Advanced Markets

Business Analyzer

Choosing a Business Entity When working with business owners, it is important to consider the business structure in which the business operates in order to assess the suitable options available for executive benefits offerings. In particular, non-qualified benefit plans, including Supplemental Executive Retirement Plans (SERP), Non-qualified Personal Retirement Plans, 401(k) Mirror Plans, Split Dollar Arrangements and Section 162 Executive Bonus Plans can provide both business owners and executives a tax-favored retirement savings vehicle, potential creditor protection and estate planning benefits.

The Business Analyzer summarizes some of the more common types of business entities available followed by a decision matrix to help you narrow down which types of non-qualified benefit plans may work well based on business structure and planning objectives. This tool considers the owner’s personal tax bracket compared to the entity’s as well as the timing of deductions, and takes into account creditor protection and business transfer considerations for both a business owner and an executive.1

Simply put — the Business Analyzer tool is a starting point to help you consider the non-qualified plan options available to business owners and executives to fund their retirement and to address estate planning objectives.

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Part 1: Questions and Design Options for the Business Owner Question 1a: Is the life insurance or executive benefits intended for a business owner or a non-owner executive?  If business owner, go to Question 1b  If non-owner executive, go to Part 2

Design I: Personal Retirement Plan Typically used with sole proprietors, personal service corporations, and most S corporation or partnership owners. The design issue for this client becomes “what is the best after-tax planning vehicle available?” This may be a life insurance retirement plan, a deferred annuity, a traditional IRA or a Roth IRA.

Question 1b: What is the business

tax structure?  If Sole Proprietor, consider Design I: Personal

Retirement Plan  If Partnership, LLC, or S corporation, go to Question 1d  If C corporation, go to Question 1c

Design II: Split Dollar2 Provides needed life insurance coverage in situations where the corporate tax bracket is significantly lower than the business owner’s personal tax bracket. By paying the life insurance premiums in the lower corporate bracket, and taxing the business owner on just the relatively small reportable economic benefit in his/her higher tax bracket, tax leverage can be gained.

Question 1c: What is the annual net

corporate profit of the company?  If under $75,000, go to Question 1e  If over $75,000, go to Question 1f  For personal service corporations (doctors, etc.),

go to Question 1f Question 1d: What is the ownership

percentage of the client?  If under 25%, go to Question 1g  If over 25%, consider Design I: Personal

Retirement Plan Question 1e: What is the personal tax bracket of the business owner?  If over 28%, go to Question 1g  If under 28%, consider Design I: Personal

Retirement Plan Question 1f: What is the personal tax bracket

of the business owner?  If under 34%, consider Design III: Bonus Plan  If over 34%, consider Design I: Personal

Retirement Plan Question 1g: What is the purpose of the life insurance or executive benefit?  If the need is primarily for death benefits,

consider Design II: Split Dollar  If the need is for retirement accumulation, go to Question 1h

Design III: Bonus Plan Helps fund personal life insurance for either death benefit or retirement accumulation needs, or other tax-favored vehicles like a deferred annuity. It is used in those situations where the business owner’s personal tax bracket is equal to or lower than the corporate bracket. This could occur in personal service corporations, high-net-profit corporations, or where the business owner has a low tax bracket due to other write offs or charitable gifts. By taking an income tax deduction in the higher corporate tax bracket and taxing the owner in his/her lower personal bracket, tax leverage can be gained. Taking a bonus also eliminates possible double taxation in the future, which would occur when money is left in the corporation.

Design IV: Deferred Compensation Typically used with non-owner executives but can be used with business owners in situations where the personal tax bracket is higher than the corporate bracket and the business owner is not a majority owner. By leaving money in the lower corporate bracket, higher personal taxes can be delayed until a later date such as retirement. Deferred compensation is not recommended for majority corporate owners whether tax leverage can be gained or not. This design can also be used with S corporation or partnership owners who have a very small ownership percentage of the business. However, given the pass-through nature of S corporations and partnerships, owners pay tax on profits whether they leave them in the company or take them out. Consequently, deferred compensation provides no tax advantage. However, if the owner holds only a small percentage of the company, some of the personal tax can be deferred, and the money will be taxed to the other owners.

Question 1h: What is the ownership percentage of the client?  If under 50%, consider Design IV: Deferred

Compensation  If over 50%, consider Design III: Bonus Plan Page 3 of 8. Not valid without all pages.

Part 2: Questions and Design Options for Non-Owner Executives Question 2a: Who is going to be included in the executive benefit plan?  If only the top executives in the company,

go to Question 2b  If a broader group of employees than the top executives, go to Question 2f Question 2b: What is the financial stability

of the company?  If strong, go to Question 2c  If company is new, or not in good financial

condition, go to Question 2f Question 2c: Where are the benefit funds

going to come from?  If from the employee, consider Design I:

Voluntary Deferral Plan  If from the employer, go to Question 2d  If from both, consider Design III: 401(k) Mirror Plan Question 2d: Are golden handcuffs an important design component for the employer?  If yes, go to Question 2e  If no, consider Design V: Executive Bonus Plan

Question 2e: Is a current tax deduction

important to the employer?  If yes, consider Design IV: Restricted Executive

Bonus Arrangement (REBA)  If no, consider Design II: Supplemental Executive Retirement Plan (SERP) Question 2f: Is a current tax deduction

important to the employer?  If yes, go to Question 2g  If no, go to Question 2h

Question 2g: Are golden handcuffs an important design component for the employer?  If yes, consider Design IV: Restricted Executive

Bonus Arrangement (REBA)  If no, consider Design V: Executive Bonus Plan

Question 2h: Is life insurance the desired benefit?

Design I: Voluntary Deferral Plan Here, the executive agrees to defer a portion of his/her salary on a pre-tax basis. Typically in this design the executive is making the maximum deferral to his/her 401(k) plan but would like to defer more. The money put aside in the Voluntary Deferral Plan is not taxed to the executive until it is paid out to him/her. Also, the employer does not get a tax deduction until the employee is taxed. Consequently the employer has a delayed tax deduction. One important issue for the executive is that the deferred compensation benefits payable by the employer are subject to attachment by the employer’s creditors. Therefore, if the employer becomes insolvent, the employee could lose his/her benefits. All forms of deferred compensation plans can only be offered to the very top executives in the company (also referred to as a Top Hat Plan).

Design II: Supplemental Executive Retirement Plan (SERP) A SERP is very similar to the Voluntary Deferral Plan. The significant difference is that instead of the employee, the employer is contributing the money to the plan. Since it is employer contributions, there is normally some sort of vesting schedule attached to the plan. The employer can select any vesting schedule desired, and the plan payments can be based on either a defined benefit or a defined contribution. The tax treatment for the employee and employer is identical to the voluntary deferral plan, as is the risk that the employee could lose this money if the company becomes insolvent.

Design III: 401(k) Mirror Plan In the 401(k) Mirror Plan, the employee agrees to voluntarily defer some salary and the employer makes some sort of matching contribution. The employer can determine what the match is and when it becomes vested. All of the tax and insolvency issues that apply to a Voluntary Deferral or Restricted Executive Bonus Plan also apply to a 401(k) Mirror Plan.

Design IV: Restricted Executive Bonus Arrangement (REBA) A life insurance plan that should allow the employer to take up-front deductions for the bonuses while putting a restriction on the employee’s access to the cash value in the life insurance policy. The Restricted Bonus does not provide a true handcuff since the cash values of the policy can never revert back to the employer. If the employee forfeits access to the cash value, the money stays in the policy to provide continuing death benefit protection. The employee’s access to the policy cash values can be arranged on a graded or vesting schedule. Once vested, the restriction is removed and the employee can use the policy cash values for supplemental retirement or other purposes.3

Design V: Executive Bonus Plan A Bonus Plan helps fund personal life insurance for either death benefit or retirement accumulation needs or could fund other tax-favored vehicles like a deferred annuity or Roth IRA. The Executive Bonus has the advantages of a current up-front deduction for the employer, and can be offered to employees below the top executive level. The employee pays tax on the bonus, though the employer may “gross up” the bonus with an additional amount to cover the tax. The drawback for the employer is that there is no handcuff on the money bonused to the employee.

 If yes, consider Design VI: Split Dollar

Design VI: Split Dollar2

 If no, consider Design V: Executive Bonus Plan

Split Dollar can be used in situations where the desired benefit is additional life insurance coverage for the executive. Split Dollar can be offered to both the top executives and non-top executives without ERISA implications. Split Dollar can also be used as an additional benefit when life insurance is purchased to fund deferred compensation plans. Page 4 of 8. Not valid without all pages.

Check out some of the more common types of business entities. Business Entities Comparison Chart

Sole Proprietorship

General Partnership

Limited Partnership

C Corporation

S Corporation

LLC

Professional Corporation

Business Owned By

Sole proprietor

Partners

Partners

Shareholders

Shareholders

Members

Shareholders

Number of Owners

One

One to unlimited

One general & one limited partner minimum

One to unlimited

1 to 100

One to unlimited

One to unlimited

Liability Protection?

No

No

Yes for limited partners

Yes

Yes

Yes

Yes (except for professionals’ own malpractice)

Management Made by sole Decisions proprietor

Made by partners

Made only by general partners

Made by Board of Made by Board Directors of Directors

Made by members Made by Board unless LLC elects of Directors manager to manage

Transfer of Ownership

Easy

Consent of all partners usually required by agreement

Consent of all partners usually required by agreement

By stock transfer (securities law may limit)

By stock transfer (securities law may limit)

Consent of all members usually required by agreement

Tax Treatment

Disregarded Paid by partners entity – all income, unless corporate etc., recognized on tax status elected sole proprietor’s individual income tax return

Passed through and paid by shareholders

Paid by members Paid by unless corporate corporation – tax status elected 35% flat tax

Paid by partners Paid by unless corporate corporation tax status elected

By stock transfers – transfers generally restricted to persons providing professional services

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Tax and ERISA Consequences The possible application of the Employee Retirement Income Security Act (ERISA) should be considered for all non-qualified executive benefit plans, including a SERP. In most instances, a SERP may be exempt from most ERISA requirements as a “top hat” plan. A plan may qualify as a top hat plan if it is created for the purpose of providing deferred compensation for select management or highly compensated employees. A top hat plan must be in writing and a written plan document must be filed with the Department of Labor within 120 days. Qualification of a SERP as a top hat plan must be considered on a case-by-case basis. In addition to ERISA considerations, Section 409A of the Internal Revenue Code can apply to any nonqualified plan that provides for the deferral of compensation. If a Deferred Compensation Plan does not comply with Section 409A, participant(s) income may be subject to immediate income taxation, as well as interest and a 20% excise tax on the taxable income.

Section 101(j) of the tax code (also known as COLI Best Practices) can also apply to a SERP and unless all of the requirements of Section 101(j) for an employerowned life insurance policy are met, a portion of the death benefit may be subject to income tax. Employer-owned life insurance taxation Section 101(j) of the Internal Revenue Code may impose income tax on the death benefit of life insurance contracts owned by the employer of the life insured unless certain exceptions apply. All such exceptions include satisfaction of notice and consent requirements set forth in the section. See IRS Notice 2009-48 for further clarification. Tax Law Considerations The design options listed are based on current tax laws. Clients should consult their own tax advisors to address their particular situation and the tax laws that may apply at that time.

For more information about the Business Analyzer, contact the Advanced Markets Group at 888-266-7498.

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Common Business Entities Sole Proprietorship A sole proprietorship is created when one person is engaged in business for himself or herself. The sole proprietor can engage employees to carry out the business but personally retains the profits and assumes the losses of the business. A sole proprietor is fully liable for all business obligations to the full extent of his or her personal as well as business assets. For tax purposes, a sole proprietorship is considered a disregarded entity and all tax passes through to the individual owner on his or her personal tax return. General Partnership (GP) A general partnership is an association of two or more persons (or entities) who carry on a business as co-owners. No special filings, certificates or documents need to be filed to form a general partnership, and, unless otherwise agreed, the control and management of the partnership is shared equally by all the partners. There is no liability protection for the partners in a general partnership; each partner is liable for the obligations of the partnership to the extent of his or her business and personal assets. The general partnership is a pass-through entity where all items of income, credit, deduction, gain and loss are passed through to the partners, unless the partnership elects to be treated as a corporation under the “check-thebox” regulations.4 Limited Partnership (LP)

These discounts can help to reduce estate, gift and income tax liability of the transferring partner and thus can be an excellent way for older generations to pass assets to the younger generation while enjoying impressive tax benefits. Corporation (C Corp or S Corp) A corporation is a type of business entity, created under the laws of the state in which it is incorporated, that offers its owners, known as shareholders, limited liability protection. If the corporation fails, shareholders typically are only liable to the extent of their investment in the company and are not personally liable for the debts and obligations of the corporation itself. Shareholders are the owners of the company and elect the board of directors, who in turn oversee and direct corporation affairs and decision-making, but are not responsible for day-to-day operations. The directors elect the officers to manage daily business affairs. For tax purposes, a corporation is automatically designated as a “C corporation” unless it elects to be treated as an “S corporation.”5 A C corporation is taxed first at the corporate level and again at the individual shareholder level when income is later distributed to the shareholders as dividends. If an election is made to treat a corporation as an S corporation, the profits and losses of the business skip the corporate-level tax and instead are “passed through” to the shareholders, similar to the taxation of partnerships.6

A limited partnership is a form of partnership that offers limited liability protection to the limited partners. This type of partnership is formed by two or more persons and requires that at least one person be a general partner and one be a limited partner. A general partner has the same liabilities as a partner in a general partnership while a limited partner is liable only to the extent of his business interest in the partnership. To preserve limited liability, a limited partner generally may not participate in the control or management of the partnership’s business.

C corporations have no restrictions on ownership, but S corporations do. S corporations are restricted to no more than 100 shareholders, and shareholders must be U.S. citizens/residents. S corporations cannot be owned by C corporations, other S corporations, LLCs, partnerships or many trusts. Also, S corporations can have only one class of stock (disregarding voting rights), while C corporations can have multiple classes.7

This type of entity is authorized by state statute and cannot be formed unless statutory requirements are satisfied. Failure to observe the appropriate formalities may result in the formation of a general partnership with general, rather than limited, liabilities for all partners. Like a general partnership, a limited partnership is a pass-through entity unless it elects to be treated otherwise.

An LLC is a business entity permitted by state law that combines characteristics of both the partnership and corporate structures. Like a corporation, an LLC offers its owners, referred to as “members,” limited personal liability for the debts and actions of the LLC. For tax purposes, however, an LLC is automatically taxed as a pass-through entity, like a partnership or sole proprietorship, unless the members specifically elect to have it taxed as a corporation.8

Given the lack of control and management ability of the limited partners, interests in LPs may qualify for a lack-of-control discount when determining the value of an LP interest for transfer purposes. Family Limited Partnership (FLP) A Family Limited Partnership is merely a planning term used for a limited partnership that is restricted to family members and which generally holds family investments and/or business interests. Because ownership of an FLP is limited to family members and generally cannot be transferred to individuals outside the family, interests in an FLP may receive a lack-of-marketability discount in addition to the lack-of-control discount commonly used with LPs. A lack-of-marketability discount may apply in valuing an FLP interest because the transfer restrictions placed on the FLP make the interests less marketable than an LP interest without any such restrictions.

Limited Liability Companies (LLC)

The LLC is a popular choice of business entity because of its simplicity and increased management flexibility as compared to a corporation, which governs through a Board of Directors. Members of an LLC can choose to share management equally among the members or can appoint one or more managers to manage the business. Moreover, the use of an LLC provides liability protection without necessitating a general partner as compared to the use of limited partnerships. Many states now permit a single member LLC, which is taxed as a sole proprietor (a single level of tax) but the individual member enjoys limited liability. Similar to LPs and FLPs, discounts may be available to reduce the value of a transferred interest in a LLC.

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Common Business Entities (continued) Limited Liability Partnership (LLP)

Professional Corporation (P.C.)

A limited liability partnership is another type of partnership that provides all of its owners with limited personal liability. The partners of this type of entity are generally not personally liable for the debts, liabilities or obligations of the partnership, but remain personally liable for their own negligence, wrongful acts, errors, or omissions. An LLP is distinct from limited partnerships in that limited liability is granted to all partners and not just to a subset of “limited partners.”In addition, all partners of an LLP may take an active role in the management of the partnership as opposed to limited partners in an LP.

A professional corporation is a type of corporation authorized by state law for a particular group of licensed professionals, including, but not limited to, lawyers, doctors, accountants and architects.10 Unlike a traditional corporation where shareholders and officers are generally free from personal liability, a professional corporation does not protect a shareholder from personal liability associated with his or her own negligence or malpractice. Other shareholders of a P.C., however, are protected from the negligent actions of another.

Limited Liability Partnerships are particularly well suited to professional groups, such as lawyers and accountants, because of the liability protection afforded from another partners’ negligence or malpractice. In fact, in some states LLPs are only available to certain professionals.9

A professional corporation is generally taxed as a “qualified personal service corporation,” which requires a 35% flat tax rate at the corporate level. In some states, limited liability partnerships and/or limited liability companies may offer the same benefit as a professional corporation.

Similar to limited partnerships and limited liability companies, a limited liability partnership is sanctioned by state statute and all requirements and formalities must be adhered to.

1. This tool does not consider the effect that the Alternative Minimum Tax (AMT) may have on the owner’s personal tax liability nor the entity’s tax liability. 2. Sarbanes-Oxley Act of 2002 (the “Act”) may prohibit a publicly traded corporation from entering into a Split Dollar Arrangement or 7872 loan with a Director or executive officer. Tax counsel should be consulted to determine whether the Act is applicable to a particular case. 3. Loans and withdrawals will reduce the death benefit, cash surrender value, and may cause the policy to lapse. Lapse or surrender of a policy with a loan may cause the recognition of taxable income. Policies classified as modified endowment contracts may be subject to tax when a loan or withdrawal is made. A federal tax penalty of 10% may also apply if the loan or withdrawal is taken prior to age 59½. Cash value available for loans and withdrawals may be more or less than originally invested. 4. See Treas. Reg. §301.7701-3(b). 5. IRC §1361(a). 6. IRC §1363. 7. IRC §1361(b). 8. Treas. Reg. §301.7701-3(b). 9. For example, in California an LLP is limited to persons who are licensed to practice in the fields of public accountancy, law, architecture, engineering and land surveying. See Cal. Corp. Code §16101. 10. The ability to form a P.C. is determined by individual states, and states determine which professionals may form professional corporations in their state. For agent use only. This material may not be used with the public. This material does not constitute tax, legal or accounting advice and neither John Hancock nor any of its agents, employees or registered representatives are in the business of offering such advice. It was not intended or written for use and cannot be used by any taxpayer for the purpose of avoiding any IRS penalty. It was written to support the marketing of the transactions or topics it addresses. Comments on taxation are based on John Hancock’s understanding of current tax law, which is subject to change. Anyone interested in these transactions or topics should seek advice based on his or her particular circumstances from independent professional advisors. Insurance products are issued by John Hancock Life Insurance Company (U.S.A.), Boston, MA 02116 (not licensed in New York) and John Hancock Life Insurance Company of New York, Valhalla, NY 10595. IM6084 10/11 MLINY10031115668

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