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Employer-financed life insurance

Employer-financed life insurance is an equity collateral assignment split-dollar strategy that allows a business to provide life insurance for an owner, key executive or other key employee.

Although the employee owns the policy, the business pays the premiums as a loan to the employee. The policy is assigned to the employer as collateral for the loaned premium, and the executive names a beneficiary of the policy’s tax-free death benefit.

There are two possible tax methods that can be used with employer-financed life insurance:

  • If the economic benefit method of taxation is used, the business receives a portion of the death benefit equal to the greater of the cash value of the contract or the business’s premiums paid.
  • If the loan method is used, a portion of the death benefit equal to the premiums loaned or cash surrender value is paid to the business.

Why choose employer-financed life insurance

Target employer

Most employer-financed life insurance arrangements are provided for the key employees or business owners who need survivor income or other life insurance coverage, or have an estate tax problem.

Employer-financed life insurance may be sought by a company that:

  • Wants to reward a key executive who has an estate tax problem
  • Wants to recover cost eventually
  • Does not need an income tax deduction

Target employee

  • Can be an owner or key executive
  • Needs life insurance
  • May have need to exclude death benefit from estate

Features

Employer

  • Employee owns the policy
  • Flexible and minimal administrative costs
  • Company can select employees it wants to reward

Employee

Affordable death benefit coverage for employee

  • Death benefit paid to insured’s beneficiary income tax-free
  • Ability to exclude death benefit from estate with proper planning

How employer-financed life insurance works

The policy is collaterally assigned to the business to secure its interest in the policy.

The amount assigned to the business depends on which tax method is used for the arrangement.

  • If the loan method is used, a portion of the death benefit equal to the premiums loaned or cash surrender value is paid to the business.
  • The company loans money to an executive to pay premium on a permanent life insurance policy, which accumulates cash value.
  • The executive purchases a policy. Working with a licensed attorney, a split-dollar agreement is established that collaterally assigns a portion of the death benefit to the company.
  • The executive names a beneficiary.
Employer financed life insurance

 

At rollout or at the executive’s death, the company receives a portion of the policy’s cash value equal to the premiums paid, plus interest. The executive or the executive’s family receive the balance of the policy’s death benefit or cash value.

Employer financed split-dollar taxation

Key employee income taxes

  • Any interest paid to the business by the key employee or the trust for the loaned premiums is not deductible to the key employee.
  • If the interest due is not paid to the business, the interest amount is deemed income taxable to the key employee.
  • If the split-dollar agreement is terminated, the key employee or trust must pay back premiums paid or any other outstanding loan amount.
  • The death benefit paid to the insured’s chosen family member is income tax-free.

Employer income taxes

  • The business cannot income tax deduct the premiums paid.
  • If the business is a flow-through tax entity such as a partnership, S corporation or LLC, the owners of the business are taxed on their pro-rata share of the nondeductible premium.
  • Any interest paid to the business for the loaned premiums is taxable to the business.

Employer-financed life insurance benefits and considerations

Benefits

Employer
  • Employee owns the policy
  • Flexible and minimal administrative costs
  • Company can select employees it wants to reward
Employee
  • Affordable death benefit coverage for employee
  • Death benefit paid to insured’s beneficiary income tax-free
  • Ability to exclude death benefit from estate with proper planning

Considerations

Employer
  • No income tax deduction for premium payments
  • Special issues for flow-through tax entities (LLCs, partnerships, etc.)
  • Costs may not be fully recovered
  • Attorney fees for drafting agreement
  • Any interest paid to company for loaned premium is taxable to company
Employee
  • Taxed annually; method depends on type of taxation option chosen (loan or economic benefit)
  • Must be acceptable underwriting risk
  • Death proceeds may be included in estate
  • Subject to employer’s creditors

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Life insurance products contain fees, such as mortality and expense charges, (which may increase over time) and may contain restrictions, such as surrender periods.

Please keep in mind that the primary reason for purchasing life insurance is the death benefit.

Additional agreements may be available. Agreements may be subject to additional costs and restrictions. Agreements may not be available in all states or may exist under a different name in various states and may not be available in combination with other agreements.

Policy loans and withdrawals may create an adverse tax result in the event of lapse or policy surrender and will reduce both the surrender value and death benefit. Withdrawals may be subject to taxation within the first fifteen years of the contract. Clients should consult their tax advisor when considering taking a policy loan or withdrawal.

The Policy Design chosen may impact the tax status of the policy. If too much premium is paid, the policy could become a modified endowment contract (MEC). Distributions from a MEC may be taxable and if the taxpayer is under the age of 59 ½ may also be subject to an additional 10% penalty tax.    

An annuity is intended to be a long-term, tax-deferred retirement vehicle. Earnings are taxable as ordinary income when distributed, and if withdrawn before age 59½, may be subject to a 10% federal tax penalty. If the annuity will fund an IRA or other tax qualified plan, the tax deferral feature offers no additional value. Qualified distributions from a Roth IRA are generally excluded from gross income, but taxes and penalties may apply to non-qualified distributions. Please consult a tax advisor for specific information. There are charges and expenses associated with annuities, such as surrender charges (deferred sales charges) for early withdrawals.

This information may contain a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.

For financial professional use only. Not for use with the public. This material may not be reproduced in any form where it is accessible to the general public.

DOFU 9-2022

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