Insurance benefits: Large tax exposure may require creative retirement solutions

By Bert Livingston    

Most small business owners and professionals are familiar with group term life insurance programs—particularly those that offer up to $50,000 of term life insurance to employees.

These programs, sanctioned by Section 79 of the Internal Revenue Code, also permit employers to provide additional amounts of term life insurance in excess of $50,000 to employees. To the extent that they do so, the employer must report the value of the excess coverage in the employee’s W-2 as additional compensation.

The value of this coverage for tax reporting purposes is determined under Table I of the Treasury Regulations, in the form of uniform premiums computed on the basis of five-year age brackets. So long as the employer is not directly or indirectly a beneficiary of the insurance, all employer contributions to the plan are currently deductible and the employee not taxable on the first $50,000 of coverage.

Permanent benefits

What is less commonly known is the same Section 79 permits a group term insurance plan to provide permanent benefits. The regulations define a “permanent benefit” as “an economic value extending beyond one policy year (for example, a paid-up or cash surrender value) that is provided under a life insurance policy.”

When a Section 79 plan containing permanent benefits is adopted by an employer, there are several significant advantages:

•All contributions to the plan are currently deductible to the business;

•Only a portion of these amounts are includible in the participant’s income;

•Plan assets (in the form of life insurance policy cash values) accumulate tax-deferred;

•In the event of the participant’s death, an income tax-free survivor benefit is provided;

•Benefits can be structured to avoid estate taxes; and

•Once the plan is terminated, the participant has the option of receiving a tax-free income stream from the insurance policy to the extent of the policy’s cash value.

Determining eligibility

Section 79(d) does contain nondiscrimination rules as to eligibility and benefits. Certain types of employees can be excluded from consideration, such as employees who are covered by a collective bargaining agreement, employees who have not completed three years of service, and part-time (not more than 20 hours per week) or seasonal (not more than five months per calendar year) employees.

A plan is nondiscriminatory as to benefits if “the type and amount of benefits available under the plan do not discriminate in favor of participants who are key employees.” A well-designed plan requires that all eligible participants be offered the option to elect the same type of benefits offered to key employees (e.g., permanent benefits).

Such a plan will also require that all employees be offered a nondiscriminatory amount of benefits, by mandating that ALL participants shall be offered a life insurance in an amount that represents a uniform percentage or multiple of W-2 compensation.

Know the options

Because the options available to eligible employees that involve coverage in excess of $50,000 of term insurance will result in an increase in the employee’s gross income—and generally an increase in the employee’s income tax liability—employees are permitted to decline coverage in excess of $50,000.

Most employees accept the free (to them) $50,000 of group term life insurance and waive their right to higher amounts of insurance or permanent benefits.

Employees who do not elect to receive permanent benefits must include the value of the permanent benefits in their gross income, reduced by any amounts they contribute from their own funds for the permanent benefits.

The actuarial formula for calculating the value of permanent benefits is set forth in the Treasury Regulation under Section 79 of the Internal Revenue Code, and is based on such factors as the age of the employee and the type of insurance contract used. Only specially designed life insurance contracts will produce favorable tax results under this formula.

Is it for your business?

Section 79 plans are not for every business and your insurance professional will help you determine eligibility. But for those closely held businesses and professional practices where there is a fit, these plans provide an exciting, tax-advantaged opportunity for both owners and employees.

Bert Livingston is a financial advisor at National Financial Services Group with 30 years of experience in the financial services industry. He is a registered representative and investment adviser representative of Equity Services Inc. He can be contacted at 904-296-3300.

Disclaimer: This is not offered as tax or legal advice. For advice concerning your own situation, consult with an appropriate professional advisor. The views and information contained herein have been prepared independently of the presenting representative and are presented for informational purposes only. TC58753(0910)

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