Life Insurance. Chrest CPA Tax & Financial PC BRIAN CHREST, CPA 1511 York Road Lutherville, MD brian@cpainthebox.

Transcription

1 Chrest CPA Tax & Financial PC BRIAN CHREST, CPA 1511 York Road Lutherville, MD Life Insurance Page 1 of 28, see disclaimer on final page

2 Table of Contents Tax Planning Tips: Life Insurance... 5 Life insurance contracts must meet IRS requirements... 5 Keep in mind that you can't deduct your premiums on your federal income tax return... 5 Employer-paid life insurance may have a tax cost... 5 You should determine whether your premiums were paid with pre- or after-tax dollars...5 Your life insurance beneficiary probably won't have to pay income tax on death benefit received... 5 In some cases, insurance proceeds may be included in your taxable estate...6 If your policy has a cash value component, that part will accumulate tax deferred... 6 You usually aren't taxed on dividends paid... 6 Watch out for cash withdrawals in excess of basis--they're taxable...6 You probably won't have to pay taxes on loans taken against your policy...6 You can't deduct interest you've paid on policy loans... 7 The surrender of your policy may result in taxable gain... 7 You may be able to exchange one policy for another without triggering tax liability...7 When in doubt, consult a professional...7 Life Insurance and Charitable Giving...8 Why use life insurance for charitable giving?... 8 What are the disadvantages of using life insurance for charitable giving?... 8 Ways to give life insurance to charity... 8 Trust Basics What is a trust?...10 Why create a trust?...10 The duties of the trustee Living (revocable) trust Irrevocable trusts Testamentary trusts Life Insurance for the Self-Employed...13 Why life insurance is important...13 Page 2 of 28, see disclaimer on final page

3 Why life insurance may be even more important when you're self-employed...13 What to do about it...13 Group Term Life Insurance...14 Eligibility information Bells and whistles What's in it for the employees?...14 What's in it for the employer? Cost concerns...15 Key Employee Life and Disability Insurance...16 When bad things happen to good people If death does you part--key employee life insurance Riding out the hurt--key employee disability insurance Split Dollar Insurance Plans...18 How does a split dollar life insurance plan work? Why use a split dollar life insurance plan?...18 Advantages of split dollar life insurance plans...18 Disadvantages of split dollar life insurance plans Tax issues...19 Funding a Buy-Sell Agreement with Life Insurance...20 How funding with life insurance works...20 Advantages of using life insurance Disadvantages of using life insurance How to set up different types of buy-sell agreements...20 The buy-sell agreement should be fully funded The value of the business could change over time...21 Should group life insurance be used? Possible negative tax consequences...21 Keeping track of your buy-sell agreement My life insurance s death benefit will be paid to an ILIT. What if it s needed to pay estate taxes? Are withdrawals from a cash value life insurance policy ever tax free?...23 Page 3 of 28, see disclaimer on final page

4 Is it possible to name a charity as the beneficiary of my life insurance policy? Will my beneficiaries have to pay taxes on the proceeds of my life insurance policy?...25 Will I be taxed on the growth of the cash value of my life insurance? I own a business. Are there any creative ways I can use life insurance in my business? Page 4 of 28, see disclaimer on final page

5 Tax Planning Tips: Life Insurance Understanding the importance of life insurance is one thing. Understanding the tax rules is quite another. As insurance products have evolved and become more sophisticated, the line separating insurance vehicles from investment vehicles has grown blurry. To differentiate between the two, a mix of complex rules and exceptions now governs the taxation of insurance products. If you have neither the time nor the inclination to decipher the IRS regulations, here are some life insurance tax tips and background information to help you make sense of it all. Life insurance contracts must meet IRS requirements For federal income tax purposes, an insurance contract cannot be considered a life insurance contract--and qualify for favorable tax treatment--unless it meets state law requirements and satisfies the IRS's statutory definitions of what is or is not a life insurance policy. The IRS considers the type of policy, date of issue, amount of the death benefit, and premiums paid. The IRS definitions are essentially tests to ensure that an insurance policy isn't really an investment vehicle. The insurance company must comply with these rules and enforce the provisions. Keep in mind that you can't deduct your premiums on your federal income tax return Because life insurance is considered a personal expense, you can't deduct the premiums you pay for life insurance coverage. Employer-paid life insurance may have a tax cost The premium cost for the first $50,000 of life insurance coverage provided under an employer-provided group term life insurance plan does not have to be reported as income and is not taxed to you. However, amounts in excess of $50,000 paid for by your employer will trigger a taxable income for the "economic value" of the coverage provided to you. You should determine whether your premiums were paid with pre- or after-tax dollars The taxation of life insurance proceeds depends on several factors, including whether you paid your insurance premiums with pre- or after-tax dollars. If you buy a life insurance policy on your own or through your employer, your premiums are probably paid with after-tax dollars. Different rules may apply if your company offers the option to purchase life insurance through a qualified retirement plan and you make pretax contributions. Although pretax contributions offer certain income tax advantages, one tradeoff is that you'll be required to pay a small tax on the economic value of the "pure life insurance" in the policy (i.e., the difference between the cash value and the death benefit) each year. Also, at death, the amount of the policy cash value that is paid as part of the death benefit is taxable income. These days, however, not many companies offer their employees the option to purchase life insurance through their qualified retirement plan. Your life insurance beneficiary probably won't have to pay income tax on death benefit received Whoever receives the death benefit from your insurance policy usually does not have to pay federal or state income tax on those proceeds. So, if you die owning a life insurance policy with a $500,000 death benefit, your beneficiary under the policy will generally not have to pay income tax on the receipt of the $500,000. This is generally true regardless of whether you paid all of the premiums yourself, or whether your employer subsidized part or all of the premiums under a group term insurance plan. Different income tax rules may apply if the death benefit is paid in installments instead of as a lump sum. The Page 5 of 28, see disclaimer on final page

6 interest portion (if any) of each installment is generally treated as taxable to the beneficiary at ordinary income rates, while the principal portion is tax free. In some cases, insurance proceeds may be included in your taxable estate If you hold any incidents of ownership in an insurance policy at the time of your death, the proceeds from that insurance policy will be included in your taxable estate. Incidents of ownership include the right to change the beneficiary, the right to take out policy loans, and the right to surrender the policy for cash. Furthermore, if you gift away an insurance policy within three years of your death, then the proceeds from that policy will be pulled back into your taxable estate. To avoid having the policy included in your taxable estate, someone other than you (e.g., a beneficiary or a trust) should be the owner. Note: If the owner, the insured, and the beneficiary are three different people, the payment of death benefit proceeds from a life insurance policy to the beneficiary may result in an unintended taxable gift from the owner to the beneficiary. If your policy has a cash value component, that part will accumulate tax deferred Unlike term life insurance policies, some life insurance policies (e.g., permanent life) have a cash value component. As the cash value grows, you may ultimately have more money in cash value than you paid in premiums. Generally, you are allowed to defer income taxes on those gains as long as you don't sell, withdraw from, or surrender the policy. If you do sell, surrender, or withdraw from the policy, the difference between what you get back and what you paid in is taxed as ordinary income. You usually aren't taxed on dividends paid Some policies, known as participating policies, pay dividends. An insurance dividend is the amount of your premium that is paid back to you if your insurance company achieves lower mortality and expense costs than it expected. Dividends are paid out of the insurer's surplus earnings for the year. Regardless of whether you take them in cash, keep them on deposit with the insurer, or buy additional life insurance within the policy, they are considered a return of premiums. As long as you don't get back more than you paid in, you are merely recouping your costs, and no tax is due. However, if you leave these dividends on deposit with your insurance company and they earn interest, the interest you receive should be included as taxable interest income. Watch out for cash withdrawals in excess of basis--they're taxable If you withdraw cash from a cash value life insurance policy, the amount of withdrawals up to your basis in the policy will be tax free. Generally, your basis is the amount of premiums you have paid into the policy less any dividends or withdrawals you have previously taken. Any withdrawals in excess of your basis (gain) will be taxed as ordinary income. However, if the policy is classified as a modified endowment contract (MEC) (a situation that occurs when you put in more premiums than the threshold allows), then the gain must be withdrawn first and taxed. Keep in mind that if you withdraw part of your cash value, the death benefit available to your survivors will be reduced. You probably won't have to pay taxes on loans taken against your policy If you take out a loan against the cash value of your insurance policy, the amount of the loan is not taxable (except in the case of an MEC). This result is the case even if the loan is larger than the amount of the premiums you have paid in. Such a loan is not taxed as long as the policy is in force. If you take out a loan against your policy, the death benefit and cash value of the policy will be reduced. Page 6 of 28, see disclaimer on final page

7 You can't deduct interest you've paid on policy loans The interest you pay on any loans taken out against the cash value of your life insurance is not tax deductible. Certain loans on business-owned policies are an exception to this rule. The surrender of your policy may result in taxable gain If you surrender your cash value life insurance policy, any gain on the policy will be subject to federal (and possibly state) income tax. The gain on the surrender of a cash value policy is the difference between the gross cash value paid out (plus any loans outstanding) and your basis in the policy. Your basis is the total premiums that you paid in cash, minus any policy dividends and tax-free withdrawals that you made. You may be able to exchange one policy for another without triggering tax liability The tax code allows you to exchange one life insurance policy for another (or a life insurance policy for an annuity) without triggering current tax liability. This is known as a Section 1035 exchange. However, you must follow the IRS's rules when making the exchange. When in doubt, consult a professional The tax rules surrounding life insurance are obviously complex and are subject to change. For more information, contact a qualified insurance professional, attorney, or accountant. Page 7 of 28, see disclaimer on final page

8 Life Insurance and Charitable Giving Life insurance can be an excellent tool for charitable giving. Not only does life insurance allow you to make a substantial gift to charity at relatively little cost to you, but you may also benefit from tax rules that apply to gifts of life insurance. Why use life insurance for charitable giving? Life insurance allows you to make a much larger gift to charity than you might otherwise be able to afford. Although the cost to you (your premiums) is relatively small, the amount the charity will receive (the death benefit) can be quite substantial. As long as you continue to pay the premiums on the life insurance policy, the charity is guaranteed to receive the proceeds of the policy when you die. (Guarantees are subject to the claims-paying ability of the issuing insurance company.) Since life insurance proceeds paid to a charity are not subject to income and estate taxes, probate costs, and other expenses, the charity can count on receiving 100 percent of your gift. Giving life insurance to charity also has certain income tax benefits. Depending on how you structure your gift, you may be able to take an income tax deduction equal to your basis in the policy or its fair market value (FMV), and you may be able to deduct the premiums you pay for the policy on your annual income tax return. When an insurance contract is transferred to a charity, the donor's income tax charitable deduction is based on the lesser of FMV or adjusted cost basis. What are the disadvantages of using life insurance for charitable giving? Donating a life insurance policy to charity (or naming the charity as beneficiary on the policy) means that you have less wealth to distribute among your heirs when you die. This may discourage you from making gifts to charity. However, this problem is relatively simple to solve. Buy another life insurance policy that will benefit your heirs instead of a charity. Ways to give life insurance to charity The simplest way to use life insurance to give to a charity is to name a charity to receive the benefits of your life insurance policy. You, as owner of the policy, simply designate the charity as beneficiary. Designating the charity as beneficiary may allow you to make a larger gift than you could otherwise afford. If the policy is a form of cash value life insurance, you still have access to the cash value of the policy during your lifetime. However, this type of charitable gift does not provide many of the income tax benefits of charitable giving, because you retain control of the policy during your life. When you die, the proceeds are included in your gross estate, although the full amount of the proceeds payable to the charity can be deducted from your gross estate. Another alternative is to donate an existing life insurance policy to charity. To do this, you must assign all rights in the policy to the charity. You must also deliver the policy itself to the charity. By doing this, you give up all control of the life insurance policy forever. This strategy provides the full tax advantages of charitable giving because the transfer of ownership is irrevocable. You may be able to take an income tax deduction equal to the lesser of your adjusted cost basis or FMV. The policy is not included in your gross estate when you die, unless you die within three years of the transfer. In this case, your estate would get an offsetting charitable deduction. A creative way to use life insurance to donate to a charity is simply for the charity to insure you. To use this strategy, you would allow the charity to purchase an insurance policy on your life. You would make annual tax-deductible gifts to the charity in an amount equal to the premium, and the charity would pay the premium to the insurance company. One final method is to use a life insurance policy in conjunction with a charitable remainder trust. This strategy is relatively complex (it will require an attorney to set up), but it provides greater advantages than other, simpler methods. You set up a charitable remainder trust and transfer ownership of other, income-producing assets to the trust. The income beneficiary of the trust (you or whomever you designate) will get the income from the assets in the trust. At the end of the trust term (which might be a certain number of years or upon the occurrence of a certain event, such as your death), the property in the trust would pass to the charity. You'll receive a current tax deduction when you establish the trust for the FMV of the gifted assets, reduced according to a formula determined by the IRS. Page 8 of 28, see disclaimer on final page

9 Life insurance can then be purchased (usually inside an irrevocable life insurance trust to keep the proceeds out of your estate) to replace the assets that went to the charity instead of to your heirs. Page 9 of 28, see disclaimer on final page

10 Trust Basics Whether you're seeking to manage your own assets, control how your assets are distributed after your death, or plan for incapacity, trusts can help you accomplish your estate planning goals. Their power is in their versatility--many types of trusts exist, each designed for a specific purpose. Although trust law is complex and establishing a trust requires the services of an experienced attorney, mastering the basics isn't hard. What is a trust? A trust is a legal entity that holds assets for the benefit of another. Basically, it's like a container that holds money or property for somebody else. You can put practically any kind of asset into a trust, including cash, stocks, bonds, insurance policies, real estate, and artwork. The assets you choose to put in a trust depend largely on your goals. For example, if you want the trust to generate income, you may want to put income-producing securities, such as bonds, in your trust. Or, if you want your trust to create a pool of cash that may be accessible to pay any estate taxes due at your death or to provide for your family, you might want to fund your trust with a life insurance policy. When you create and fund a trust, you are known as the grantor (or sometimes, the settlor or trustor). The grantor names people, known as beneficiaries, who will benefit from the trust. Beneficiaries are usually your family and loved ones but can be anyone, even a charity. Beneficiaries may receive income from the trust or may have access to the principal of the trust either during your lifetime or after you die. The trustee is responsible for administering the trust, managing the assets, and distributing income and/or principal according to the terms of the trust. Depending on the purpose of the trust, you can name yourself, another person, or an institution, such as a bank, to be the trustee. You can even name more than one trustee if you like. Why create a trust? Since trusts can be used for many purposes, they are popular estate planning tools. Trusts are often used to: Minimize estate taxes Shield assets from potential creditors Avoid the expense and delay of probating your will Preserve assets for your children until they are grown (in case you should die while they are still minors) Create a pool of investments that can be managed by professional money managers Set up a fund for your own support in the event of incapacity Shift part of your income tax burden to beneficiaries in lower tax brackets Provide benefits for charity The type of trust used, and the mechanics of its creation, will differ depending on what you are trying to accomplish. In fact, you may need more than one type of trust to accomplish all of your goals. And since some of the following disadvantages may affect you, discuss the pros and cons of setting up any trust with your attorney and financial professional before you proceed: A trust can be expensive to set up and maintain--trustee fees, professional fees, and filing fees must be paid Depending on the type of trust you choose, you may give up some control over the assets in the trust Maintaining the trust and complying with recording and notice requirements can take up considerable time Page 10 of 28, see disclaimer on final page

11 Income generated by trust assets and not distributed to trust beneficiaries may be taxed at a higher income tax rate than your individual rate The duties of the trustee The trustee of the trust is a fiduciary, someone who owes a special duty of loyalty to the beneficiaries. The trustee must act in the best interests of the beneficiaries at all times. For example, the trustee must preserve, protect, and invest the trust assets for the benefit of the beneficiaries. The trustee must also keep complete and accurate records, exercise reasonable care and skill when managing the trust, prudently invest the trust assets, and avoid mixing trust assets with any other assets, especially his or her own. A trustee lacking specialized knowledge can hire professionals such as attorneys, accountants, brokers, and bankers if it is wise to do so. However, the trustee can't merely delegate responsibilities to someone else. Although many of the trustee's duties are established by state law, others are defined by the trust document. If you are the trust grantor, you can help determine some of these duties when you set up the trust. Living (revocable) trust A living trust is a special type of trust. It's a legal entity that you create while you're alive to own property such as your house, a boat, or investments. Property that passes through a living trust is not subject to probate--it doesn't get treated like the property in your will. This means that the transfer of property through a living trust is not held up while the probate process is pending (sometimes up to two years or more). Instead, the trustee will transfer the assets to the beneficiaries according to your instructions. The transfer can be immediate, or if you want to delay the transfer, you can direct that the trustee hold the assets until some specific time, such as the marriage of the beneficiary or the attainment of a certain age. Living trusts are attractive because they are revocable. You maintain control--you can change the trust or even dissolve it for as long as you live. Living trusts are also private. Unlike a will, a living trust is not part of the public record. No one can review details of the trust documents unless you allow it. Living trusts can also be used to help you protect and manage your assets if you become incapacitated. If you can no longer handle your own affairs, your trustee (or a successor trustee) steps in and manages your property. Your trustee has a duty to administer the trust according to its terms, and must always act with your best interests in mind. In the absence of a trust, a court could appoint a guardian to manage your property. Despite these benefits, living trusts have some drawbacks. Assets in a living trust are not protected from creditors, and you are subject to income taxes on income earned by the trust. In addition, you cannot avoid estate taxes using a living trust. Irrevocable trusts Unlike a living trust, an irrevocable trust can't be changed or dissolved once it has been created. You generally can't remove assets, change beneficiaries, or rewrite any of the terms of the trust. Still, an irrevocable trust is a valuable estate planning tool. First, you transfer assets into the trust--assets you don't mind losing control over. You may have to pay gift taxes on the value of the property transferred at the time of transfer. Provided that you have given up control of the property, all of the property in the trust, plus all future appreciation on the property, is out of your taxable estate. That means your ultimate estate tax liability may be less, resulting in more passing to your beneficiaries. Property transferred to your beneficiaries through an irrevocable trust will also avoid probate. As a bonus, property in an irrevocable trust may be protected from your creditors. There are many different kinds of irrevocable trusts. Many have special provisions and are used for special purposes. Some irrevocable trusts hold life insurance policies or personal residences. You can even set up an irrevocable trust to generate income for you. Page 11 of 28, see disclaimer on final page

12 Testamentary trusts Trusts can also be established by your will. These trusts don't come into existence until your will is probated. At that point, selected assets passing through your will can "pour over" into the trust. From that point on, these trusts work very much like other trusts. The terms of the trust document control how the assets within the trust are managed and distributed to your heirs. Since you have a say in how the trust terms are written, these types of trusts give you a certain amount of control over how the assets are used, even after your death. Page 12 of 28, see disclaimer on final page

13 Life Insurance for the Self-Employed If you're like most people, you bought life insurance to provide for your loved ones in the event of your death. But because you're self-employed, you may have an even greater need for life insurance: You'll want to protect your family after you die, as well as protect the financial needs of your business. Why life insurance is important As long as you are alive and healthy, your income-producing capability is relatively secure, and you and your family can enjoy the lifestyle you have established. If you were to die, however, your family could face hard economic times. Your family's financial needs may include: Final expenses, such as burial and funeral costs Unpaid medical bills Income replacement Mortgage balance Debt repayment (credit cards) Education fund for children Emergency expenses Why life insurance may be even more important when you're self-employed As a sole proprietor, you are personally liable for all of the debts of your business. Legally, there is no difference between personal and business assets. By definition, a sole proprietorship ends when the owner dies. So, any losses or financial obligations at your death become the responsibility of your estate. It is possible that personal assets may have to be sold or transferred to pay off business debts. Business debts may include: Business loans Mortgage or lease payments on business location Payments due to suppliers, vendors, consultants, employees, and so on Taxes due to local, state, and federal taxing authorities Fees to lawyers, accountants, and other advisors to settle business affairs Life insurance can be used to cover these debts, as well as to provide for the ongoing needs of your family after your death. What to do about it Ask your financial professional or insurance representative to help you assess your need for life insurance and design a program to fit your needs. Page 13 of 28, see disclaimer on final page

14 Group Term Life Insurance Group term life insurance is simply term insurance issued to people who belong to a group that has a common interest or association, such as an employer, a trade, or a school affiliation. Premiums increase annually or in "bands" of three- or five-year periods. Group term life insurance offers pure financial protection against premature death (there is no cash value component with term insurance, as there is with permanent insurance). For an employer, group term life insurance is a convenient way to offer employees easy-to-buy, affordable life insurance coverage. Employers often provide a flat amount of coverage, such as $10,000 per employee. Many employers offer coverage that is a multiple of an employee's earnings, such as two times his or her annual salary. Eligibility information As an employer, you can choose to include all of your employees in a group term life insurance plan, or select only a class of employees, such as managers. You can also exclude certain employees from coverage. For instance, you could require employees to work a minimum number of hours per week, such as 20, before they would qualify for coverage. You could also exclude employees based on the number of months worked per year, such as requiring at least five months of work in order to obtain coverage. Or, employees may have to have been employed for a certain period of time before they are eligible to participate. A business can start group coverage with as few as 2 employees, though most employers begin thinking about offering coverage when they have 10 or more employees. The number of employees may determine whether an insurer will offer immediate coverage without evidence of insurability. Plans that limit coverage to $50,000 or less usually skip any medical underwriting requirements; amounts over $50,000 may require individuals to answer medical questions and satisfy underwriting standards to be accepted. Bells and whistles Some group term policies may offer supplemental coverage (for a spouse) or dependent coverage (for children). These coverage amounts often carry limitations. For instance, the spousal coverage may be limited to 50 percent of the employee's amount, while dependent coverage may be a flat amount, such as $2,000. Some policies also offer an accelerated death benefit that allows an employee with a terminal illness to collect a percentage of his or her coverage in advance. When employees leave your firm or retire, they may also be able to keep the coverage as personally owned term insurance, or convert the group term to permanent life insurance. Available options vary among insurers, so be sure to ask about features that are important for your business needs and for your employees. What's in it for the employees? Essentially, group term coverage can represent free life insurance for an employee. But because many employers limit group term coverage to $50,000, employees should often think of this coverage as supplemental to their own personal life insurance plans, not as their main source of protection. Employers often stop at $50,000 of coverage for tax reasons. The cost to provide coverage of up to the $50,000 limit is deductible by the employer but not includable in the income of the employee. Also, an employee's beneficiary will not pay federal income taxes on the death benefits. A state may, however, require income taxes on the death benefits. Employers that pay for more than $50,000 of group term coverage must include the "economic value" of the cost of the excess insurance as taxable income to the employee (reported on their W-2s as "additional compensation"). One way around these limitations is for an employer to pay for the first $50,000 of coverage and allow employees to pay for any optional coverage in excess of this amount. Page 14 of 28, see disclaimer on final page

15 What's in it for the employer? As the employer, you can offer different coverage amounts for different classes of employees. For example, you might buy $50,000 of coverage for your customer service personnel, but buy coverage for your engineers equal to three times their annual salaries. The downside is that if you do "discriminate" among different classes of employees, the economic value of the cost of the first $50,000 of coverage may be taxable to your key employees (i.e., certain officers, highly compensated individuals, and owners with 5 percent or more ownership). As mentioned, you may pay all or part of the cost of group life coverage, and many employers pass on the costs of any additional features to their employees. The good news, from a federal income tax standpoint, is that group term life premiums paid by an employer are tax deductible by the business, even if your plan is discriminatory. Also note that the way your business is organized will affect your business tax benefits. Owners of more than 2 percent of an S corporation, partners, and sole proprietors are not considered employees, so premiums paid for their group term insurance are generally not tax deductible. In a corporation that is not an S corporation, premiums paid for all employees (including owner-employees) are generally tax deductible. Cost concerns Typically, you can expect to pay a set amount per $1,000 of coverage per employee (e.g., $.10 per $1,000 per month). Premium costs depend on the coverage amounts you want to provide and whether medical underwriting is required. Premium costs will also depend on the number of employees, their ages, their genders, and the type of business you operate. For instance, a commercial fishing fleet will probably pay more in premiums than a bookstore. For any type of business, though, you can expect costs to rise as your employee population ages. In general, the larger the group of employees, the lower the premium charged. And just like many group health plans, an insurer may also charge higher life insurance premiums for smokers than for nonsmokers. Page 15 of 28, see disclaimer on final page

16 Key Employee Life and Disability Insurance You've got a great group working for you now, and business is good. You know that much of that success is due to one or two key people with both skills and personalities that are hard to match. Suppose they were injured and out of work for a while, or suppose they died? Would your business survive? Key employee life and disability insurance coverage can help make sure that it does. When bad things happen to good people Your key employees are those special people with such unique skills and talents that they contribute greatly to the financial success of your business. If a key employee were disabled and out of work, or were to die, your business would suffer a financial loss. Here are some possibilities: While the employee is out of work, the revenue that he or she generates may substantially decrease You'll incur unexpected expenses recruiting and training a temporary or permanent replacement Less capable or inexperienced employees trying to fill in can make mistakes or cause delays that cost you money If a key person dies, a business loan may come due Customers or even other employees may look elsewhere, concerned for the future of the business after the loss of a key employee Key employee life and disability insurance policies can help soften the impact of these blows. Generally speaking, these policies are sold to small or medium-size businesses; it's in those operations that a single person can make the most difference to the bottom line. If you own a large company that's better able to absorb the financial losses caused by losing a key employee, you may have difficulty buying the coverage you desire. If death does you part--key employee life insurance Typically, your business purchases a life insurance policy on a key employee, pays the premiums, and is the beneficiary in the event of the employee's death. As the owner of the policy, the business may surrender it, borrow against it, and use either the cash value or death benefits as the business sees fit. In determining how much insurance you'll need, putting a dollar value on a key employee's economic worth may be difficult. Although there are no rules or formulas to follow, several possible methods to determine the insurance amount may be used. The appropriate level of coverage might be the cost of recruiting and training an adequate replacement. Alternatively, the insurance amount might be the key employee's annual salary times the number of years a newly hired replacement might take to reach a similar skill level. Finally, you might consider the key employee's value in terms of company profits; the level of insurance coverage might then be tied to any anticipated profit loss. The premiums you pay for key employee life insurance are not a tax-deductible business expense for federal income tax purposes, since your business is the recipient of the benefits. Prior to August 16, 2006, the death benefits your company receives as the beneficiary of the policy aren't considered to be taxable income. But for policies issued after August 16, 2006, proceeds from a life insurance policy insuring the life of an employee and payable to the employer-policy owner may be subject to income tax, unless an exception applies. Also, if your business is a C corporation, the death benefits may increase the corporation's liability for the alternative minimum tax. You should consult a tax professional for information on your circumstances. Riding out the hurt--key employee disability insurance The death of a key employee isn't the only threat to your business. Suppose a key employee is injured or becomes ill, and is out of work for an extended period? Disability insurance on such a key employee is another way you can Page 16 of 28, see disclaimer on final page

17 protect your business against any resultant financial loss. A critical part of key employee disability insurance policies is the definition of disability. Usually, these policies define disability as the inability of the employee to perform his or her normal job duties due to injury or illness. As with life insurance, your business buys a disability insurance policy on the employee, pays the premiums, and is named as the beneficiary. When the employee is disabled, the insurance coverage pays monthly disability benefits to your business. These benefits can equal a certain percentage of the key person's monthly salary, up to either a maximum monthly limit or 100 percent of that salary. The benefits may be used to pay the operating expenses of the business and to cover the expense of finding a temporary or permanent replacement for the key employee. The policies typically offer elimination periods (i.e., the waiting period between the disability and when the benefits begin) ranging from 30 to 180 days. Depending on the policy, your business may receive the benefits for 6 to 18 months--long enough to allow the key employee to return to work or to allow the company to replace the key employee. The policy is normally a noncancelable contract, guaranteeing the premiums and the coverage amount. A waiver of premium option can be an important part of these policies. This option provides that, once the elimination period has been satisfied, the insurance company will pay the premiums as long as the disability lasts or until the benefit period ends. Sometimes included in the base disability policy coverage (or available as an optional benefit for an additional premium) is personnel replacement expense coverage that pays for the cost of finding and hiring a replacement for the key employee. These benefits are usually payable after the key employee's disability has lasted at least 6 months. Your business will be compensated for actual replacement expenses incurred, including advertising costs, employment agency fees, and the first 3 months of the new employee's salary. As with key employee life insurance, the premiums you pay for the key employee disability policy are not a tax-deductible business expense. As a result, the benefits your business receives are not generally considered taxable income. Page 17 of 28, see disclaimer on final page

18 Split Dollar Insurance Plans Let's say you want to reward a few key executives with low-cost life insurance. Can you do so without providing the same benefit to your other employees? You can with a split dollar life insurance plan. In fact, such an arrangement can provide your business with several benefits. It can help you attract and retain employees, reward key executives, and fund severance packages and certain other benefit plans. How does a split dollar life insurance plan work? Split dollar life insurance is an arrangement between an employer and an employee to share the costs and benefits of a life insurance policy. Specifically, the parties join together to purchase an insurance policy on the life of the employee and agree, in writing, to split the cost of the insurance premiums, as well as the policy's death proceeds, cash value, and other benefits. The actual life insurance policy used can be whole life, universal life, second-to-die (survivorship), or any other cash value policy. Split dollar arrangements usually take one of two forms. Under the endorsement form, the employer is formally designated as the owner of the life insurance contract and endorses the contract to specify the portion of the death proceeds payable to the employee's beneficiary. Under the collateral assignment form, the employee is formally designated as the owner of the contract, and the employer 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. Why use a split dollar life insurance plan? Split dollar life insurance is widely used in gift and estate planning and can be an important part of the compensation package of many key employees. You don't have to cover all of your employees--the coverage, amounts, and terms of the split dollar arrangement are generally not subject to Employee Retirement Income Security Act (ERISA) nondiscrimination rules. Split dollar plans can be used to: Attract, motivate, and retain employees Provide low-cost life insurance protection to employees Fund severance benefits Fund stock purchase agreements Fund nonqualified deferred compensation plans Advantages of split dollar life insurance plans Split dollar life insurance offers a number of advantages: A split dollar plan allows an executive to obtain life insurance coverage using employer funds. The investment by your business in the plan is fully secured. If the insured employee dies or his or her employment is terminated, your business is reimbursed from the policy proceeds for its payment of premiums. Split dollar plans can be customized to meet the objectives of both employer and employees. The death benefit from a split dollar plan (both the employer's share and the share going to the beneficiary of the employee) is generally free from income tax. Page 18 of 28, see disclaimer on final page

19 Note: If the death proceeds are paid in installments, any interest element in the installment payments will generally be taxable. Disadvantages of split dollar life insurance plans Split dollar plans have some disadvantages as well, including the following: Tax issues Your business will generally receive no tax deduction for its share of premium payments under the split dollar plan. Depending on how the agreement is structured, employees may have to pay income taxes each year on the value of the economic benefits provided to them. Alternatively, if the employer's premium payments are considered a series of loans to the employee, then the employee must pay a reasonable rate of interest to the employer. If the employee does not do so, the employee is considered to have received taxable income up to the amount of interest that should be paid. Tax rules regarding split dollar life insurance are complicated. Under current regulations, two mutually exclusive sets of rules govern the taxation of split dollar arrangements. Generally, if the employer owns the policy (an endorsement form arrangement), the employer is treated as transferring "economic benefits" to the employee. The employee must include in income the value of the life insurance protection provided by the employer, plus the cash value (if any) to which he or she may have access (to the extent that it has not been taken into account in a prior taxable year). Under the loan regime, the employer is treated as lending premium payments to the employee. The loan regime generally governs the taxation of those arrangements under which the employer's premium advances are secured by a collateral assignment of the policy. Before entering into a split dollar life insurance arrangement, it's important to ask a financial planning professional to assess how the current regulations might impact your business. Page 19 of 28, see disclaimer on final page

20 Funding a Buy-Sell Agreement with Life Insurance As a partner or co-owner (private shareholder) of a business, you've spent years building a valuable financial interest in your company. You may have considered setting up a buy-sell agreement to ensure your surviving family a smooth sale of your business interest and are looking into funding methods. One of the first methods you should consider is life insurance. The life insurance that funds your buy-sell agreement will create a sum of money at your death that will be used to pay your family or your estate the full value of your ownership interest. How funding with life insurance works When using life insurance with a buy-sell agreement, either the company or the individual co-owners buy life insurance policies on the lives of each co-owner (but not on themselves). If you were to die, the policyowners (the company or co-owners) receive the death benefits from the policies on your life. That money is paid to your surviving family members as payment for your interest in the business. If all goes well, your family gets a sum of cash they can use to help sustain them after your death, and the company has ensured its continuity. Advantages of using life insurance Life insurance creates a lump sum of cash to fund the buy-sell agreement at death Life insurance proceeds are usually paid quickly after your death, ensuring that the buy-sell transaction can be settled quickly Life insurance proceeds are generally income tax free; a C corporation may be subject to the alternative minimum tax (AMT) If sufficient cash values have built up within the policies, the funds can be accessed to purchase your business interest following your retirement or disability Disadvantages of using life insurance Life insurance premiums are paid with after-tax dollars because the premiums are generally not a tax-deductible expense Premium requirements are an ongoing expense One or more co-owners may be uninsurable due to age or illness If the co-owners' ages vary widely, younger co-owners will have to pay higher premiums on the lives of the older co-owners If the ownership percentages vary widely, more insurance will be needed to cover the owners with the larger ownership interests, resulting in higher premium costs for those with smaller ownership interests How to set up different types of buy-sell agreements In an entity purchase buy-sell agreement, the business itself buys separate life insurance policies on the lives of each of the co-owners. The business usually pays the annual premiums and is the owner and beneficiary of the policies. In a cross purchase buy-sell agreement, each co-owner buys a life insurance policy on each of the other co-owners. Each co-owner usually pays the annual premiums on the policies they own and are the beneficiaries of the policies. If your company has a large number of co-owners, multiple policies must be purchased by each co-owner. A wait and see (or hybrid) buy-sell agreement allows you to combine features from both the entity purchase and Page 20 of 28, see disclaimer on final page

21 cross purchase models. The business can buy policies on each co-owner, the individual co-owners can buy policies on each other, or a mixture of both methods can be used. The buy-sell agreement should be fully funded The amount of insurance coverage on your life should equal the value of your ownership interest. Then, when you die, there will be enough cash from the policy proceeds to pay your family or estate in full for your share of the business. But if all that is affordable is insurance coverage for a portion of your interest, you might want to go ahead and fund that amount. Later, the company may be able to increase the amount of insurance or use additional funding methods. In the meantime, the agreement should specify how your family or estate will be paid. The value of the business could change over time What if the insurance proceeds turn out to be less than the value of your business interest, due to growth in the business? Your surviving family members might end up getting less than full value for your business interest. Your buy-sell agreement should specify how the valuation difference will be handled. Conversely, the insurance proceeds might be greater than the value of your business interest when you die. Your buy-sell agreement should address this potential situation upfront and specify whether the excess funds will belong to the business, the surviving co-owners, or your family or estate. Should group life insurance be used? Using a company's group life insurance plan to fund a buy-sell agreement is generally not recommended. Normally, group life insurance premiums are tax deductible to the company. But premiums are no longer deductible if the business is the beneficiary. Possible negative tax consequences For policies issued after August 16, 2006, the death benefits of life insurance on the life of an employee payable to the employer/policy owner may be subject to income taxes unless an exception applies. Assume your business is a corporation or is taxed as one. When one of your co-owners dies, his or her estate becomes the owner of the insurance policies covering you and the other co-owners of the business in a cross purchase agreement. If these policies are then transferred to the surviving co-owners to pay for future buyouts, a transfer-for-value (gain) may occur, and a portion of the proceeds received from the transferred policies may be taxable. If a policy is canceled (surrendered) for cash to buy out your interest while you are living, any gain on the policy is subject to federal income tax for the policyowner. Gain includes all policy loans outstanding at the time of surrender. Also, the policy may carry surrender charges. The proceeds received by a C corporation under an entity purchase agreement may be subject to the AMT. Keeping track of your buy-sell agreement Each year, the premiums on the policies must be paid, or the insurance will lapse. So monitor premium payments carefully. Your buy-sell agreement should include a feature requiring ongoing proof of payment. Also, review the amount of insurance regularly. The insurance coverage may have to be increased periodically to reflect increases in the value of the business. If additional insurance is not possible, another funding method should be established. Finally, periodically check the financial rating of your insurance company. The policies funding your buy-sell agreement will do your family no good if the insurer becomes insolvent. Page 21 of 28, see disclaimer on final page