Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  What is it?  An executive benefit that promises payments from the employer to the survivors of an eligible employee at the employee’s death  DBO plan promises only death benefits and no lifetime payments  DBO payments of benefits conditioned upon  Survival of the employee by an employer designated beneficiary  The employee’s continued employment until death  Key goals of plan  Provide a significant death benefit  Generate a substantial amount of income to the family of the deceased employee  Help to recruit, retain, and reward employees

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  When is the use of such a device indicated?  When the employer seeks to recruit, retain, and reward employees and counterbalance limitations upon key employees found in qualified retirement plans  When an employer wants a benefits that is  Simple  Cost effective  Free from administrative burdens  When an employer want to pick and choose who will be covered, under what terms and conditions, and at what amounts  To supplement a qualified retirement plan

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  When is the use of such a device indicated? (cont‘d)  When a shareholder-employee wants to utilize his corporation to provide personal financial security  means to supplement payments under a buy-sell agreement  When an employer wants to provide liquidity and income security for a younger employee’s surviving family  If the employee survives until retirement, employer could convert the DBO plan to a nonqualified deferred compensation plan in order to provide retirement security  Conversion of a split dollar plan to a DBO plan to remove taxable income implications arising from the split dollar arrangement while alive  Death benefits from the employer from the DBO plan will be treated as taxable income

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  When is the use of such a device indicated? (cont‘d)  To provide additional income or estate liquidity for survivors of a client with a large estate  Where group term life insurance is inadequate for the highly compensated employees  Where an employer is truly and deeply concerned with the well being of the families of company employees, but does not want the death benefit diverted to someone other than a survivor of a deceased employee  Especially for widows between the ages of 50 and 65  Employment is hard to find  May be difficult to remarry

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  Advantages  Proceeds are excludable from employee’s gross estate  If 50% or less shareholder  Large amounts of continuing income provided to the beneficiary through the employer  Employee is not taxed on the employer’s premium payments  Employers can pick and choose who will be covered, the terms of that coverage, and the level of benefit payments to be provided  Benefits received are taxed at the beneficiaries’ tax brackets, which may be lower than that of the employee  Benefit payments are tax deductible to the employer

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  Disadvantages  Payments are subject to ordinary income tax  No deduction is allowed until the benefit is paid  beneficiary must include payments in taxable income  Employee given no right to name beneficiary  Plan covering a large and broad group of employees may have to comply with ERISA  Premiums must be paid with after-tax dollars  Formal funding through a trust may trigger constructive receipt, may cause estate tax inclusion, and will probably result in ERISA reporting, disclosure and funding requirement implications

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  What are the requirements?  Written agreement between employer and employee  Amount of the benefit or the formula upon which the benefit is based  The employee(s) covered by the plan  The class of beneficiaries entitled to the benefit  The terms upon which the benefit can be forfeited  Collection procedures  There is no IRS or Department of Labor guidance or requirement with respect to the formula for determining how much the survivors will be paid

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  What are the requirements? (cont‘d)  Corporate resolution by the board of directors should be adopted  No amounts are set aside beyond the claims of the corporate creditors  Obligation of the corporation to make payments contingent upon  Employee’s continued employment  Survival of a beneficiary from among the employer specified eligible class  Life insurance should not be mentioned in the contract with the employee  Linking the insurance with the benefit could cause unnecessary estate tax inclusion, income taxation on premium payments, and Department of Labor intrusion

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  What are the tax implications?  No income tax is payable by the covered employee on the premium payments that the employer pays  Premiums are not income tax deductible  Except for any AMT, proceeds are received by the employer income tax free  Corporate profits and earnings  Decreased by the premium payments  Increased by the cash surrender value increases and the excess of death proceeds over cash surrender value in the year of death  Cash values, per se, should not trigger an accumulated earnings tax

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  What are the tax implications? (cont‘d)  Benefits paid by a corporation to an employee’s beneficiary are taxable in full as ordinary income to the beneficiary  Benefits paid by the corporation are deductible as deferred salary to the extent that amount represent “reasonable compensation”  Payments from the corporation to the beneficiaries of the covered employee may be excludable from the employee’s gross estate  Give the employer sole discretion as to the class of beneficiary to receive death proceeds  Give the employee mo lifetime postretirement benefit or plan (other than qualified pension or profit sharing plan  Give the employee no right to dispose of the payments should one or more of the specified beneficiaries die

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  What are the tax implications? (cont‘d)  Excluding from employee’s gross estate (cont’d)  The employee should be given no right to alter, amend, revoke, or terminate the agreement or change its terms  Payments to a surviving spouse outright, or to the estate of a surviving spouse, or to a general power of appointment or QTIP trust could qualify for the estate tax marital deduction  IRS will no longer claim that payments of the death benefit at the employee’s death constitutes a completed gift at the time of death  Death benefits paid to beneficiaries are not considered wages subject to income tax withholding

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  What are the tax implications? (cont‘d)  If a DBO only covers a single employee  Only the benefits paid to the beneficiaries in the calendar year of the employee’s death will be subject to FICA taxes  Benefits paid after that calendar year should escape FICA taxation  What are the ERISA implications?  DBO plan is considered an employee welfare benefit plan  Subject to the requirement of Title I of ERISA  Reporting and disclosure is streamlined if the DBO plan is limited to:  A select group of highly compensated employees (generally less than 5% of the total employees should be participants)

Death Benefit Only (DBO) Plans Chapter 29 Tools & Techniques of Life Insurance Planning  What are the ERISA implications? (cont‘d)  Successfully avoiding ERISA’s funding requirement  Counsel should state in the contract between the employer and employee that employees have no right to any instrument that will be used to finance the employer’s potential obligations under the DBO plan  The employer should maintain any life insurance as part of it’s general unrestricted assets  No financing vehicle, especially life insurance, should be tied to the DBO plan in any way  Only a select group of management and highly compensated employees should be covered under a DBO plan