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Loans and Life Insurance

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Table of Contents Below-Market Executive Loans ............................................................................................................................. 3 Executive Bonus (Section 162) Plans ....................................................................................................................6 Split Dollar Life Insurance, Including Nonqualified Deferred Compensation Plans ............................................... 8 Taxation of Split Dollar Arrangements ................................................................................................................... 11 Life Insurance as an Employee Benefit ................................................................................................................. 15

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Below-Market Executive Loans What is it? Below-market executive loans are loans a nonpublicly held company makes available to its executives as a supplement to their regular compensation. Typically, such loans are interest free or made at a favorable interest rate. In other words, these loans are provided at a rate of interest below the applicable federal rate (AFR), set monthly by the IRS. (The AFR is based on the average yield on U.S. Treasury obligations.) Caution: The Sarbanes-Oxley Act of 2002 (the Corporate Responsibility Act) was signed into law on July 30, 2002. This law prohibits publicly traded companies from making personal loans, directly or indirectly, to executive officers and directors. Civil and criminal penalties will be imposed for making such loans. Loans to executives of nonpublic companies are not prohibited by the act.

Background At one time, loans with below-market interest rates were a popular executive benefit. In 1984, however, Congress amended the tax laws to clarify that where a loan's interest is below the market rate (predetermined by the IRS monthly), interest is imputed under a series of rules. If an executive loan fails to provide for adequate interest, the loan is recharacterized as a two-step transaction in which the company is deemed to transfer additional compensation (or dividends) to the executive equaling the foregone loan interest for the period the loan is outstanding. The executive, in turn, is deemed to pay the foregone interest to the company. Executive loans are typically offered for the following: • Mortgage or "bridge" loans to help in the purchase of a home when the employee is moving from one of the employer's business locations to another • College or private school tuition for members of the executive's family • Purchase of the employer's stock through a company stock purchase plan or other method • Meeting extraordinary medical needs, tax bills, or other personal or family emergencies such as divorce settlement costs • Purchase of life insurance • Purchase of a car, vacation home, or other expensive item

When can it be used? Below-market executive loans are usually restricted by the employer to specified purposes (such as the ones listed previously). These loan programs can be very attractive as a compensation supplement to help executives meet cash needs in special situations. Employers can use these programs whenever they wish to help attract, motivate, and retain key employees and executives.

ERISA considerations The avoidance of substantial requirements under the Employee Retirement Income Security Act of 1974 (ERISA) is usually a prime concern to employers when designing compensation arrangements (and employee plans in particular). Fortunately, below-market executive loans do not appear to fall within the definition of either a "welfare benefit plan" or a "pension plan" for ERISA purposes. Therefore, ERISA requirements should not apply.

Strengths There are a number of advantages to below-market executive loans. These include the following:

Helps business to attract, motivate, and retain key employees A principal challenge to employers is to attract, motivate, and retain key employees (and executives in particular). These goals

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can be promoted by providing below-market executive loans because obtaining a loan at favorable or below-market rate is an unusual perk.

Avoids cumbersome Employee Retirement Income Security Act (ERISA) requirements and provides flexibility Because ERISA does not apply, executive loan programs do not need to comply with nondiscrimination rules. In other words, loans can be provided to selected groups of executives or even to a single executive. Moreover, the terms, amounts, and conditions of executive loans can be varied from one executive to another as the employer wishes.

Provides financial benefits to executives Below-market executive loans provide a valuable benefit to executives in that these loans make cash available where regular bank loans might be difficult to obtain. Furthermore, the loans are provided at a more favorable rate of interest.

Certain of these loans are exempt from the imputed interest rules Some below-market loans to executives are exempt from the normal imputed interest tax rules. These exclusions include the following: • De minimis loans aggregating less than $10,000. The below-market rules do not apply to a compensation-related loan if the aggregate loans outstanding between the company and the executive do not exceed $10,000 and the loans do not have tax avoidance as a principal purpose. A husband and wife are treated as one borrower for this purpose. • Low-interest loans without "significant tax effect" on the lender or borrower. A loan is exempt if the taxpayer can show that the interest arrangements will have no significant effect on any federal tax liability of the lender or borrower. The Internal Revenue Service will consider a number of factors here, including whether items of income and deduction generated by the loan offset each other. • Sometimes employers will provide loans to certain employees in order to enable them to purchase a principal residence at a new place of work. In such cases, the AFR for testing the loan will be the AFR as of the date the written contract to purchase the residence was entered into. Obviously, the topics discussed here are quite complicated; more detailed treatment is beyond the scope of this discussion. For more information, consult additional sources.

Tradeoffs Tax rules for these loans are complex The tax rules for below-market loans are complicated and confusing, which increases the administrative cost of the loan program for both employer and employee.

Tax treatment may be unfavorable to employee The tax treatment of term loans (as opposed to demand loans) is unfavorable--the employee must include a substantial portion of the loan in income immediately in some cases.

Employer must bear administrative costs and risk of default If the employee defaults, the employer will lose the money altogether or incur expenses to pursue foreclosure. Furthermore, the employer must bear the cost of administering the loan (for instance, by monitoring the payback).

How to do it Consult an attorney and accountant to set up the plan It is important to ensure that proper tax rules are understood and followed. An attorney will consider the goals of your business and your financial situation and advise you of the most advantageous compensation plan to adopt. In addition, it may be necessary to consult a certified public accountant to ensure that proper accounting methods are followed.

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Tax considerations Income Tax

If loan is a below-market demand loan Interest actually paid along with any interest deemed to be paid by the executive is taxable income to the company (lender) and is deductible by the borrower, subject to the usual limitations on interest deductions. For instance, if the loan qualifies as a home mortgage loan, the interest is fully deductible. If it is a personal loan not secured by a home mortgage, it is nondeductible. If no exception applies, the employer is treated as if it paid additional compensation to the employee in the amount of the difference between the actual rate of interest and the AFR. This additional compensation income is deductible by the employer and is taxable to the executive. The executive is treated as if he paid interest in the amount of the aforementioned additional compensation to the employer. This amount is additional taxable income to the employer. The amount is deductible by the executive, again under the usual limitations on interest deductibility.

If loan is below-market term loan The executive is treated as if he or she immediately received an amount equal to the excess of (1) the amount of the loan over (2) the present value of all payments required to be made under the loan. This amount is treated as additional compensation income. The company can deduct this amount. Interest is also imputed at the AFR, and the company must include this interest in income. For more information, consult additional sources.

Gift and Estate Tax Typically not applicable unless it is a small corporation and there is a family relationship. The loan must qualify as compensation-related and not a gift loan, or else there may be gift and estate tax consequences.

Questions & Answers These loan programs are complex and involve substantial administrative costs. Are there any alternatives that would provide substantially the same benefits to executives? Yes. You might consider providing loans to your executives at full market interest rates and then "bonus" the interest cost to the executive as additional compensation. You could also guarantee a regular bank loan taken out by your employee.

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Executive Bonus (Section 162) Plans What is it? A bonus is an addition to regular salary or compensation that enables employees to share in profits resulting from a successful year. Bonuses are often used for executives as an incentive-oriented form of compensation, based on the attainment of profit or other goals during the year. Bonuses are sometimes used to assist executives in funding their share of the premium to a split dollar life insurance plan. Example(s): XYZ Corporation expected each of its sales executives to bring in $100,000 worth of new business in Year 1. Any executive exceeding this goal in Year 1 would be given a bonus on January 1 of Year 2 in an amount equal to 10 percent of his or her new business in excess of $100,000. Because Joe brought in an extra $50,000 worth of business, he received a $5,000 bonus check on January 1, Year 2.

When can it be used? Employers can use bonus plans whenever they want to attract, motivate, and retain key employees. These plans can be informal or even oral. There are no tax or other legal requirements for a written plan or for filing anything with the government. However, a written plan is often desirable. First, a written plan helps to avoid disallowance of the corporation's deduction on the grounds that the bonus was unreasonable. Without a written plan, the Internal Revenue Service (IRS) is likely to conclude that a bonus is simply an excessive discretionary payment. And if this payment is made to a shareholder, the IRS may recharacterize it as a dividend instead of deductible compensation. A second reason for a written agreement is that it defines the terms of the bonus plan and assures the employee of legal grounds to require the corporation to live up to the agreement. For this reason, the terms of the agreement should be clearly defined. Tip: Other forms of deferred compensation with many of the same incentive features as cash bonus plans exist. In particular, you may wish to consider incentive stock options.

Strengths Helps business to attract, motivate, and retain key employees A principal challenge to employers is to attract, motivate, and retain key employees (and executives in particular). These goals can be promoted by providing executive bonus plans to key employees. Receiving a lump sum of cash in-hand for quality work can serve as a significant motivational tool for many people. In addition, it can help to make one firm more attractive than another firm that offers the same salary.

Promotes increased productivity Bonuses represent an incentive-based form of compensation that is very effective because of the close connection between performance and receipt of the reward. Bonuses can be used for a number of purposes, such as assisting an executive in the purchase of a life insurance policy.

Tied to company performance Bonuses allow flexibility in compensation to reflect company performance. Thus, both the employer and the employee can reap the benefits of outstanding performance.

Plan is flexible and easy to design Bonus plans are flexible and easy to design (within certain tax restraints). This is because bonus plans need not be written and need not be filed with the government.

Employee's income tax can be deferred to next year Because employees use the cash method (rather than the accrual method) of accounting, a bonus earned in one year does not

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have to be included in taxable income until it is received, usually in the following year. You can also allow your employees to defer the receipt of a bonus until some later date. However, to avoid adverse tax consequences, make sure your bonus arrangement satisfies the requirements of IRC Section 409A if applicable.

Tradeoffs Deductibility limited to "reasonableness" Bonuses are limited by the requirement of "reasonableness" for the deductibility of compensation payments by the employer. More specifically, Section 162 of the Internal Revenue Code states that only reasonable allowances for salaries or other forms of compensation (which includes bonuses) will qualify for trade or business expense deductions. Caution: In the case of publicly held corporations, no deduction will be allowed if compensation to particular employees exceeds $1 million in a given year.

How to do it Consult with an attorney and an accountant to set up the plan It is important that proper tax rules are understood and followed. An attorney will consider the goals of your business and your financial situation, and advise you of the most advantageous compensation plan to adopt. In addition, it may be necessary to consult with a certified public accountant to ensure that proper accounting methods are followed.

Tax considerations Income Tax

To the employer Bonuses are generally deductible by an employer according to the same rules as other forms of cash compensation. A bonus cannot be deducted unless it constitutes a reasonable allowance for services actually rendered. Also, note that no deduction is allowed for compensation in excess of $1 million paid to certain top executives. Since bonuses are often payable after the end of the year in which they were earned, the "2½ Safe Harbor Rule" is important for bonus planning. Under this rule, an accrual method corporation can deduct a compensation payment that is properly accrued before the end of a given year, as long as the payment is made no later than 2½ months after the end of the corporation's tax year. Note, however, that the 2½ Rule does not apply to payments made to employees who own or control 50 percent or more of the corporation. For those employees, the corporation must pay the bonus during its taxable year to deduct it during that taxable year.

To the employee A bonus is taxed to the employee as ordinary taxable income. Since employees file taxes according to the cash method (rather than the accrual method), the bonus is taxable to the employee when it is received.

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Split Dollar Life Insurance, Including Nonqualified Deferred Compensation Plans What is it? In general A split dollar life insurance arrangement, or SDA, is an agreement between an employer and an employee to split the premium payments and the benefits (e.g., cash value, death proceeds, and possibly the dividends) of a life insurance policy on the employee's life. For an employer, split dollar life insurance arrangements offer a way to attract, motivate, and retain key employees. They also provide a source of cash to fund nonqualified deferred compensation plans for them. For an employee, an SDA offers partially subsidized life insurance.

When can you use it? An employer can use a split dollar life insurance arrangement for the following purposes: • • • • •

To attract, motivate, and retain key employees To fund nonqualified deferred compensation plans for key employees To provide life insurance for a key employee in an amount that the employee might not be able to afford To fund stock purchase agreements To fund severance benefits

How does it work? Cash value method In the classic split dollar arrangement (called the cash value method), the employer pays the portion of the premium that equals the annual increase in the cash value of the policy, and the employee pays the balance. When the annual increase in the cash value of the policy equals or exceeds the net premium (the gross premium less the dividends), the employer pays the entire amount. The employer benefits from this approach because it ensures that the cash value of the policy is always sufficient to reimburse the cash outlay. Split dollar arrangements usually take one of two forms. In the endorsement form, the employer is formally designated as the owner of the insurance contract and endorses the contract to specify the portion of the insurance proceeds payable to the employee's beneficiary. In the collateral assignment form, the employee is formally designated as the owner of the contract, and the employer's premium advances are secured by a collateral assignment of the policy. Caution: The Sarbanes-Oxley Act of 2002 makes it a criminal offense for a public company to lend money to its executives or directors. This may prohibit the use of the collateral assignment form in these companies. Split dollar life insurance is an important part of the compensation package of many key employees. In a typical split dollar arrangement, the employer funds all or part of the cost of providing an employee with life insurance protection and then recoups that cost by sharing in the insurance proceeds at the employee's death. Split dollar arrangements have also come into wide use in gift and estate planning.

Nonqualified deferred compensation plans A split dollar arrangement can also operate as an informal funding device for an employer's nonqualified deferred compensation plan . Split dollar life insurance allows an employer to fund benefits payable under a NQDC plan with the proceeds the employer receives from the split dollar life insurance policy. While there are a number of variations, one way an employer can accomplish this is by establishing an unfunded NQDC plan to provide employees with a promised level of deferred compensation benefits. The employer then purchases a life insurance policy on the employees' lives. The premiums may be split between the employees and the employer in any way desired. Typically the employees are entitled to a death benefit from the policy equal to some multiple of compensation, for example 3 times pay. The face amount of the policy, however, is usually greater than that amount.

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Each year, your employer credits employees' NQDC plan accounts with an amount specified in the plan. When distribution is scheduled to occur, the employer pays the NQDC plan benefits from his or her general assets. Upon an employee's death, the employee's beneficiary receives the promised level of death benefits from the life insurance policy, and the employer receives the balance of the policy proceeds. The life insurance benefits are tax-free. By informally funding a NQDC plan with split dollar life insurance, employees can receive death benefit protection under the life insurance policy along with deferred compensation under the NQDC plan, and the employer can recoup all or part of the cost of providing these benefits. Caution: Informal funding of a NQDC plan with split dollar life insurance may only be possible using the endorsement method. In a collateral assignment split dollar arrangement taxed under the loan regime, the employer's premium payments will not be treated as a split dollar loan if the owner does not intend full repayment. An example in the preamble of the regulations provides that if a separate agreement is entered into that the employer will make a future transfer to the employee sufficient to pay off the loan, the arrangement will not be treated as a split dollar loan. This suggests that if the employee and employer want their arrangement to be treated as a split dollar loan, they cannot enter into a separate deferred compensation agreement that will provide the employee with a future benefit sufficient to pay off the loan amount. The regulations as written do not clearly back up this assertion from the preamble.

Strengths Low-cost benefit for key employees A split dollar arrangement provides a low-cost mechanism for an employer to recruit and retain desirable employees. With an SDA, an employee can purchase life insurance at a cost lower than he or she could obtain outside the arrangement, or can purchase more life insurance for the same amount of money. Most split dollar arrangements allow an employee to purchase the policy from the employer at retirement, which enables the employee to continue the policy at rates that were set when he or she was younger. Some employers provide pay increases or bonuses to help employees fund their share of the premiums, while other employers loan their employees the funds at low or no interest.

Fully secured cash outlay The employer's cash outlay is usually fully secured. At the employee's death or termination of employment, the employer is reimbursed from the policy's cash value for the cost of the premiums.

Can be limited to selected employees An employer can selectively offer a SDA to key employees without having to offer it to all employees, since split dollar arrangements are exempt from the Employee Retirement Income Security Act (ERISA) nondiscrimination rules.

Flexible plan designs Because split dollar arrangements can be designed in a variety of ways, they can be customized to meet employer and employee objectives.

Tradeoffs Arrangement must remain in effect for a long period The SDA must remain in effect for a reasonably long period (e.g., 10 to 20 years) so the policy cash values rise to a level sufficient to maximize the arrangement's benefit.

Arrangement may be terminated at age 65 The arrangement may generally end when the employee reaches age 65, since the employee's taxable cost may rise sharply after age 65.

Tax considerations Effective as of September 17, 2003 are two mutually exclusive regimes for taxing split dollar life insurance arrangements: the economic benefit regime and the loan regime. Both the owner and the non-owner are required to fully and consistently account for

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all amounts under a split dollar agreement under either the economic benefit regime or the loan regime. Under the economic benefit regime, the owner of the life insurance contract is treated as transferring economic benefits to the non-owner. This regime generally governs the taxation of compensatory arrangements in which the employee is not the owner of the contract (e.g., endorsement split dollar arrangements). Under the loan regime, the non-owner is treated as lending premium payments to the owner. The loan regime generally governs the taxation of collateral assignment split dollar arrangements (e.g., arrangements in which the employee is designated as the owner of the contract and the employer (non-owner) pays all or a portion of the premiums).

No direct tax benefit to employer In most cases, an employer receives no direct tax benefit. Since an employer is either a direct or indirect beneficiary of a life insurance policy underlying an SDA, the employer's share of the premiums is not tax deductible. If the arrangement is taxed under the economic benefit regime, the IRS even disallows a deduction for the portion of the employer's contribution that results in taxable income to the employee. If the arrangement is taxed under the loan regime, the employer is entitled to a tax deduction for any compensatory bonus paid to the employee to offset any interest paid by the employee. However, the employer must include these interest payments in its taxable income for the year.

Employee recognizes taxable income If the arrangement is structured as an SDA taxed under the economic benefit regime, the employee must pay income taxes each year on the value of the economic benefits provided by the insurance policy underlying the arrangement (less any premiums paid by the employee). The economic benefits may include: • The cost of current life insurance protection provided to the employee • The amount (if any) of policy cash value to which the employee has current access (that has not been taken into account in a prior taxable year) • The value of any other economic benefits (not taken into account in a prior taxable year) provided by the employer to the employee If the arrangement is structured as an SDA taxed under the loan regime, the employer is considered to be lending to the employee the funds to make the premium payments on the life insurance policy. If the employee is paying little or no interest on these loans to the employer, then the below market loan rules apply, and the employee must pay tax annually on the imputed interest on the loans.

Death benefits received by surviving family members are exempt from income tax Generally, death benefit proceeds attributable to life insurance protection offered under an SDA are excludable from the income of the employee's beneficiary to the extent that the employee has either paid for the coverage or taken its economic value into account.

Estate tax considerations If death benefits are payable to an employee's estate, the proceeds are includable in the employee's gross estate for federal estate tax purposes. Similarly, these proceeds are includable in the employee's gross estate when they are payable to a beneficiary and the employee possesses incidence of ownership in the policy at the time of death. In general, an employee has incidents of ownership if he or she has the power to change the beneficiary or has access to the economic benefits of the policy. The death benefit is not includable in the employee's gross estate if the employee had no incidents of ownership.

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Taxation of Split Dollar Arrangements What is a split dollar arrangement (SDA)? A new definition As of September 17, 2003, the Internal Revenue Service (IRS) and the Department of the Treasury jointly issued new regulations governing the taxation of split dollar life insurance arrangements. These new regulations radically revise the taxation of these arrangements. The regulations define a split dollar arrangement (SDA) as any arrangement between an owner and a non-owner of a life insurance contract under which: • Either party pays all or part of the premiums • One party paying the premiums may recover some or all of those premium payments • Recovery of the premium payments may be made from (or may be secured by) the proceeds of the insurance contract This definition and the new regulations apply for purposes of federal income, employment, self-employment, and gift taxation of SDAs entered into or materially modified after September 17, 2003.

How are SDAs classified? While there may be as many varieties of SDAs as there are financial professionals designing them, they are generally classifiable as either endorsement SDAs or collateral assignment SDAs.

What is an endorsement SDA? Generally, under an endorsement SDA, the owner of the life insurance contract endorses to the insured non-owner the right to name the beneficiary of the death benefits of the policy. The owner of the policy also makes some or all of the premium payments. As stipulated by the agreement governing the SDA, the owner will be reimbursed for these payments either from the cash value of the policy (upon termination of the agreement) or from a portion of the death benefits (upon the death of the non-owner). The agreement governing the SDA also stipulates whether the non-owner will be entitled to any policy equity, which is any portion of the cash value in excess of the amount reserved under the agreement to repay the premium payments made by the owner. If the non-owner is entitled to the policy's equity, the arrangement is known as an equity SDA.

What is a collateral assignment SDA? Under a collateral assignment SDA, the insured party is the owner of the life insurance contract, while the non-owner pays all or part of the premium. These premium payments made by the non-owner are considered to be loans to the owner. As stipulated by the agreement governing the SDA, the owner agrees to assign an interest in the life insurance contract to the non-owner as collateral securing these loans. The loans may be repaid either from the cash value of the insurance policy (upon termination of the agreement) or from a portion of the policy's death benefits (upon the death of the owner). Depending on how the SDA is structured, the owner may or may not retain control of the insurance contract's equity, or the amount of cash value in excess of that reserved to repay the collateral assignment. If the owner relinquishes control of all the policy's equity, the arrangement is known as a non-equity SDA.

Split dollar arrangement taxation, then and now Caution: The following is not a comprehensive discussion of the regulations governing the taxation of split dollar life insurance arrangements. You should consult additional resources.

That was then For several decades, the IRS guidance governing SDA taxation generally did not address the distinctions between endorsement

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and collateral assignment SDAs, nor did it address the taxation of equity accumulation. For the most part, the party to the SDA who benefited from the policy's insurance coverage was required to include in his or her taxable income the value of each year's death benefit protection that was in excess of any premium he or she paid that year. Generally, as long as the party to the SDA who benefited from the policy's coverage included the value of that coverage in his or her taxable income each year, he or she was not taxed on the accruing equity accumulation to which he or she had rights.

This is now The regulations that became effective in September 2003 define two mutually exclusive regimes for determining the tax treatment of an SDA. Ownership of the life insurance policy underlying the SDA will largely determine the regime that applies for taxation purposes. If the owner of the policy provides economic benefits (death benefits, rights to policy equity, and/or other benefits) to the non-owner, then the SDA will be governed by the economic benefit regime, and the non-owner must include in his or her taxable income the economic value of those benefits. Thus, the economic benefit regime will govern most endorsement SDAs. The SDA will be governed by the loan regime if the relationship between the non-owner and the owner of the insurance policy is such that: • The non-owner makes a premium payment on behalf of the policyowner • The payment is either considered a loan under the general principles of federal tax law, or a reasonable person would expect the non-owner to be repaid, and • Repayment is to be made from (or is secured by) the policy proceeds Thus, the loan regime will generally govern most collateral assignment SDAs. A special rule, however, indicates that non-equity SDAs entered into in either a compensatory or a gift context will be governed by the economic benefit regime, whether they are collateral assignment or endorsement SDAs.

SDA taxation under the economic benefit regime In general Under the economic benefit regime, the owner of the life insurance policy underlying the SDA is considered to be providing economic benefits to the insured non-owner of the policy. For tax purposes, both the owner and the non-owner must account for these benefits fully and consistently.

What is taxed Under the economic benefit regime, the value of the benefits provided by the owner of the insurance contract to the non-owner, reduced by any consideration paid by the non-owner to the owner, is taxable income to the non-owner. These benefits include: • The cost of current life insurance protection provided to the non-owner • The amount (if any) of policy cash value to which the non-owner has current access (that has not been taken into account in a prior taxable year) • The value of any other economic benefits (not taken into account in a prior taxable year) provided by the owner to the non-owner The valuation of these benefits is determined as of the last day of the non-owner's taxable year, unless both the owner and the non-owner of the policy agree to use the policy's anniversary date for this purpose. The amount of the policy's cash value is determined without regard to surrender charges or other similar charges. The concept of access by the non-owner to the cash value of the life insurance contract underlying the SDA is broadly construed. The non-owner is considered to have access to any portion of the policy's cash value to which he or she (currently or in the future) has a right, and that is currently (indirectly or directly) accessible to the non-owner, inaccessible to the owner, or inaccessible to the owner's creditors. A non-owner would be deemed to have access to cash value if he or she can directly or indirectly withdraw or borrow from the policy, totally or partially surrender the policy, or encumber the policy's cash value. The non-owner would also be considered to have access to the cash value if that cash value is available to the non-owner's creditors by attachment, garnishment, or levy and execution.

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Determining the economic value of the insurance coverage For an SDA entered into prior to September 18, 2003 (and not modified materially since), the economic value to the non-owner of the life insurance coverage may be determined in one of two ways. One way is to base the valuation on IRS Table 2001. The other is to use the insurer's lower published premium rates that are available to all standard risks applying for initial issue one-year term insurance. However, if the SDA was entered into after January 28, 2002, any such alternative rates used to calculate the economic value of the insurance coverage after December 31, 2003, must meet two criteria: • They must be rates the insurer makes known and available to all standard risks applying for term insurance coverage from the insurer (which is as it has been • They must be rates at which the insurer regularly sells term insurance to individuals who apply for such coverage through the insurer's normal distribution channels (which is a new and more restrictive requirement)

SDA taxation under the loan regime Under the loan regime, the non-owner is considered to be lending to the insured owner of the policy the funds to make the premium payments on the life insurance contract underlying the SDA. Each premium payment must be treated as a separate loan. Generally, these loans are expected to be repaid from either the cash value of the life insurance policy (upon termination of the SDA) or the death benefit (upon the death of the owner). The owner of the policy assigns an interest in the policy to the non-owner as collateral to secure the loans. Generally, the (owner) borrower is expected to pay market-rate interest (based on the applicable federal rate, or AFR, set by the IRS) to the (non-owner) lender on the outstanding loan balances. If the (owner) borrower were doing so, he or she would incur no annual tax liability. The (non-owner) lender would include the interest payments received in his or her taxable income for the year. The borrower would not be able to deduct the interest he or she paid. However, if the (owner) borrower is paying little or no interest to the (non-owner) lender (as is most often the case), then the below market loan rules apply, and the borrower must pay tax annually on the imputed interest on the loans. Under the loan regime, the owner of the policy is not taxed directly on his or her share of the cash value equity, either during the arrangement or upon rollout (the termination of the SDA). When the SDA is terminated, the owner of the policy is expected to repay the loans made by the non-owner. The IRS has taken the position that tax-deferred inside buildup of the cash value in the policy applies only to the taxpayer who owns the policy. As a result, once the SDA is terminated, the owner could surrender the policy and be subject to income tax only on the gain on the policy. The gain is the difference between the net cash value received at surrender and the basis in the policy (the total premium paid, less any policy dividends and tax-free withdrawals).

Safe harbor options available to parties participating in equity SDAs entered into prior to September 18, 2003 The new regulations are a significant departure from previous IRS guidance governing the taxation of equity SDAs. In the past, the accessible cash value of the insurance policy underlying an SDA was not subject to annual taxation. Since the new regulations stipulate that all SDAs will be taxed under one of the two mutually exclusive regimes, non-owner parties to existing endorsement equity SDAs may now be subject to taxation on their accessible cash value. In accordance with IRS Notice 2002-8, a party participating in an equity SDA entered into prior to September 18, 2003, may avoid taxation of any currently accessible equity by choosing one of the following alternatives: 1. Choose to treat the arrangement as what may be referred to as "split dollar for life." In an endorsement SDA, the non-owner must continue to treat and report the economic value of the life insurance protection as taxable income for the remainder of his or her life. If this is done, the IRS will not treat the SDA as being terminated or materially modified, and thus will not assert there has been a transfer for value that would require current taxation of the cash value. 2. Convert the SDA to one that will be governed by the loan regime. If the SDA has been an endorsement SDA, the original owner of the policy will become the non-owner, and the former non-owner will become the owner. All premium payments that had been made by the original owner (now the non-owner) of the policy since the inception of the SDA must be treated as loans (to the new owner) entered into at the beginning of the first year in which such payments will be treated as loans. If the loans are below-market loans, the (new) owner of the policy will be required to report as taxable income any imputed interest

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on them. 3. If an SDA was entered into before January 28, 2002, the IRS will not assert there has been a taxable event (and thus will not require taxation of the cash value) if the SDA is either terminated entirely or converted to the loan arrangement described above. Tip: This change must be made before January 1, 2004. Failure to do so could result in income taxation of the equity buildup if cash is later withdrawn from the policy or the policy is surrendered. Caution: An individual may be participating in an equity SDA that will not have yet reached the crossover point--the point where the cash value of the policy exceeds the aggregate premium paid--as of January 1, 2004. As a result, the individual need not choose one of the above alternatives by that date. However, to avoid future taxation of any developing equity, the SDA must be unwound (terminated) prior to reaching the crossover point. Caution: The Sarbanes-Oxley Act of 2002 makes it a criminal offense for a public company to lend money to its executives or directors. While converting an equity SDA entered into before January 28, 2002, to a loan arrangement may satisfy the IRS, an employee of a public company with access to accumulated policy equity may still wish to terminate such an SDA before January 1, 2004. Doing so will not only avoid taxation of the accessible cash value but would also circumvent any suspicion of participation in criminal activity.

Other tax considerations Premiums are not deductible Policy premiums are not deductible to either the owner or the non-owner. Tip: If the SDA is between an employer and an employee, and the employer pays the employee a bonus to help fund his or her portion of the premium, the amount of the bonus is tax deductible for the employer but is taxed as income to the employee.

Beneficiary generally receives proceeds free from income tax Generally, death benefit proceeds attributable to life insurance protection offered under an SDA are excludable from the income of the insured individual's beneficiary to the extent that the insured individual has either paid for the coverage or taken its economic value into account.

Third-party considerations A collateral assignment SDA may involve a third party, such as the covered individual's spouse, child, or irrevocable life insurance trust. In this instance, the third party owns the insurance policy, makes the collateral assignment to the non-owner in exchange for the non-owner's premium payments, and may (if it's an equity SDA) have rights to cash value equity. When a third party is the owner of the policy, that party should be the covered individual's named beneficiary. If the third-party policyowner names another beneficiary (a three-party contract), the third-party owner would be deemed to have made a gift of the full proceeds received upon the death of the insured. Depending on how the SDA is structured, the third-party owner may be subject to income tax on the economic benefit of the insurance coverage or on imputed interest under the below-market loan rules. Further, the covered individual may be treated as having made a gift to the third party, which is subject to gift tax.

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Life Insurance as an Employee Benefit What is it? In general Life insurance is a contract whereby the insurance company pays a sum specified within the contract to a named beneficiary upon the death of the insured, in exchange for the payment of an agreed upon premium. If your employer offers life insurance as an employee benefit, it most likely will be in the form of group life insurance. Group life insurance provides insurance for a group of employees through a contract that exists between an employer and an insurance company. The actual group life insurance is usually issued to the employer rather than to each individual employee. This contract is known as the master contract and provides coverage for the entire group. In lieu of having the actual contract in hand, the insurance company will issue each employee a certificate of insurance as proof of coverage. Although you as an employee are not a party to the master contract, you still are able to enforce your legal rights under the master contract as a third party beneficiary. Generally, group life insurance mirrors the types of life insurance policies that are available on an individual basis, such as term , whole , and universal . If a group life insurance policy is permanent, it accumulates cash value. In other words, any excess funds that you pay towards the permanent contract (the part of the premium that exceeds the cost of providing the death benefit) builds up equity in the policy. Cash value life insurance provides protection, in addition to accumulating cash within the policy for your future use. Cash value can be a useful tool for the individual policyholder because it offers the opportunity to obtain a policy loan or to surrender the policy. If a group life insurance policy is a term one, it provides protection as long as the premium is paid. A term policy does not accumulate cash value that you can draw upon in the future. While term insurance does not accumulate cash value, it requires minimal cash outlay in the beginning and does not require a long-term commitment. Tip: Some companies will provide insurance to their employees by making payroll deductions to any insurer. Many companies will offer employees insurance at no cost (e.g., one to two times an employee's annual salary), and allow employees to purchase additional insurance with low premiums.

Advantages of group life insurance In addition to the obvious advantage of providing your beneficiaries with funds upon your death, a group life insurance policy can offer many additional advantages. Typically, the cost you incur funding a group life insurance policy must be included in your gross income. However, there are certain limited exceptions (e.g., the first $50,000 of group term life insurance), although it is rare that these exceptions apply to the average employee. In addition to its possible tax benefits, group life insurance usually does not require medical underwriting. Individual life insurance policies generally require the insurance company to evaluate your health in order to prove to the company that you are insurable. If you are in poor health, it is likely that an individual policy may require you to pay high premiums or that the company may not find you insurable. With a group life insurance policy, the insurance company does not perform medical underwriting on an individual basis. Instead, you may be asked a series of simple medical questions while the characteristics of the group as a whole (e.g., size, stability, and group makeup) are evaluated. Tip: A group life insurance plan qualifies as an ERISA welfare benefit plan and is subject to ERISA rules . Caution: Since group term life insurance is a contract between your employer and the insurer, your employer can terminate a group term life insurance plan at any time. Caution: If you change jobs, you will lose coverage under your group life insurance plan. However, you may be able to convert your group coverage into an individual policy.

Group term life insurance In general Group term life insurance is a contract between an employer and an insurance company that lasts for a specific period of time (usually until you retire, reach a certain age, or leave the company) and provides death benefits upon your death. Caution: Since a group term life insurance plan provides only term coverage, it does not accumulate any cash value.

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Tip: Since you may only have to pay a small portion of the premium for a group term life insurance policy, group term life insurance can be a low-cost method of providing your beneficiaries with death benefits.

Group life insurance carve-out plan Under a group life insurance carve-out plan, your employer removes certain highly compensated employees from the group term life insurance plan coverage and provides those employees that were "carved-out" with individual life insurance policies. Caution: One of the major disadvantages of a carve-out plan is that because it is an individually based plan, it is likely to require you to be individually underwritten. If you have health problems, you should be aware that you may have a heavy policy rating or be deemed uninsurable under an individual plan.

Contributory or noncontributory Under a group term life insurance policy, your employer usually pays for a base amount while you pay for any supplemental amounts. The amount of the premium that your employer pays depends on whether the policy is contributory or noncontributory. If a group term life insurance policy is contributory, your employer pays the majority of the premium, while you pay a small portion of the premium. If a policy is noncontributory, your employer pays the entire premium.

Beneficiary designation You are free to name any person or persons who you want to receive the proceeds of your group term life insurance policy upon your death. In addition, you can name your beneficiary on either a revocable or irrevocable basis.

Death benefit coverage Generally, the amount of death benefit coverage you have under a group term life insurance policy is determined by using a benefit schedule. However, some plans may place a ceiling on the amount of coverage that the policy provides. Example(s): Example 1: Mary works for XYZ Company and earns an annual salary of $30,000. Mary's group term life insurance policy provides death benefit coverage in an amount that is equal to twice her annual salary, or 2 x $30,000 = $60,000. Example(s): Example 2: Mary works for XYZ Company and earns an annual salary of $60,000. Mary's group term life insurance policy provides death benefit coverage in an amount that is equal to twice her annual salary, with a $100,000 limitation on the coverage amount. As a result, Mary would not receive $120,000 (or 2 x $60,000) worth of coverage, but a death benefit of $100,000. In addition to being based on your annual salary, death benefit coverage can be a set amount (e.g., $50,000) for all employees.

IRS tax treatment of group term life insurance In general As long as your group term life insurance plan meets certain requirements, you can exclude the cost of the first $50,000 of insurance from your gross income. The cost of any amount over the $50,000 limit must be included in your gross income, unless you pay for the coverage with after-tax dollars. Tip: The amount over $50,000 that is included in your gross income is known as imputed income. Tip: In order for a group term life insurance plan to qualify for the $50,000 exclusion, it must meet the requirements of Section 79 of the Internal Revenue Code.

Exception to $50,000 limit Generally, the cost of employer-provided group term life insurance that exceeds $50,000 is taxable to you. If you fall within an exception, the cost of group term life insurance that exceeds $50,000 is not included in your gross income. Group term life insurance costs that exceed $50,000 are not taxable to: • Retired employees who fall within a special grandfather rule • Employees who have terminated employment because of disability

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• Employees whose beneficiary under the policy is their employer (either directly or indirectly), or • Employees whose beneficiary under the policy is a charitable organization

Dependent group term life insurance The cost of group term life insurance on the life of your spouse or dependent (also known as employer-provided dependent group term life insurance) is included in your gross income. However, the cost is not included in your gross income if you pay for it on an after-tax basis. In addition, the cost of dependent group term life insurance can be excluded from your gross income as a de minimis fringe benefit if the face value of the insurance payable on either your spouse's or dependent's death is limited to under $2,000.

Exclusion of death benefits from your beneficiary's gross income In order for an individual to be able to exclude death benefits (any amount that he or she receives from a life insurance policy as a result of your death) from his or her gross income, the individual must be a beneficiary and the amounts paid must be by reason of the death of the insured.

Group whole life insurance In general Under group whole life insurance, you pay a fixed premium either over your lifetime (ordinary life) or over a shorter period of time (limited pay life). While many variations of the group whole life insurance policy exist, it is mainly a mixture of both term and permanent insurance. Your premium payment usually goes to the permanent insurance portion, while your employer's payment goes to the term insurance portion. Group whole life insurance allows your employer to offer employees employer-paid term insurance with the additional coverage of a permanent group life insurance plan. Example(s): Bill works for XYZ Company. XYZ offers its employees a group whole life insurance policy. XYZ pays a portion of the premium that purchases the term life insurance, while the employee pays the premium for any permanent coverage. Bill can elect to receive only the term life insurance and have the premium paid completely by XYZ. In addition, Bill can choose to have both term and permanent coverage. In this case, he will be personally responsible for that portion of the premium that purchases the permanent coverage. Tip: Since premium payments are fixed under a group whole life insurance policy, payments cannot be made in lump sums. Tip: Since group whole life insurance is a permanent type of life insurance, it accumulates a cash value. The cash value of most group whole life insurance policies grows at a set rate. However, if a group whole life insurance policy is interest sensitive, the cash value grows at an interest rate that is subject to change. In addition, if a group whole life insurance policy is current assumption whole life , the interest rate, policy premium, and death benefit that are credited to the cash value of the policy may vary. Tip: When you retire, you can choose to either surrender the policy or continue your coverage by paying the premiums yourself.

Dividend options If a whole life insurance policy is "participating," it allows you to receive annual dividends. Usually, a participating whole life insurance policy offers a variety of dividend options from which to choose, such as buying paid up additions, reducing the policy's premium, accumulating at interest, buying additional term life insurance, or refunding the excess premiums as cash. If you use dividends to buy paid up additions, the insurance company uses each dividend to purchase you an additional amount of life insurance that does not require premium payments. If you use dividends to reduce the policy's premium, you pay a lower premium, but the death benefit of the policy will remain the same. If the insurance company pays the dividend to you in cash, the policy premium and the death benefit remain the same. If you choose to let the dividends accumulate at interest, the dividends stay with the insurance company, which pays a set rate of interest on the dividends. Finally, if you choose to buy additional term life insurance with your policy dividends, the insurance company will purchase term life insurance on your behalf.

Nonforfeiture options If you are unable to pay your group whole life policy premium, you have two options: surrender the policy for cash value or exercise a nonforfeiture option. While you can surrender your group whole life insurance policy for its cash value at any time, if

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you surrender the policy, any death benefit coverage that you had under the policy terminates immediately. If you choose to exercise a nonforfeiture option, some of your death benefit coverage will remain, either for a shorter period of time or a lesser amount of coverage. Generally, nonforfeiture options come in two forms: paid up term life insurance and reduced paid up whole life insurance. If you choose the paid up term life insurance nonforfeiture option, your premium payments end and you are left with a term policy that provides a certain amount of death benefit coverage for a specific period of time. Example(s): John wants to end his premium payments for his whole life insurance policy. However, John has a child for whom he still wants to provide death benefit coverage. John can exercise the paid up term nonforfeiture option that can end his premium payments, but still offer death benefit coverage for his child. If you choose the reduced paid up whole life nonforfeiture option, you use the cash value of the policy to purchase life insurance on a paid up basis. Tip: Unless a policy has been held for many years, you may receive only a percentage of a policy's cash value upon surrender. An insurance company may seek reimbursement for unrecovered costs by issuing surrender charges on a policy's existing cash value. In today's transient job market, employees tend to move from job to job before surrender charges disappear.

Group universal life insurance In general Under a group universal life insurance policy, you can choose to either pay a minimum premium or fully fund the policy. By paying the minimum premium, you cover the cost of keeping the policy in effect. However, the minimum premium is usually not enough to accumulate a large amount of cash value. On the other hand, you can choose to fully fund the policy. If you fully fund the policy, you can cover the cost of keeping the policy in effect, while at the same time, accumulating a large amount of cash value. Minimum premium payments may be a good idea for an individual who cannot afford to spend a lot of money on insurance premiums. Fully funding a plan is a useful tool for the employee who wants to limit his or her premium payments during retirement, or to accumulate funds in the policy for use at a later date. Tip: Unlike group term life insurance, group universal life insurance is not governed by Section 79 of the Internal Revenue Code. Group universal life insurance is taxed the same as if you purchased a universal life insurance policy on an individual basis. As a result, you cannot deduct premiums that you pay from your gross income. Caution: The interest rate that is credited to your universal life insurance policy's cash value is subject to change by the insurance company.

Selection of amount of death benefit coverage In addition to choosing the type of premium payment, group universal life insurance allows you to choose the amount of death benefit coverage for your policy. Most policies will offer you a few choices, usually an amount that is equal to one-half, one, or two times your annual salary. The policy will normally impose a minimum death benefit level so that, even if one-half of your salary is less than the minimum amount, you must choose the minimum amount in order to participate. Example(s): XYZ Company offers its employees a group universal life insurance plan. The plan offers a few choices for the amount of death benefit coverage you can have. These choices include one or two times your annual salary. In addition, the policy has minimum death benefit coverage of $15,000. Richard, an employee of XYZ, earns an annual salary of $60,000 and chooses the death benefit equal to two times his salary for a total of $120,000 in death benefit protection. Mary, an employee of XYZ, earns an annual salary of $28,000 and chooses the death benefit equal to one-half her salary or $14,000. Because the XYZ policy has a minimum death benefit selection of $15,000, and because one-half of Mary's salary is less then the minimum amount required, Mary's death benefit coverage would be $15,000. Usually, a universal life insurance policy will offer a choice between two benefit options: Option A and Option B. Option A provides a death benefit coverage that remains constant. Example(s): Mary's coverage under a universal life insurance policy begins at age 35. Mary chooses an Option A death benefit coverage of $100,000. Twenty years later, when Mary is 55 years old, the death benefit coverage of her policy will still be $100,000.

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An Option B death benefit coverage does not remain constant. Instead, it increases over time in proportion to the increases in the policy's cash value. The death benefit coverage under Option B is equal to the policy's face value plus the policy's cash value. Example(s): Mary has a universal life insurance policy with death benefit coverage of $100,000. After five years of coverage, Mary's policy has accumulated $5,000 of cash value. If Mary chooses death benefit coverage Option B, her policy's death benefit coverage in year five will be $105,000. Tip: The amount of death benefit coverage provided under a group universal life insurance policy can be either increased or decreased, depending on your individual needs.

Split dollar life insurance In general A split dollar life insurance arrangement, or SDA, is an agreement between you and your employer to share the costs and benefits of a life insurance policy on your life. An SDA is an agreement that concerns (at least in part) the life insurance premium payment (and eventual repayment); it is not a type of policy. Split dollar arrangements usually take one of two forms. In the endorsement form, the employer is formally designated as the owner of the insurance contract and endorses the contract to specify the portion of the insurance proceeds payable to the employee's beneficiary. In the collateral assignment form, the employee is formally designated as the owner of the contract, and the employer's premium advances are secured by a collateral assignment of the policy. Caution: The Sarbanes-Oxley Act of 2002 makes it a criminal offense for a public company to lend money to its executives or directors. This may prohibit the use of the collateral assignment form in these companies. Split dollar life insurance is an important part of the compensation package of many key employees. In a typical split dollar arrangement, the employer funds all or part of the cost of providing an employee with life insurance protection and then recoups the cost either from the cash value of the policy or from the death benefit. Split dollar arrangements have also come into wide use in gift and estate planning.

Key employee life insurance Key employee life insurance is a life insurance policy that insures the life of an employee whose death would cause significant economic loss to a business. Under a key employee life insurance policy, your employer takes out an insurance policy on your life. Your employer becomes both the owner and the beneficiary of the policy and is responsible for paying the premiums. Upon your death, the insurance company pays the death benefits to your employer's business. The proceeds are not included in your employer's income.

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Securities and Advisory Services offered through Royal Alliance Associates, Inc., member FINRA/SIPC. Insurance products offered through The Athena Financial Group which is not affiliated with Royal Alliance Associates. Tax planning and Preparation are offered Through the Athena Financial Group.

The Athena Financial Group 900 W. University Suite F Rochester, MI 48307 248-453-5252 248-453-5391 FAX [email protected] www.theathenagrouponline.com

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