Life Insurance

Gregory J. Cook, EA, CPA+ Accredited Tax Advisor Past President Alabama Society of Enrolled Agents Past President Alabama Association of Accountants

Planning for the future of your family can involve many complex issues. Some issues may not be very evident, or as evident today as they will be five or ten years from now. Life insurance should always be one of the topics you address in financial, retirement and estate planning.

At age 49, I can tell you that shopping for life insurance after age 40 is expensive. The problem is that we usually reach our most financially productive years of life around age 35 and continue until age 55. At this stage in life you may find yourself taking on projects or ventures where you need additional life insurance protection.

If you did not over-plan for your life insurance needs when you were younger, and lock in the lower rates, you will learn what I'm talking about. At age 25 I had no idea that I would buy a multi-million dollar business at age 34. When I was 38, I didn't know that in ten years I would build a colonial style home on a five acre estate. Sometimes I think we get so involved with our day-to-day and perhaps year-to-year plans, we don't consider what we might be doing ten years down the road.

If I had planned properly, I should have over-planned my life insurance needs. Looking back, I recall a couple of clients (good friends) advising me to get more life insurance. I think at the time I shrugged it off. Why did I shrug it off? I was unmarried and couldn't see what the future held. Instead of only considering my current need for life insurance back then, I should have anticipated my future needs.

Anticipating future needs can be difficult, but when it comes to life insurance, I think this is one area you should over do things if possible. If I could go back in time, here's what I would do differently when it comes to life insurance.

First I would have bought a minimum of $1 million dollars death benefit. I would not buy just one big policy. I would buy four policies for $250,000 each. Breaking the death benefit up into separate policies would have given me the flexibility to; drop or cash out a portion easily, assign one or more individual policies to a lender, perhaps change ownership of individual life insurance policies to a trust and utilize other policy benefits in different ways on different policies (i.e., paid-up life insurance, extended term, etc.).

I would buy permanent life insurance, not term policies that expire or increase the premiums with age. I dropped a term life insurance policy this year because at the policy anniversary date, the premium became prohibitive. A lot of insurance advisors will tell you to get the cheapest coverage during the time you need it the most. Well, the time most of us will need it the most is at age 72!

The biggest cost factor I've witnessed first hand is the difference between smoker and non-smoker rates. The smoker rate was more than double the non-smoker rate for life insurance. The other factor that affects the premium of life insurance is medical problems. When we're young and healthy we take our health for granted. Blood pressure and blood sugar problems are things that happen to the other guy.

For example, I always had very good eye sight and never pictured myself needing glasses. Well at age 45 I had to get reading glasses. At first I was devastated. Luckily I have a client that is an eye surgeon. I went to him and he fixed me up with some very cool reading glasses that I enjoy (as much as that is possible).

Life insurance is one of those things that is easy to brush aside when you are younger, but it is one of the things that takes on greater importance in our more financially productive years. Anticipate your needs if you can, and if there is one thing that you "over do" in your financial planning, make it life insurance.

Split Dollar Life Insurance

Split-dollar life insurance arrangements can be a key feature of executive compensation packages. Over the years, the Service has provided limited guidance regarding the taxation of these arrangements. Beginning in 2001, transitional guidance on the valuation of split-dollar life insurance arrangements was provided in the form of notices and proposed regulations in anticipation of final regulations. The final regulations apply to any split-dollar life insurance arrangement “entered into” or “materially modified” after September 17, 2003, the date of publication for the final split-dollar regulations.

Review the Securities and Exchange Commission (SEC) Form 10-K, Annual Report, including items 10,11 and 12 to identify the 16b executives. The Def 14A is useful as well in providing more detailed information regarding executive and director compensation. The Board of Director and Compensation Committee Minutes may also have useful information pertaining to the company’s insurance arrangements. Inspect the employment contracts of executives and other highly paid individuals as frequently insurance arrangements are contractual. Inspect the schedule M-1 for adjustments to taxable income for the payment of life insurance on employees. Inspect the general ledger and/or accounts payable journal for insurance expense payments.

Once you’ve established that the issue exists, determine who the policy owner is and whether the employee or his beneficiary is entitled to receive any death benefit or cash surrender value under the policy. Review contracts between the employer and employees for splitting the costs and benefits of life insurance policies. Determine how the economic benefit being provided the employee is being valued—using the alternative rates provided by the insurance company or Table 2001. Because this area involves transition rules, it is imperative that you obtain a copy of the split-dollar arrangement, the life insurance policy, and any amendments.

Interim Valuation Rules

Notice 2002-8, 2002-1 C.B. 398, outlined the rules that were expected to be included in the final regulations. The Notice also provided interim guidance on the valuation of current life insurance protection and certain safe harbor provisions for agreements in effect before the issuance of the final regulations. The key points to consider when a split-dollar arrangement is in place prior to September 17, 2003, and not materially modified thereafter are:

Valuation of current life insurance protection—Determine whether the TP can use the alternate valuation rates furnished by the insurance provider or should they be using the new Table 2001 rates published in Notice 2002-8. Key factors to consider:
If the TP is using the lower published premium rates instead of the PS 58 Tables or Table 2001, is the rate being used a published rate available to all persons who apply for term insurance coverage from the insurer? (See section III(3) of Notice 2002-8 for additional rules if the arrangement is entered into after January 28, 2002.)
Is the alternate rate for a one year standard term policy, all risks, or is the rate based on a policy with a renewal feature?
Request a copy of the rate sheet. The rate sheet will describe the terms of the policy (renewal factor), policy applicability (standard risks, non-smoking), dollar value of the policy, etc. Look on the rate sheet for items such as “not for publication” or “internal use only.” Check the company’s website—do they sell individual term insurance or do they only sell corporate policies? Any of these factors could indicate that the economic value of the term coverage should be recomputed using Table 2001.

Safe Harbor Rules

Notice 2002-8 contains special provisions for split-dollar arrangements that were entered into prior to January 28, 2002 as well. The employer has several options with respect to such arrangements and must make a decision which option to apply to a particular arrangement by December 31, 2003. You will want to review carefully any split-dollar arrangement in effect prior to January 28, 2002 to determine that the employer has selected one of the available options.

Some of the safe harbors in Notice 2002-8 also apply to split-dollar arrangements entered into after January 28, 2002 and before the effective date of the final regulations.

Final Regulations

Under the final regulations issued September 17, 2003, it is imperative to determine who owns the split-dollar policy. If the executive owns the policy, the employer’s premium payments are treated as loans to the executive. Consequently, unless the executive is required to pay the employer interest on the loan at or above the applicable Federal rate (AFR), the executive will be taxed on the difference between the AFR interest and the actual interest. Verify that the rate of interest being charged is at least AFR. If the rate being charged is below market, impute the taxable income to the employee using the rules under section 1.7872-15 of the regulations.

If the employer is the owner of the split-dollar policy, the employer’s premium payments are treated as providing taxable economic benefits to the executive. The economic benefits include the executive’s interest in the policy’s accessible cash value and current life insurance protection. Be certain that if alternate valuation rates are being used to value the current life insurance protection, they meet the aforementioned requirements of all standard risks, the policy is for one year, etc.

The final split-dollar regulations apply to any split-dollar life insurance arrangement “entered into” after September 17, 2003. The term “entered into” is defined in 1.61-22(j)(1)(ii) of the regulations. Under section 1.61-22(j)(2) of the regulations, an arrangement entered into on or before September 17, 2003 that is materially modified after September 17, 2003 is treated as a new arrangement entered into on the date of the modification, and is subject to the final regulations.

Section 1.61-22(j)(2)(ii) of the regulations provides a non-exclusive list of changes that are NOT considered material modifications. Again, it is important when asking for a copy of the split-dollar arrangement and the life insurance policy to include a request for any modifications and/or amendments made after September 17, 2003.

Group-Term Life Insurance

Total Amount of Coverage

IRC section 79 provides an exclusion for the first $50,000 of group-term life insurance coverage provided under a policy carried directly or indirectly by an employer. There are no tax consequences if the total amount of such policies does not exceed $50,000. The imputed cost of coverage in excess of $50,000 must be included in income, using the IRS Premium Table, and are subject to social security and Medicare taxes.

Carried Directly or Indirectly by the Employer

A taxable fringe benefit arises if coverage exceeds $50,000 and the policy is considered carried directly or indirectly by the employer. A policy is considered carried directly or indirectly by the employer if:

The employer pays any cost of the life insurance, or
The employer arranges for the premium payments and the premiums paid by at least one employee subsidize those paid by at least one other employee (the “straddle” rule).
The determination of whether the premium charges straddle the costs is based on the IRS Premium Table rates, not the actual cost. You can view the Premium Table in the group-term life insurance discussion in Publication 15-B.

Because the employer is affecting the premium cost through its subsidizing and/or redistributing role, there is a benefit to employees. This benefit is taxable even if the employees are paying the full cost they are charged. You must calculate the taxable portion of the premiums for coverage that exceeds $50,000.

Not Carried Directly or Indirectly by the Employer

A policy that is not considered carried directly or indirectly by the employer has no tax consequences to the employee. Because the employees are paying the cost and the employer is not redistributing the cost of the premiums through an insurance system, the employer has no reporting requirements.

Example 1 - All employees for Employer X are in the 40 to 44 year age group. According to the IRS Premium Table, the cost per thousand is .10. The employer pays the full cost of the insurance. If at least one employee is charged more than .10 per thousand of coverage, and at least one is charged less than .10, the coverage is considered carried by the employer. Therefore, each employee is subject to social security and Medicare tax on the cost of coverage over $50,000.

Example 2 - The facts are the same as Example 1, except all employees are charged the same rate, which is set by the third-party insurer. The employer pays nothing toward the cost. Therefore there is no taxable income to the employees. It does not matter what the rate is, as the employer does not subsidize the cost or redistribute it between employees.

Coverage Provided by More Than One Insurer

Generally, if there is more than one policy from the same insurer providing coverage to employees, a combined test is used to determine whether it is carried directly or indirectly by the employer. However, the Regulations provide exceptions that allow the policies to be tested separately if the costs and coverage can be clearly allocated between the two policies. See Regulation 1.79 for more information.

If coverage is provided by more than one insurer, each policy must be tested separately to determine whether it is carried directly or indirectly by the employer.

Coverage for Spouse and Dependents

The cost of employer-provided group-term life insurance on the life of an employee’s spouse or dependent, paid by the employer, is not taxable to the employee if the face amount of the coverage does not exceed $2,000. This coverage is excluded as a de minimis fringe benefit.

Whether a benefit provided is considered de minimis depends on all the facts and circumstances. In some cases, an amount greater than $2,000 of coverage could be considered a de minimis benefit. See Notice 89-110 for more information.

If part of the coverage for a spouse or dependents is taxable, the same Premium Table is used as for the employee. The entire amount is taxable, not just the amount that exceeds $2,000.

Example 3 - A 47-year old employee receives $40,000 of coverage per year under a policy carried directly or indirectly by her employer. She is also entitled to $100,000 of optional insurance at her own expense. This amount is also considered carried by the employer. The cost of $10,000 of this amount is excludable; the cost of the remaining $90,000 is included in income. If the optional policy were not considered carried by the employer, none of the $100,000 coverage would be included in income.