined Contribution Account Balance Plans

2. Use of Corporate-Owned Life Insurance as the General Asset Reserve Behind a Plan

a. Background

b. Annuities

(1) Corporate-Owned Annuities

(2) Annuities Owned by "Natural Persons"

c. Life Insurance Contracts

(1) Plan Cost Recovery with Employer-Owned Life Insurance

(2) Leveraged Life Insurance

(3) Non-Leveraged Life Insurance

d. Administration of the Plan and the Corporate-Owned Life Insurance

B. An Overview of Nonqualified Deferred Compensation Plans Using EOLI as a General Asset

1. Tax Consequences

a. Income Taxation

(1) Employer

(a) COLI and Nonqualified Deferred Compensation

(b) Deductibility of Premium Payments

(c) Deductibility of Current Plan Interest Accruals

(d) Deductibility of Plan Benefit Payments

(e) Taxability of Annual Cash Value Increases

(i) Employer-Owned Annuities

(ii) Employer-Owned Life Insurance

(f) Taxability of Employer-Owned Life Insurance Death Proceeds

(g) Deductibility of Policy Loan Interest

(2) Employee - Current Income Tax Consequences

(a) General Overview

(b) Section 409A

(c) Other Income Tax Theories

(i) Constructive Receipt Doctrine

(ii) Economic Benefit Doctrine

(iii) Section 83

(d) Retirement Benefits

(e) Death Benefits

(f) Severance Benefits

(g) Withholding

(h) Section 409A Plan Reporting - Taxation and Informational

(i) Taxation

(i) Informational Reporting

(ii) Corrections Program for § 409A Violations

b. Estate Taxation

(1) In General

(2) Death Benefit Only Plans

c. Gift Taxation

(1) In General

(2) Death Benefit Only Plans

2. ERISA Requirements

a. In General

b. Excess Benefit Plan Exemption

c. Select Group Exemptions for Nonqualified Deferred Compensation Plans

(1) What Is a "Select Group"?

(2) When Is a Plan Unfunded?

d. Welfare Plan Exemptions

(1) Select Group Exemptions for Welfare Benefit Plans

(2) Limited Exemption for Small Welfare Plans

e. Combination Plans

3. Social Security Considerations

a. Social Security Taxation

b. Social Security Benefits

(1) In General

(2) Compensation for Corporate Directors

(3) Social Security Taxation of Death Benefits

(4) Income Taxation of Social Security Benefits

c. Practice Recommendations

4. Security Devices

a. In General

b. Rabbi and IRS Model Trusts

(1) Rabbi Trusts

(2) IRS Model Grantor Trusts

c. Secular Trusts

(1) In General and Nonapplicability of § 409A

(2) Non-Grantor Secular Trusts

(3) Employee Grantor Secular Trusts

(4) Employer Grantor Secular Trusts

(5) Taxation of Distributions from a Secular Trust

d. Surety Bonds and Indemnification Insurance

e. Third-Party Guarantees

f. Rabbicular Trusts

5. SEC Considerations

a. Compensation Disclosure for Key Executives

b. Definition of "Securities" in the Nonqualified Deferred Compensation Plan Context

c. SEC Registration of Nonqualified Deferred Compensation Plans

6. Special Rules for All Companies Receiving Troubled Asset Relief Program (TARP) Assistance and Banks that Own Life Insurance

7. Exchanging Nonqualified Deferred Compensation Plan Benefits for the Proceeds of Life Insurance Under a Split-Dollar Plan (Benefit "Swapping")

8. Deferred Compensation for Nonprofit Employers (Section 457 Plans)

a. In General

b. Notice 2007-62

c. Use of Organizational-Owned Life Insurance

9. Evaluating and Designing the Plan

a. Pre-Drafting Considerations

(1) Is Nonqualified Deferred Compensation the Appropriate Benefit?

(a) Employer-Paid Account or Nonaccount Balance Plan

(b) Voluntary Employee Account Balance Plan

(c) General Preconditions

(2) The Parties to Nonqualified Deferred Compensation Agreements

(a) In General

(b) Outside Directors and Independent Contractors

(3) Vesting of Plan Benefits

(4) Plans for Sole or Majority Shareholders

b. Documentation of the Plan

c. Obtaining an Advance Ruling from the IRS

VI. Split-Dollar Life Insurance Plans

A. Background

B. Overview of Split-Dollar Structure and Documentation Methods

1. Equity or Premium Splits

2. Traditional and Non-Traditional

C. Income Tax Consequences of Split-Dollar Arrangements - Prior to Proposed and Final Regulations

1. Rev. Rul. 64-328

2. Rev. Rul. 66-110

3. Notice 2001-10

a. Section 83 Transfer

b. Loan

c. Reverse Split-Dollar Arrangements

d. Interim Guidance

e. Value of Current Life Insurance Protection

4. Notice 2002-8

a. In General

b. Economic Benefit Treatment

c. Loan Treatment

d. Equity Treatment

e. Arrangements Entered into Prior to January 28, 2002

f. Arrangements Entered into After January 28, 2002, but Before September 17, 2003

D. 2002 Proposed Split-Dollar Regulations

1. Applicability

2. Taxation of Equity Under § 61

3. Economic Benefit Doctrine

4. Split-Dollar Defined

5. Mutually Exclusive Regimes

a. Economic Benefit Regime

b. Loan Regime

6. Gift Tax Issues

E. 2003 Proposed Regulations - Valuation of Economic Benefits

F. Final Split-Dollar Regulations

1. Split-Dollar Defined Under Final Regulations

2. Mutually Exclusive Regimes - In General

3. Economic Benefit Regime

a. Current Life Insurance Protection

b. Current Access to Policy Values

c. Valuation Date

d. Amount Received Under the Contract

e. Other Tax Consequences

f. Taxation of Death Benefit

g. Policy Transfers

4. Loan Regime

5. Choosing a Regime Under the Final Regulations

G. Types of Split-Dollar Arrangements

1. Equity Split-Dollar Theories

a. Rev. Rul. 66-110 and § 61

b. Section 72

c. Collateral Assignment Documentation

d. Section 83

e. Interest-Free Loan

f. Rev. Rul. 64-328

g. Employee Contribution

2. Frozen Split-Dollar

3. Late Start Split-Dollar

4. Third-Party Split-Dollar

5. Shareholder and Partner Split-Dollar

6. S Corporation Split-Dollar

7. Reverse Split-Dollar

a. In General

b. Tax Consequences

c. Notice 2002-59

8. Charitable Reverse Split-Dollar

9. Private Split-Dollar

10. Private Reverse Split-Dollar

H. Exit Strategies

I. Use of Different Types of Insurance Policies

1. Universal and Variable

2. Single Premium

3. Survivorship

J. Extending the Use of Split-Dollar Arrangements

1. Section 457

2. Purchase Price

3. SERP Swaps

K. Group-Term Carve-Out Plans

L. Public Company Arrangements

1. In General

2. Application of Sarbanes-Oxley Act to Split-Dollar Arrangements

a. Other Regulatory Guidance to Sarbanes-Oxley Act

b. Interpretation of Sarbanes-Oxley Act

c. Grandfather Provision of Sarbanes-Oxley Act

d. Making Future Premium Payments

e. Loan Treatment of Public Companies

3. SEC Disclosure Rules

M. Taxation of Split-Dollar as Nonqualified Deferred Compensation Under § 409A

1. In General

2. Application of § 409A to Certain Compensatory Split-Dollar Arrangements

3. Post-Final Regulation Equity Economic Benefit Compensatory Split-Dollar Agreements Subject to § 409A

4. Pre-Final Regulation Equity Economic Benefit Compensatory Split-Dollar Agreements Subject to § 409A

5. Loss of "No Inference" Protection of Notice 2002-8 for Pre-Final Regulation Compensatory Equity Split-Dollar Agreements Subject to § 409A

6. Compensatory Split-Dollar Agreements, All or a Portion of Which Are Grandfathered from the Application of § 409A

7. Allocation Between Grandfathered and Non-Grandfathered Amounts

8. Requirements of § 409A That Compensatory Split-Dollar Agreement Must Satisfy If It Provides Non-Grandfathered Lifetime Benefits

9. Modifications to Comply with Notice 2007-34 Are Not Material Modifications for Purposes of the Final Split-Dollar Regulations

10. Notice 2007-86

11. Split-Dollar Under Proposed § 409A Income Inclusion Regulations

N. Split-Dollar Life Insurance Arrangements and the Notice and Consent Requirements of § 101(j)

VII. Group-Term Life Insurance

A. Taxation of the Employee

1. Section 79 - In General

2. Group-Term Life Insurance Defined

3. Groups of Fewer than 10 Full-Time Employees

4. Superimposing

5. Treatment of Group-Term Life Insurance When Combined with Other Benefits

6. Determining the "Cost" of Group-Term Insurance

7. Determining the Amount Includible in Income by Employees Receiving Permanent Benefits

8. Effect of State Issue Limits

9. Other Benefits

a. Dependent Life Coverage

b. Accidental Death Benefits

10. Nondiscrimination Restrictions on Group-Term Life Insurance Exclusion

B. Taxation of the Employer

C. Taxation of the Beneficiary

1. Transfer for Value

2. Interest Payments and Deferred Payments of Insurance Proceeds

D. Retired Lives Reserve

1. Before the 1984 TRA

a. Deductibility of Contributions

b. Taxation of RLR Funds and Sponsoring Employers

c. Taxability to Employees

2. After the 1984 TRA

a. Deductibility of Contributions

b. Taxation of WBFs and Sponsoring Employers

(1) Exempt Trusts

(2) Nonexempt Trusts

c. Taxability to Employees

3. Effective Dates

E. Federal Gift and Estate Taxation of Group Life Insurance

1. Gift Tax

2. Estate Tax

a. Section 2042

b. Section 2035

(1) Indirect Transfers

(2) Renewable Policies, Including Group-Term Policies

(3) Change of Insurance Carriers

F. Group Life Insurance Plans Under ERISA

1. General

2. ERISA Implications

Working Papers

Working Papers

Table of Worksheets

Worksheet 1 Corporate Resolution Authorizing an Executive Legacy Program; Corporate Charitable Contribution Recommendation Form; Specimen Proxy Statement

Worksheet 2 Uniform Premiums for $1,000 of Group-Term Life Insurance Protection

Worksheet 3 Living Proceeds Summary Chart for Non-Annuity Amounts

Worksheet 4 Transfer for Value Summary Chart

Worksheet 5 1958 Commissioner's Standard Ordinary Mortality Table

Worksheet 6 Richey, Baier and Brady, "Protecting the Income Tax Exemption for Death Benefit Proceeds on Employer-Owned Life Insurance: The New Rules Under IRC § § 101(j) and 6039I," reprinted from 37 Compensation Plan. J. 47 (2/6/09), including Sample § 101(j) Notice & Consent Form

Worksheet 7 Vested § 409A Employer-Paid Nonaccount Balance Plan

Worksheet 8 Unvested § 409A Employer-Paid Nonaccount Balance Plan

Worksheet 9 Vested § 409A Voluntary Deferral Employee Account Balance Plan

Worksheet 10 Decision Tree for Choosing Split-Dollar Design

Worksheet 11 Outline of Split-Dollar Arrangements for Drafters

Worksheet 12 Collateral Assignment Non-Equity Split-Dollar Agreement

Worksheet 13 Restricted Collateral Assignment Non-Equity Split-Dollar Agreement

Worksheet 14 Endorsement Method Equity Split-Dollar Agreement

Worksheet 15 Collateral Assignment Equity Split-Dollar Agreement

Worksheet 16 Application for Group Insurance and Administration & Benefits Supplement

Worksheet 17 Group Life Master Agreement

Worksheet 18 Group Insurance Certificate and Summary Plan Description




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