Executive Benefits

What Is Key Employee Life Insurance?
Nearly every business has key employees who are critical to the overall success and profitability of the business. Key employee life insurance is insurance on the life of a key employee, purchased to help reimburse an employer for the economic loss caused by the death of the employee. As such, key employee life insurance is not a specific type of life insurance policy; rather, it is an effective way for a business entity to use life insurance.

Typical Key Employees
A key employee is anyone in whom the business is deemed to have an insurable interest, usually based upon a substantial impact on the financial success of a business. Smaller companies tend to have a greater need for key employee insurance since they do not have a pool of employees from which to select a replacement if a key employee dies. Further, the success of a smaller business can be directly attributed to the vital contributions of a few individuals. In general, a key employee can be anyone who—
• is responsible for management decisions,
• is highly paid,
• has a significant impact on sales, or
• has a special rapport with customers and creditors.

The Purpose of Key Employee Life Insurance
The purpose of key employee insurance is to help protect a business from economic losses that can occur when a key employee dies.

Losses from a Key Employee's Death
A business can typically suffer in four ways if a key employee dies:
1. The death may cause a loss of management skill and experience. This can be particularly devastating for companies without management depth.
2. There may be a disruption in sales or business production. When a key employee's talents are vital to these areas, the business is certain to suffer. And if clients recognize the key employee as vital to the business operations, they may delay orders or refrain from doing business until they find out how the organization will respond to this loss.
3. The business may experience credit difficulties. A drop in business income may make it more difficult to make credit payments. In addition, creditors may hesitate to extend loans or favorable credit terms to a business that has lost a key employee, particularly if that employee's talents or resources were factors that encouraged the creditor to extend loans or special terms in the past.
4. Losses also surface from expenses associated with hiring and training a replacement for the key employee. Even if the company can promote from within, business losses may continue to accrue until the replacement becomes thoroughly familiar with the job.

Advantages of Key Employee Life Insurance
It is clear that there are serious financial consequences when a key employee dies. Here are the advantages businesses enjoy when key employee life insurance is in place:
• The employer receives needed funds which can be used to help meet financial obligations and train a replacement if the key employee dies.
• While the policy is in force and the employee is alive, the cash value of a permanent policy is available for use in a variety of ways.*
*Withdrawals and loans will affect policy values and death benefits and may have tax consequences.
For policies issued before August 18,2006, death proceeds are exempt from the regular tax, but may be subject to the corporate alternative minimum tax.For policies issued after August 17,2006, the death proceeds may be exempt if the Notice and Consent requirements of IRC Sec. 101(j) have been met

How Key Employee Insurance Works
Key employee life insurance is one of the simplest of the business life insurance programs to implement. The business obtains Notice and Consent from the employee and applies for the policy on the employee’s life. The business applies for the policy on the life of a key employee. If the business is a corporation, the board of directors must adopt a resolution authorizing the purchase of the policy. The resolution should mention that the policy is being purchased to protect the corporation from loss it could suffer if the key employee died.
• The employer applies for, owns and is the beneficiary of insurance on the key employee's life.
• If the employee dies, policy proceeds are paid to the employer to use as it wishes.
The business pays all of the premiums and is the policy owner and beneficiary. All incidents of ownership should belong to the business. If the insured has any of these incidents of ownership, the policy proceeds will be included in his or her estate for federal estate tax purposes.

What Is a Buy-Sell Agreement?
When a business owner dies, the disposition of his or her business interest can become a two-edged sword, creating problems for the business owner's heirs as well as the business itself. There are 4 ways that owners of a business can leave: quit, retire, disability, and death. A buy-sell agreement is a legal document which outlines the disposition of a business owner’s interest in the business. Critical questions must be answered:
• Who will purchase the business interest?
• What is a fair price?
• When will the sale be made?
• Where will the funds come from?
This "disposition dilemma" is easily resolved when a buy-sell agreement is established. This agreement provides that:
• someone (e.g., the business entity, the surviving owners, or a key employee) will purchase a deceased owner's interest at an agreed-upon price, and
• the deceased owner's estate is obligated to sell the interest at that price.

The Purpose of Buy-Sell Agreements
For illustrative purposes, imagine yourself in partnership with two associates. The other two partners are John and Brad. If John dies, his business interest passes on to his estate, and ultimately to his wife, Megan. Unfortunately, Megan knows nothing about the business. You and Brad do not want to form a new partnership with Megan as a business partner, and you don't want John’s interest sold to an outsider.
It should be added that John and Brad face the same dilemma regarding your heirs. Fortunately, if a buy-sell agreement is in place, none of these potential problems will arise. All the owners know who will receive the deceased owner's business interest as well as how much will be paid for that interest.
A properly drafted buy-sell agreement:
• minimizes the possibility that the business might fall into the hands of outsiders
• minimizes the possibility that the parties involved will not be able to agree on a proper value for the business and puts everyone on equal footing while all the parties are alive
• minimizes the possibility that funds will be unavailable to make the purchase
• provides a deceased owner's estate with needed liquidity by converting an illiquid asset into cash.
It's easy to see why a buy-sell agreement is so valuable. It helps assure business continuity for the surviving owners and fair treatment of the deceased owner's heir(s).

What Is a Cross-Purchase Agreement?
A cross-purchase agreement is a tool used by business owners to assure that "business as usual" continues if co-owner dies. Like an entity or stock redemption agreement, the cross-purchase buy-sell agreement stipulates that—
• a deceased owner's estate must sell the business interest to surviving owners, and
• the surviving owners will buy that interest.
There are no exceptions—the estate must sell and the survivors must buy.

A cross-purchase agreement also establishes the price to be paid for the deceased owner's business interest. The price is based on: (1) a definite fixed amount stated in the agreement; or (2) a formula by which a definite price can be established. Current tax law has made the second method the more prudent choice in recent years.

Purpose of the Cross-Purchase Buy-Sell Agreement
Two concepts stand at the root of all cross-purchase buy-sell agreements: protection and fairness. A surviving business owner wants to be protected from interference by outsiders when a co-owner dies. Concurrently, a business owner wants to assure fair treatment of his or her heirs in the event of death.
Shareholders and partners use cross-purchase agreements in the same way corporations and partnerships use entity or stock redemption agreements. The distinguishing factor is that, with a cross-purchase agreement, each owner buys a policy on the life of every other owner. Under an entity or stock redemption agreement, the business itself owns a policy on each owner. Click here for more information on entity or stock redemption buy-sell agreements.
Regardless of whether the buyout is cross-purchase, entity, or stock redemption, a properly drafted buy-sell agreement:
• minimizes the possibility that the business might fall into the hands of outsiders
• minimizes the possibility that the parties involved will not be able to agree on a value for the business at the death of an owner
• provides the deceased owner's estate with a ready purchaser for the business interest.

A cross-purchase agreement helps to protect everyone's financial interests, business owners and heirs alike. And funding the agreement with life insurance helps to provide a secure foundation for the agreement.

How the Cross-Purchase Agreement Works
Assume Grant, Lee and Jackson are equal partners in a business with a total value of $450,000, which means each has an interest of $150,000. Under a cross-purchase agreement, agreements are made that at the death of any partner, the other two will purchase his or her interest from the estate.

In our example, Grant and Lee would each purchase a $75,000 face amount policy on the life of Jackson. The total insurance in force on Jackson's life, then, is $150,000—enough to purchase his or her business interest. Similar arrangements are made for each partner.
With a cross-purchase agreement, the individual owners own the policies, pay the premiums, and are named beneficiaries, e.g., Jackson is the insured and Grant is the owner and beneficiary. At the death of one owner, the surviving owners receive the insurance proceeds and use them to purchase the deceased owner's interest from his or her estate.

In the example, if Jackson dies, Grant and Lee each pay $75,000 to complete the buy-sell agreement. Then Grant and Lee each own one-half of the business.

What Is a Nonqualified Deferred Compensation Arrangement?
"Nonqualified deferred compensation" is a compensation arrangement established by employers to provide retirement income and perhaps death and disability benefits to a select employee or a select group of highly compensated employees (or, in some cases, independent contractors). The arrangement is a contractual commitment between an employer and the participant that specifies when and under what circumstances future compensation will be paid. When properly arranged and administered, the participant (or the participant's beneficiary) can postpone federal income taxation of the deferred amounts until benefits are paid. A nonqualified deferred compensation arrangement is to be distinguished from a qualified deferred compensation plan, which refers to a pension, profit sharing, or stock bonus plan (and all the various permutations thereof) that meets the qualification requirements of Code Section 401(a) and whose assets are held in a tax-exempt trust under Code Section 501(a) or in life insurance and/or annuity contracts pursuant to Code Section 403(a).

Nonqualified deferred compensation arrangements do not have to be pre-approved by the IRS nor are they generally subject to the qualification requirements applicable to qualified retirement plans. Unlike the participation and eligibility requirements for qualified plans, employers can discriminate in favor of selected employees. Also, when properly arranged, nonqualified deferred compensation arrangements are exempt from the regulatory requirements of ERISA Title I.

A nonqualified deferred compensation arrangement may provide that an employee will receive a stipulated sum for a fixed period of time (or for life) beginning at the employee's retirement or some other specified trigger date. This is a "defined benefit" type of arrangement. The amounts deferred for the employee's benefit may also be specified in "defined contribution" terms. If an employee dies after payments have begun, the arrangement often directs that the remaining benefits be paid to a designated beneficiary or to the participant's estate.

The arrangement may provide that the employee will receive future compensation as a result of a current salary reduction or in lieu of a bonus or salary increase. This is the traditional or "true deferral" deferred compensation arrangement. In more recent times, another alternative emerged: the salary continuation arrangement. Here, the employer commits to pay future compensation in addition to current earnings, which are not reduced by participation in the arrangement. The family name, "nonqualified deferred compensation," is often used generically to describe a variety of arrangements.

Suitability
Providing compensation and benefits to owner-employees, key executives and other highly skilled people is a continuing concern to businesses large and small. However, the increasingly restrictive regulatory environment imposed on qualified retirement plans, when coupled with costs of plan administration, anti-discrimination rules and caps on contributions and benefits, have made executive benefit planning through nonqualified arrangements more attractive.

Deferred compensation arrangements fill this need by providing employers with a nonqualified planning tool that rewards selected participants by helping them create financial security for retirement, death and/or disability. A nonqualified arrangement may be used as a supplement to, or as a substitute for, a qualified retirement plan.
Deferred compensation is most useful when the following positive indicators are present:
• the employer is a stable profitable business with good cash flow,
• the employer wishes to benefit a select group of management or highly compensated employees,
• the owner-employee of a business that is structured as a C corporation wants to improve his/her own compensation and benefits package and the owner-employee is in a higher tax bracket than the corporation,
• the employer has a need to attract, retain, or reward one or more key employees,
• the participating employee is "maxed out" on contributions or benefits under the employer's qualified plan;
• the employer has no qualified retirement plan in place and does not want to establish one.

Why Deferred Compensation?
A nonqualified deferred compensation arrangement can provide business owners with the kind of flexibility that is unavailable with a qualified retirement plan. With nonqualified deferred compensation, the business can cover "top-hat" employees on a pick-and-choose basis without fear of running afoul of anti-discrimination rules or IRC Section 415 ceilings on contributions and benefits under qualified plans.

Employers can provide generous benefits to select, key-executive employees, including a different level of benefits for different employees. No government-imposed minimum vesting or funding standards apply, and the arrangement can be customized to suit many individual fact situations. Paperwork and administrative costs can be kept to a minimum.

What Is an Executive Bonus Arrangement?
In an executive bonus arrangement, the employer pays a bonus each year to selected employees, typically either in cash or in the form of premiums on life insurance or disability policies on their lives. The plan is completely discriminatory in that the employer can pick and chose who will participate in the program and at what level they will participate. This is not the same as key employee insurance, which is intended to protect the business from losses resulting from the employee's death. Rather, it is employer-financed personal life and disability insurance intended to benefit the selected employee.

The employee usually applies for and owns the policy, naming someone other than the employer as beneficiary. The bonus or premium is declared as additional compensation on the employee's W-2. The annual taxes on this bonus are, in some cases, funded by an additional cash bonus to the employee (commonly referred to as a double bonus plan). Eventually, the policy's annual cash value increase will exceed the tax on the bonus and may be borrowed or withdrawn to pay taxes. Policy loans or withdrawals will, of course, reduce the death benefit and may have tax consequences.

The executive bonus arrangement, sometimes also called a Section 162 arrangement, which refers to the tax code that governs the concept.

Since the bonus is taxed as additional compensation to the employee, it is deductible in the year paid by the employer provided it qualifies as reasonable compensation to the employee.

As with other life insurance, the death proceeds usually will be received income tax-free by the employee's personal beneficiary under IRC Sec. 101(a). Disability insurance benefits generally will also be received income tax-free by the employee.

The employer selects the employee(s) it wishes to benefit and pays tax-deductible premiums (or a cash bonus) for a policy on the employee's life or disability insurance.

The employee reports the premium (or bonus) as compensation each year for income tax purposes.