An American Benefits Cnsulting White Paper American Benefits Cnsulting, LLC 99 Park Ave, 25 th Flr New Yrk, NY 10016 212 716-3400 http://www.abcsys.cm Grup Term Life Insurance: Table I Straddle Testing and Imputed Incme fr Dependent Life Insurance Friday, September 24, 2010
Table f Cntents Intrductin... 2 Imputed Incme Definitins and Straddling... 2 Plan Design Cnsideratins... 3 Straddle Testing: Age and Pay Definitin... 4 Age Definitin... 4 Pay Definitin... 5 Dependent Life Insurance... 5 Whse Age?... 6 Child Life... 6 Summary... 6 Intrductin Many large emplyers prvide a grup life insurance plan t emplyees that includes basic and vluntary life insurance n emplyees and vluntary life insurance n dependents. It is cmmn knwledge that imputed incme under sectin 79 f the Internal Revenue Cde must be calculated n emplyer-paid basic life insurance in excess f $50,000. Hwever, emplyers may nt knw, r understand why, under certain circumstances, imputed incme calculatins must als cnsider vluntary life insurance n emplyees. Emplyers may als nt realize that under certain circumstances imputed incme must be calculated fr vluntary life insurance n dependents. Mst emplyers d nt wish t calculate imputed incme n vluntary life insurance n emplyees r dependents. This paper addresses hw certain aspects f these plans must be structured in rder t avid imputed incme n them. This paper assumes that all premium payments are made with pst-tax dllars. Sectin 79 f the Internal Revenue Cde gverns imputed incme n grup term life insurance fr emplyees. Sectin 61 f the Cde gverns the taxatin f life insurance n dependents. We will first address the sectin 79 emplyee life cncerns and then the sectin 61 dependent life cncerns. Imputed Incme Definitins and Straddling Sectin 79 f the Cde says that an emplyee must include in his r her incme the value f grup term life insurance in excess f $50,000. Grup Term Life Insurance is specifically defined in the regulatins fr sectin 79 ( 1.79-1), as fllws: 1. It prvides a general death benefit that is excludable frm grss incme 2. It is prvided t a grup f emplyees 3. It is prvided under a plicy carried directly r indirectly by the emplyer 4. The amunt f insurance prvided t each emplyee is cmputed under a frmula that precludes individual selectin This cnditin may be satisfied even if the amunt f insurance prvided is determined under a limited number f alternative schedules 2 American Benefits Cnsulting LLC Cnfidential
Fr this paper, the third item in the definitin, and, in particular, the wrds plicy and carried directly r indirectly by the emplyer are imprtant. The regulatins say that all the life insurance bligatins (basic and vluntary life are tw bligatins) f the same insurer sld in cnjunctin are cmbined and cnsidered ne plicy. This is the case even if the basic and vluntary life cverages are prvided under separate insurance plicies issued by the insurer. Carried directly r indirectly by the emplyer means that either the emplyer pays any part f the cst f the insurance r the rates straddle Table I. Straddling Table I means that at least ne rate is belw Table I and at least ne rate is abve Table I. Fr example, the fllwing excerpt frm a hypthetical rate table demnstrates a straddle: Age Bracket Premium Table I 40-44 $0.09 $0.10 45-49 $0.16 $0.15 Figure 1: Simple Straddle Example In this case, the premium rate fr the 40-44 age bracket is less than the crrespnding Table I rate, while the age 45-49 rate is mre than Table I. This is what is meant by a straddle. If an emplyer wishes t avid calculating imputed incme n vluntary emplyee life insurance, the vluntary life insurance must be deemed t be prvided under a plicy that is nt carried directly r indirectly by the emplyer. Hw des an emplyer achieve this? Plan Design Cnsideratins First, the emplyer must be able t deem the vluntary emplyee life insurance as being prvided under a separate plicy. Remember that bth bligatins (assuming they are prvided by the same insurer) ffered t a grup f emplyees must be cnsidered tgether. Hw can the vluntary life be lked at separately? The regulatins prvide that the tw bligatins can be treated as being prvided under separate plicies if the premiums are prperly allcated amng such plicies. The regulatins d nt define prperly allcated, hwever a subsequent Private Letter Ruling gives the fllwing ptential guidelines fr evaluating this: structures fr basic and vluntary Life are selfsupprting and dn t subsidize each ther Premium rates fr the cverages are determined separately and independently Finances f the cverages are accunted fr separately and independently Reserves are nt shifted between the cverages Dividend and rate credits attributable t each f the cverages are determined separately frm each ther, based n independent retrspective adjustments (if any) If the abve cnditins are met, the emplyer may be able t treat the basic and vluntary life as separate plicies. This is the first step t aviding imputed incme n vluntary life. The secnd step is making sure the (nw separate) vluntary life plicy is nt carried directly r indirectly by the emplyer. We will assume that the emplyer pays n prtin f the premium. As alluded t abve, the plicy will be cnsidered t be carried by the emplyer if the premium rates straddle Table I. Fr the rates t NOT straddle Table I, all the rates must be equal t r higher than Table I r, alternatively, all the rates must be equal t r lwer than Table I. The hypthetical vluntary life premium rate tables belw illustrate the straddling cncept. Age Bracket Premium Table I Prem. vs. Table I <25 $.04 $.05 Lwer 25-29 $.05 $.06 Lwer 30-34 $.07 $.08 Lwer 35-39 $.08 $.09 Lwer 40-44 $.09 $.10 Lwer 45-49 $.16 $.15 Higher 50-54 $.23 $.23 Equal 3 American Benefits Cnsulting LLC Cnfidential
55-59 $.43 $.43 Equal 60-64 $.65 $.66 Lwer 65-69 $1.26 $1.27 Lwer 70+ $2.06 $2.06 Equal Figure 2: Mre extensive Straddle Example Figure 2 s table f premium rates straddles Table I because at least ne premium rate is higher than its crrespnding Table I rate (ages 45-49) while at least ne premium rate is lwer than Table I (e.g. ages 40-44). Age Bracket Premium Table I Prem. vs. Table I <25 $.06 $.05 Higher 25-29 $.07 $.06 Higher 30-34 $.09 $.08 Higher 35-39 $.10 $.09 Higher 40-44 $.11 $.10 Higher 45-49 $.16 $.15 Higher 50-54 $.23 $.23 Equal 55-59 $.43 $.43 Equal 60-64 $.67 $.66 Higher 65-69 $1.30 $1.27 Higher 70+ $2.50 $2.06 Higher Figure 3: N Straddle Example Figure 3 s premium rates d nt straddle Table I because all the premium rates are equal t r higher than their crrespnding Table I rates. Similarly, a premium rate table with all rates equal t r lwer than Table I wuld nt straddle Table I. S, if the vluntary life can be cnsidered t be prvided under a separate plicy, is 100% emplyee-paid, and the premium rates dn t straddle Table I, then the vluntary emplyee life insurance can be excluded fr imputed incme purpses. As a summary, here is the path by which this result is achieved: 1. Basic and vluntary life are cnsidered ne plicy and bth are subject t imputed incme (this is the starting pint under the Cde) 2. The vluntary life can be cnsidered a separate plicy if the premiums are prperly allcated between basic and vluntary life 3. The vluntary life can be cnsidered NOT carried directly r indirectly by the emplyer if it is emplyeepay-all and the premium rates dn t straddle Table I 4. If the vluntary life is a separate plicy nt carried directly r indirectly by the emplyer, it is nt cnsidered grup-term life insurance and is thus nt subject t imputed incme under Sectin 79 Straddle Testing: Age and Pay Definitin With respect t the straddle test, there are tw special cnsideratins fr emplyers age definitin and pay definitin. Age Definitin If the emplyer des nt determine age fr premium purpses n the same basis as the regulatins, the vluntary life rates can inadvertently straddle Table I. When using Table I, the IRS defines age fr the entire tax year as the age at the end f the emplyee s tax year. Let us assume that this is the end f the calendar year fr mst emplyees. And, since we are talking abut (ptential) imputed incme fr a particular tax year, this wuld be the age at the end f the year f cverage in questin. Fr example, fr calendar year 2011, fr IRS Table I purpses, an emplyee brn in 1951 is cnsidered t be age 60, the emplyee s age n December 31, 2011. Sme emplyers define age fr premium rate purpses incnsistently with the IRS, using the emplyee s age at the end f the prir year. S, fr 2011, an emplyer may determine smene brn in 1951 t be 59. This incnsistency between the premium age and the Table I age can cause an inadvertent straddle. Fr example, cnsider the fllwing excerpt f a hypthetical premium rate table fr an emplyer that defines age at the end f the prir calendar year. Age Bracket Premium Table I 55-59 $0.53 $0.43 60-64 $0.82 $0.66 4 American Benefits Cnsulting LLC Cnfidential
Figure 4: Age Definitin Example Fr an emplyee brn in 1951, in 2011, the emplyer uses the $0.53 rate because the emplyer cnsiders the emplyee t be age 59. The IRS cnsiders the emplyee 60 and wuld use the 60-64 Table I rate f $0.66. In this case, the emplyee s premium rate is lwer than the Table I rate ($0.53 vs. $0.66). Hwever, cnsider the same situatin fr an emplyee brn in 1952. The emplyer wuld use the age 58 rate f $0.53. The IRS wuld cnsider the emplyee t be age 59, fr which the Table I rate is $0.43. In this case, the emplyee is paying a rate higher than the Table I rate ($0.53 vs. $0.43). In this case, if an emplyer has emplyees in the vluntary life plan brn in bth 1951 and 1952, the emplyer is charging at least ne emplyee less than Table I and at least ne emplyee mre than Table I. This is the definitin f a straddle. If an emplyer is currently using age at the end f the prir year, and all the premium rates appear t be higher than Table I (meaning that if yu lk at a side-by-side cmparisn all the five-year age bracketed premium rates are higher than Table I), the straddle situatin described abve can be remedied by using age at the end f the current year f cverage fr premium purpses. Pay Definitin Similarly, if the emplyer des nt determine the benefit-based pay fr premium purpses n the same basis as the regulatins, there may als be an inadvertently straddle f Table I. Sme emplyers define the emplyee s pay fr premium purpses as a frzen amunt at sme pint in the prir year. Fr example, payrll deductins fr premium will be based n the emplyee s pay as f July 1 f the prir year. Hwever, this same emplyer may define the death benefit t be based n the emplyee s pay at the time f death. Fr example, assume an emplyee s pay n July 1, 2010 is $100,000 and the emplyee has chsen 3 times pay fr vluntary life. The emplyer may be calculating payrll deductins in 2011 based n a benefit amunt f $300,000. Hwever, if the emplyee gets a raise t $110,000 n March 1, 2011 and dies n May 1, 2011, the death benefit is 3 times $110,000 r $330,000. This practice may cause an effective Table I straddle as described belw. Assume that the emplyer s strategy fr nt straddling Table I rates is t have all rates equal t r higher than Table I. Further, assume that the premium rate fr the age 45-49 age bracket is $0.16 (the Table I rate fr this age bracket is $0.15). Using the hypthetical example abve, the emplyer wuld be payrll-deducting $48.00 per mnth fr premium: ($300,000 / $1,000) x $0.16 = $48.00. Hwever, the regulatins define Table I as Cst per $1,000 f prtectin fr ne mnth. (emphasis added) Prtectin wuld appear t mean the death benefit that wuld be paid if the emplyee dies. In this case, that amunt is $330,000. If the emplyer is cllecting $48.00 fr a $330,000 death benefit, the effective premium rate, per $1,000 f prtectin fr ne mnth, is $0.145: $48.00 / ($330,000 / $1,000) = $0.145. S, effectively, this emplyee is paying less than the Table I rate fr vluntary life insurance. If an emplyee with the same July 1 pay f $100,000 received n raise r a raise f, say, 3%, t $103,000, such emplyee wuld effectively still be paying mre than the Table I rate. If this situatin were t happen, there wuld be at least ne emplyee paying less than the Table I rate, and at least ne emplyee paying mre than the Table I rate. This is a straddle. This can be remedied by using a cnsistent definitin f pay fr premium and death benefit purpses. Dependent Life Insurance Many emplyers may nt be aware f the imputed incme ramificatins f having an emplyee-pay-all dependent life plan. Life insurance n nn-emplyees is nt cvered by sectin 79, hwever it is cvered by sectin 61 f the cde. Particularly, the regulatins fr 5 American Benefits Cnsulting LLC Cnfidential
sectin 61 specifically cver (the) Cst f grupterm life insurance n the life f an individual ther than an emplyee. The regulatins say: The cst (determined under paragraph (d)(2) f 1.79-3) f grup term life insurance n the life f an individual ther than an emplyee (such as the spuse r dependent f the emplyee) prvided in cnnectin with the perfrmance f services by the emplyee is includible in the grss incme f the emplyee. Sme emplyers may interpret this t say that there is nthing t d because there is n cst prvided by the emplyer since the insurance is emplyee-pay-all. Hwever, nte that the regulatin defines what the cst is, i.e. determined under paragraph (d)(2) f 1.79-3. This means the cst using the Table I rates. In a subsequent Private Letter Ruling and Technical Advice Memrandum, the IRS has specifically said that the excess f the cst using the Table I rates ver the premium actually paid is cnsidered a fringe benefit subject t tax under sectin 61 f the cde. (This is fr nn-de minimis amunts f cverage, which the IRS has defined in sme places t be amunts ver $2,000.) Child Life In many plans, Child Life Insurance is purchased cvering all children f the emplyee fr the stated death benefit fr a fixed premium. Thus, the mre children the emplyee has, the lwer the per $1,000 premium rate per persn cvered. Whether r nt the emplyee is paying a premium rate per $1,000 per persn cvered that is lwer than Table I will depend n the ttal premium paid by the emplyee and the number f children insured. Summary There are many pitfalls fr emplyers in navigating the cncept f imputed incme n emplyee and dependent life insurance. While ABC cannt and des nt ffer legal advice, we stand ready t help ur current and prspective future clients with these issues. Despite American Benefit s expertise in this area, please be sure t seek the advice f Accunting r Legal cunsel prir t making any determinatins regarding incme calculatins fr emplyees. Given the IRS s guidance n sectin 61 incme n dependent life insurance, if an emplyer wishes t NOT calculate imputed incme, the premium rates must be equal t r abve Table I. Nte that the age definitin cnsideratins discussed in the previus sectin apply t dependent life insurance as well. In additin, there are tw ther cnsideratins. Whse Age? Sme emplyers, nt knwing the age f spuses cvered fr life insurance, base the premium rate n the emplyee s age. It wuld appear that the cst under Table I wuld be based n the spuse s age, nt the emplyee s age, since it is the spuse wh is the insured. 6 American Benefits Cnsulting LLC Cnfidential
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