Making Heads Or Tails Of Executive Benefits

A simple coin toss is the most popular form of settling disputes or making decisions.  Subterfuge is often used to improve a participant’s odds.  If the caller sees through the “heads-I-win/tails-you-lose” ploy then the flipper can introduce a GMO known as a two-headed coin, usually a Washington quarter, available for a few bucks at any novelty store.

All this to illustrate that, for all the similarity of circumstances that the obverse and the reverse have on the dime, they can dictate significantly diverse patterns of events.  We use the phrase two sides of the same coin to describe the different, but closely related features, of an idea or course of action.  And so it is with certain non-qualified executive benefits.

All employers want economical ways to keep their key people.  You make your coin by helping them decide which side of the opportunities available best meet their needs and goals.

An Executive Bonus plan (EB) is the most common selective benefit format in the business marketplace, and a Death-Benefit-Only Plan (DBO) is the most overlooked.  Both have as their primary purpose to keep a key person with the company by providing life insurance protection.

Their primary difference is the amount of control the employer has – should the executive choose to leave.  Both are easy to explain, implement and administer.

With an EB plan, simply put, the employer pays for the executive’s personal insurance coverage.  In a DBO plan the employer promises to pay a benefit to a named beneficiary if the executive dies while employed, then buys a company-owned policy to fund against the contingency.  In either case the vehicle can be a permanent or term product.

Often with a DBO the employer chooses to roll the policy out to the executive at the time of retirement.  Even with term coverage the conversion privileges can make the transfer attractive if the executive has had health issues.

Consider the different sides of this coin:


Executive Bonus

Death Benefit Only

Policy Owner Executive Employer
Premiums Paid By Employer Employer
Taxation of Premiums Deductible to EmployerTaxable to Executive Not Deductible to EmployerNot Recognizable to Executive
Taxation of Death Benefit During Employment Tax-free to Executive’s BeneficiaryEmployer Not Involved Tax-free to EmployerDeductible When Paid to BeneficiaryTaxable to Beneficiary
Death Benefit After Employment Same – Executive Owns the Policy No Benefit to BeneficiaryEmployer Still Owns the Policy

Call to talk about executive benefits in particular and business planning issues in general that you should be discussing with every business client and prospect you have.

Executive Benefit Opportunities:

For what it’s worth – the simplest of all Super Bowl wagers made by bettors is on the outcome of the opening coin toss.  Those who prefer the NFC did well around and after the turn of the century.  The senior conference won the toss from 1999-2012 defying the odds (going in) of 16,384:1.

Policy Valuation: How Much Are You Worth?

A bidder at an auction purchased a Stradivarius and a Rembrandt for what he felt was an unbelievably low price.  He took them to an appraiser to see if they were authentic.  The appraiser informed him, “Yes, they are authentic. It’s just a shame that Stradivarius couldn’t paint and that Rembrandt didn’t know beans about making a violin.”

The common legal definition for fair market value of an asset is the price on which a seller and a buyer can agree, neither being under any constraint and both being aware of all the circumstances.  Simple enough.  So why is there so much confusion with regard to valuation of an inforce life insurance policy?

The need for a reliable value occurs often in the business, estate and financial planning process.  And by “reliable” we mean one that the IRS will find acceptable, because usually the value is needed to calculate the tax consequences at the time of an ownership change.

The reason the IRS takes such an interest with life policies is, probably, because most transactions don’t involve parties whose opposing interests are characterized by a level of dynamic tension that will necessarily result in a fair and final value.

Consider This:
  • An employer distributing a business-owned contract to an employee-insured (e.g. distribution of a key person policy at retirement) may appreciate the corresponding business deduction, but probably would be happy to undervalue it to augment the benefit to a long-time employee by decreasing the amount he or she must recognize as income.
  • When a policy is distributed from a qualified plan, the stated value matters not at all to the plan trustee.  But to the participant who must recognize the value as income (perhaps even with a 10% tax penalty) the lower the valuation, unrealistically or not, the better.
  • In a gifting situation the transferor of a policy is of a donative mindset anyway, so a lower value doesn’t reduce anything he or she might have received in return, except the size of a gift tax bill.  So the lower the better, again realistically or not.

The difficulty is that neither Congress nor the IRS nor the courts have put together a reliable set of laws, regulations and rulings that allow for easy or certain valuation of a policy.  Taxpayers must deal with a hodge-podge of criteria that vary with circumstances and with interpretation of the facts.

The good news for the insurance advisor is – it is not your responsibility to determine value, nor should you try.  Rendering an opinion is outside the scope of your legitimate professional activity.  The best you can, and should, do is offer to request from the carrier their “Form 712” valuations used by an executor in determining a policy’s value in an owner’s estate.  You will get back one or more numbers.

The most common is the interpolated terminal reserve, but many will also include: accumulated cash value, PERC value, premiums paid, cash surrender value, tax reserve, statutory reserve, etc.  Provide it to the attorney, CPA or appraiser to assist in their valuation.  You’ve done all you can and more than most would.

There is another story of an auctioneer who was interrupted when his clerk handed him a note.  Reading it the auctioneer announced, “A gentleman has lost a wallet containing $500 in cash.  If it is returned, he will pay a reward of $100.” After a moment someone in the audience shouted, “$150!”

Call with any questions concerning policy valuation.  We will make it worth your while.

Policy Conversions & Ownership Transfers: All Things In Good Order

It was an eye-opener the first time I walked into the office of a civil engineer back in the 1970s and saw, spread across an entire wall, the flowchart mapping out the relationship and time sequence of all that was involved in getting an eight-story building there in the Burg from ground-breaking to grand-opening.

The complexity of the diagram was a mind boggle of boxes at several levels top to bottom, each containing a task that demanded completion before progression on the line to the next box was possible.

As we sit comfortably in the air-conditioned result of a similar building plan, the ease with which we can turn a tap or flip a switch seldom causes us to pause and think of all that got us there.

The order of things is essential.  The correct order is critical.  Fortunately the order and timing of insurance conversions and ownership transfers is less complicated.

A common planning scenario involves a personally-owned term policy where conversion is considered because of a decline in the health.  The goal is to transfer the policy to an irrevocable trust either to protect the death benefit from estate taxes, creditors or spendthrift heirs – or any combination of the three!

The issue at hand is whether to convert before or after the transfer of the policy to the trust

The answer will probably turn on the “best” fair market value for the contract.

Most advisors will probably choose to determine that the FMV of the term policy is its interpolated terminal reserve.  Level term products do have a reserve to offset the “underpayment” of premium in the later years when the insured is older, but the premiums remain the same.  On the other hand most advisors will determine that the FMV of the new permanent policy (in its first contract year) as premiums paid.  Usually the advisor will opt for the lower of the two.

If the policy is to be gifted to the trust the lower FMV could keep the gift within sum of the available annual exclusions (usually $14,000 per trust beneficiary) to avoid the need to file a gift tax return.

If the policy is to be sold to a grantor trust (to avoid the three-year look-back), the lower FMV will require that less cash be gifted to the trust to be used by the trustee to purchase the policy from the insured/grantor.

Call us when client planning involves the combined issues of policy conversion and ownership transfer.  We will assist in getting the information for determining the FMV of both policies and will assist legal and tax counsel with the information they need to properly order the transactions.

Back to the 70s – before the eight-story was completed I had gotten to know many of the workers at the job-site.  They complained that working construction was too much like Christmas Day.  They did all the work only to have some fat guy in a suit get all the credit.

Coordinating Your Financial Underwriting

It is the bane of high school mathematics students and a fixture in sidebars illustrating data discussed in a newspaper, magazine or website article: the basic X-Y coordinate graph.

And two coordinates come into play when financially justifying an amount of life insurance coverage applied for.  (The X-Y graph example doesn’t really serve as a good illustration of how they interact in affecting a carrier’s decision, but graphs were the subject with which I wanted to open, so that’s that.)

Basically an underwriter is concerned about two numbers: how much is being applied for and how much is it going to cost.

Amount of Coverage

This speaks to the carrier concern about a person having too much life insurance (a concept hard to accept for a lady-friend of my wife and me who contends that you can never be too thin, never have too many silk dresses, never have too much money, and never get too much Oprah Winfrey).  The carrier doesn’t want your client worth more dead than alive.  The actuarial numbers bear out that people with too much insurance have shorter life expectantcies.

Acceptable Amounts of Coverage Vary Based on Need

The most common need is replacement of income lost to dependents when the breadwinner dies prematurely.  Appropriate amounts are usually determined by a formula based on the age of the insured and annual earned compensation.

Amount of Premium

Carriers don’t want insureds spending so much on coverage that it doesn’t leave enough for living expenses.  Absent adequate justification otherwise the limit allowed for premium expenditure is usually 20% of annual income, sometimes adjusted down by the carrier for certain factors.  This concern seldom comes into play at younger ages, because even when large amounts of coverage are purchased it is term insurance and the cost seldom approaches an unacceptable level.

Both often come into play when an insured reaches age 70-1/2 and wants to begin using RMDs from qualified assets to purchase coverage to create a greater legacy for heirs.  There is no earned income to justify coverage.  Most carriers will allow insurance based on a percentage of net worth and then determine that the RMDs are not needed for living expenses by applying a percentage of income formula.

Call with any financial underwriting questions you have, especially when the coverage is for business needs or anticipated estate taxes at death.

By the way, I caught a movie the other night entitled The X=Y Graph.  The plot was predictable and flat, but the special f(x) were good.

Unlock More Key-Person Coverage

Real old-timers remember the days of one of comedy’s iconic duos, the husband and wife team of George Burns and Gracie Allen.  Any younger connoisseurs of good humor would do well to spend some online-time calling up at least some of their radio, television, and cinema work-product on YouTube or some other source.  But search engines didn’t help me uncover one famous routine, so I will paraphrase:

Gracie: Did you hear that my friend got hit by a car that didn’t have its headlights on?
George: That’s awful! Why didn’t the driver bother to use the headlights?
Gracie: Because it wasn’t dark yet!

Knowing all the facts can certainly change the response to circumstances.

And so it is when talking to a business owner about how much company-owned coverage he or she can get on an important executive. Consider:

The standard key-person formula

Most carriers will allow a business to own coverage on an important executive in the amount of ten times his or her compensation package.  This includes not just W-2 salary, but also bonuses, cost of perks (e.g. club memberships), fringe benefit costs (e.g. health insurance, etc.), qualified retirement plan contributions, deferred compensation, as well as the use of a company car or other business assets.

Stretching the limits a bit

Some carriers will allow a larger multiple for financial justification.  But some might impose a lower multiple as well if it appears unlikely the executive will work for ten more years.  When owner-executives are involved a carrier may allow for part of the proposed insured’s Schedule K income to be taken into consideration.  If the proposed insured is being awarded ownership interests, the value of those interests might be treated as compensation.

Debt can help

Some carriers will allow additional coverage based on a percentage of the company’s longer-term obligations to financial institutions if it can be shown that loss of the executive will curtail the company’s ability to repay.  Sometimes the policy is initiated by a lender’s requirement, in which case the financial institution is secured through a collateral assignment.

Redemption obligations

A major reason a business may be economically burdened by the death of an executive is the existence of an agreement to buy his or her ownership interest in the company from the surviving family.  The agreed purchase price can be added to the amount of coverage sought.  If no agreement exists this might open up a discussion of that planning need with the client.

Company-owned policies are often more easily placed because the limited time for which coverage is needed (till the insured’s anticipated retirement or for the expected period of service) make economical term insurance a good product choice.

George Burns lost his show-biz and life partner in 1964.  His career continued after Gracie until he passed away 32 years later, just 49 days after his 100th birthday.  So we will end with the signature closing of Burns & Allen: George: Say good-night, Gracie. Gracie: Good-night, Gracie!