Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning 29 - 1 What is it? An executive benefit that promises payments

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Death Benefit Only (DBO) Plans Chapter 29Tools & Techniques of Life

Insurance Planning

What is it? An executive benefit that promises payments from the employer to the survivors of

an eligible employee at the employee’s death

DBO plan promises only death benefits and no lifetime payments

DBO payments of benefits conditioned upon Survival of the employee by an employer designated beneficiary

The employee’s continued employment until death

Key goals of plan Provide a significant death benefit Generate a substantial amount of income to the family of the deceased employee Help to recruit, retain, and reward employees

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Insurance Planning

When is the use of such a device indicated? When the employer seeks to recruit, retain, and reward employees and

counterbalance limitations upon key employees found in qualified retirement plans

When an employer wants a benefits that is Simple

Cost effective

Free from administrative burdens

When an employer want to pick and choose who will be covered, under what terms and conditions, and at what amounts

To supplement a qualified retirement plan

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Insurance Planning

When is the use of such a device indicated? (cont‘d) When a shareholder-employee wants to utilize his corporation to provide personal

financial security

means to supplement payments under a buy-sell agreement

When an employer wants to provide liquidity and income security for a younger employee’s surviving family

If the employee survives until retirement, employer could convert the DBO plan to a nonqualified deferred compensation plan in order to provide retirement security

Conversion of a split dollar plan to a DBO plan to remove taxable income implications arising from the split dollar arrangement while alive

Death benefits from the employer from the DBO plan will be treated as taxable income

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Insurance Planning

When is the use of such a device indicated? (cont‘d) To provide additional income or estate liquidity for survivors of a client with a large

estate

Where group term life insurance is inadequate for the highly compensated employees

Where an employer is truly and deeply concerned with the well being of the families of company employees, but does not want the death benefit diverted to someone other than a survivor of a deceased employee

Especially for widows between the ages of 50 and 65

Employment is hard to find

May be difficult to remarry

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Insurance Planning

Advantages Proceeds are excludable from employee’s gross estate

If 50% or less shareholder

Large amounts of continuing income provided to the beneficiary through the employer

Employee is not taxed on the employer’s premium payments

Employers can pick and choose who will be covered, the terms of that coverage, and the level of benefit payments to be provided

Benefits received are taxed at the beneficiaries’ tax brackets, which may be lower than that of the employee

Benefit payments are tax deductible to the employer

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Insurance Planning

Disadvantages Payments are subject to ordinary income tax

No deduction is allowed until the benefit is paid beneficiary must include payments in taxable income

Employee given no right to name beneficiary

Plan covering a large and broad group of employees may have to comply with ERISA

Premiums must be paid with after-tax dollars

Formal funding through a trust may trigger constructive receipt, may cause estate tax inclusion, and will probably result in ERISA reporting, disclosure and funding requirement implications

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Insurance Planning

What are the requirements? Written agreement between employer and employee

Amount of the benefit or the formula upon which the benefit is based

The employee(s) covered by the plan

The class of beneficiaries entitled to the benefit

The terms upon which the benefit can be forfeited

Collection procedures

There is no IRS or Department of Labor guidance or requirement with respect to the formula for determining how much the survivors will be paid

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Insurance Planning

What are the requirements? (cont‘d) Corporate resolution by the board of directors should be adopted

No amounts are set aside beyond the claims of the corporate creditors

Obligation of the corporation to make payments contingent upon Employee’s continued employment

Survival of a beneficiary from among the employer specified eligible class

Life insurance should not be mentioned in the contract with the employee Linking the insurance with the benefit could cause unnecessary estate tax inclusion,

income taxation on premium payments, and Department of Labor intrusion

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Insurance Planning

What are the tax implications? No income tax is payable by the covered employee on the premium payments that

the employer pays

Premiums are not income tax deductible

Except for any AMT, proceeds are received by the employer income tax free

Corporate profits and earnings Decreased by the premium payments

Increased by the cash surrender value increases and the excess of death proceeds over cash surrender value in the year of death

Cash values, per se, should not trigger an accumulated earnings tax

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Insurance Planning

What are the tax implications? (cont‘d) Benefits paid by a corporation to an employee’s beneficiary are taxable in full as

ordinary income to the beneficiary

Benefits paid by the corporation are deductible as deferred salary to the extent that amount represent “reasonable compensation”

Payments from the corporation to the beneficiaries of the covered employee may be excludable from the employee’s gross estate

Give the employer sole discretion as to the class of beneficiary to receive death proceeds

Give the employee mo lifetime postretirement benefit or plan (other than qualified pension or profit sharing plan

Give the employee no right to dispose of the payments should one or more of the specified beneficiaries die

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Insurance Planning

What are the tax implications? (cont‘d) Excluding from employee’s gross estate (cont’d)

The employee should be given no right to alter, amend, revoke, or terminate the agreement or change its terms

Payments to a surviving spouse outright, or to the estate of a surviving spouse, or to a general power of appointment or QTIP trust could qualify for the estate tax marital deduction

IRS will no longer claim that payments of the death benefit at the employee’s death constitutes a completed gift at the time of death

Death benefits paid to beneficiaries are not considered wages subject to income tax withholding

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Insurance Planning

What are the tax implications? (cont‘d) If a DBO only covers a single employee

Only the benefits paid to the beneficiaries in the calendar year of the employee’s death will be subject to FICA taxes

Benefits paid after that calendar year should escape FICA taxation

What are the ERISA implications? DBO plan is considered an employee welfare benefit plan

Subject to the requirement of Title I of ERISA

Reporting and disclosure is streamlined if the DBO plan is limited to: A select group of highly compensated employees (generally less than 5% of the total

employees should be participants)

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Insurance Planning

What are the ERISA implications? (cont‘d) Successfully avoiding ERISA’s funding requirement

Counsel should state in the contract between the employer and employee that employees have no right to any instrument that will be used to finance the employer’s potential obligations under the DBO plan

The employer should maintain any life insurance as part of it’s general unrestricted assets

No financing vehicle, especially life insurance, should be tied to the DBO plan in any way

Only a select group of management and highly compensated employees should be covered under a DBO plan

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Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning 29 - 1 What is it? An executive benefit that promises payments