In the December 2009 issue of Broker World we introduced the executive benefits ladder concept as a flexible benefits strategy which may appeal to business owners seeking to retain non-owner key employees during tough economic times.
An executive benefit ladder uses a series of related executive benefits which build over time, are funded with life insurance, and can be designed to help retain, reward and motivate most valuable employees.
Executive benefit ladders offer employers several potential advantages, including:
• The ability to start funding benefits at a lower level of costs.
• Increased effectiveness in retaining key employees because the benefits offered to an employee improve over time to reaffirm an employer’s commitment to and appreciation of an employee.
• A laddered approach to benefits may motivate employees to work harder as increased benefits may be based on an employer’s increased ability to pay for more benefits.
Additionally, using a laddered approach to benefits gives agents regular opportunities to meet with clients and review their planning and insurance needs.
Executive Benefit Ladders Are Flexible
In the December 2009 issue we explained the five-rung company-owned life insurance ladder (COLI). That series of selective benefits progressed as follows: (1) death benefit only (DBO) plan; (2) endorsement split dollar arrangement; (3) split dollar loan arrangement; (4) split dollar loan with bonuses for the tax costs; and finally (5) split dollar loan with a roll-out.
But the COLI ladder isn’t the only possible design for an executive benefit ladder. Executive benefit ladders are flexible and can be designed in a number of different ways. What makes these laddered arrangements particularly attractive in difficult economic times is the ability to start with a relatively inexpensive benefit (i.e., a DBO arrangement or an endorsement split dollar arrangement) and potentially improve it over time into a more valuable benefit.
The Restricted Bonus Ladder
The COLI ladder featured a series of benefits which culminated with offering an employee a split dollar loan with a roll-out. This ladder design appeals to employers who want to use “golden handcuffs” to retain key employees. For employers who not only want a plan with “golden handcuffs,” but who would also like an income tax deduction for some of their premium payments, a different ladder of benefits may be assembled: “the REBA ladder.”
A REBA (restricted executive bonus arrangement) ladder may be created using five levels of benefits.
1. A Survivor Income Death Benefit Only (DBO) Plan is the simplest benefit. The business promises an employee that if he dies while still employed, a series of payments will be made to one or more persons designated by the employee (e.g., $50,000 annually for 10 years). This type of death benefit is taxable as income in respect of a decedent and can supplement a key employee’s personal life insurance program, or it could be a substitute for personal life insurance.
Such a benefit provides potential savings to an employee; he doesn’t have to use personal after-tax dollars to purchase personal life insurance. Life insurance can be purchased by a business on the key employee designed to offset this new liability and to provide the funds needed to pay the promised benefits if the employee dies. However, death benefits received by an employer policyowner may be subject to income tax unless the parties have complied with the notice and consent provisions of IRC 101(j). Additionally, death benefits received by a C corporation may be subject to the corporate alternative minimum tax.1
2. An Endorsement Split Dollar (using the economic benefit regime) builds on the DBO plan and may be considered a more valuable benefit in two ways.
First, the death benefit from an endorsement split dollar arrangement paid to an employee’s designated beneficiaries is generally income tax-free. DBO plan payments, on the other hand, are fully taxable. Upgrading the plan design to make the death benefit income tax free potentially increases its value by 15 to 40 percent (depending on the beneficiaries’ marginal income tax brackets).
Second, the death benefit can be paid in a lump sum rather than in installments. The beneficiaries don’t have to wait for multiple years to receive the benefit’s full value; rather, they can choose to receive it right away and use it immediately. Also, they don’t have the risk that the business may fail during the payment period.
Life insurance purchased to fund a DBO plan’s obligation can continue to be used to fund an endorsement split dollar benefit. This life insurance can be either a cash value policy or a term policy. If an employee dies during the term of the split dollar arrangement, the business will receive a portion of the death benefit equal to the greater of the policy cash value or the total premiums paid. The balance of the death benefit will be paid to the employee’s designated beneficiary(ies). However, unlike a DBO plan, the value of the life insurance protection from the split dollar arrangement (known as the “economic benefit”) is taxed to the employee annually.
The first two rungs of the ladder focus on death benefits and if desired, can be funded with term insurance. When a business increases its profitability and has more money to spend on incentives to retain key employees, it may be time to consider a restricted executive bonus arrangement (REBA).2
3. The REBA is an arrangement in which an employer makes premium payments on a cash value life insurance policy owned by an executive. The parties may enter into a supplemental employment agreement spelling out the terms and conditions that motivate an executive to remain with an employer for an agreed upon period of time. The parties may also file an endorsement with the insurance company which restricts the executive’s rights in the policy until the terms of the arrangement have been satisfied.
While an executive must recognize premium payments as ordinary income, after expiration of the restrictions, an executive may use the policy as a source of supplemental retirement income, as a source of survivorship benefits for his family, or both.3
To transition to a REBA, an employer will either need to transfer ownership of the policy to the employee (in which case the policy’s fair market value would be treated as taxable income to the employee) or a new policy may be purchased to fund the arrangement. If the policy used for the endorsement split dollar arrangement is a term policy, then it will need to be converted to a cash value policy or a new policy may need to be purchased.
4. A Double Bonus REBA. At some point an employer may choose to enhance the benefits of the REBA by offering to cover an employee’s income tax costs. The bonus used to pay premiums in a REBA is treated as taxable income for an employee, and since there is usually a restriction on access to the policy’s cash value, an employee may have to pay these tax costs out of pocket. In addition to the bonus used for premium payments, an employer can bonus an additional amount to an employee to cover the income taxes owed on the bonus amount. This type of arrangement is often referred to as a “double bonus” or a “zero net outlay” arrangement and offers an employee a benefit with no annual out-of-pocket costs.
5. An Unrestricted Bonus Plan. To implement the REBA, a key employee agrees to restrict his access to policy cash values. The employment agreement or the endorsement agreement filed with the insurer (or both) imposed these restrictions. An employer has the ability to lift these restrictions at any time and give a key employee full access to the cash values. Because the cash values are the property of the employee, there is no cost to the employer by lifting the restriction.
Although there is no economic cost to lifting the restriction, it is an action which should be thoroughly considered. Changing the benefit to an unrestricted bonus plan is the last rung in the REBA ladder because it involves giving up an important element of control—an employer’s “golden handcuff.” Once the restrictions are gone, an employer’s only remaining bargaining chips are the amount and timing of the bonus payments.
Hypothetical Example:
The Restrictive Bonus Ladder in Action
Joe Smith (age 50) is a key employee at Black Star Industries. Even though salaries have been frozen, the owners want to show their appreciation for his hard work and give him special incentive to stay with Black Star and do his very best. Their agent has suggested they use a series of integrated executive benefits for Joe. Here’s the timeline:
Year 1—The DBO Plan. Black Star gives Joe the opportunity to name beneficiaries to receive a benefit of $50,000 paid annually by the company for 10 years if Joe dies while still an employee. There is no cost to Joe and he benefits through increased financial security for his family if he dies unexpectedly. Joe is currently under-insured and likes being able to increase his family’s financial security without incurring any out-of-pocket costs. Black Star purchases a $500,000 term insurance policy on Joe to fund its promise.
Year 3—Endorsement Split Dollar Arrangement. Black Star wants to reinforce how much it likes Joe’s work. It decides to increase the benefit’s value by restructuring the agreement so that the payments to Joe’s beneficiary(ies) may be income tax-free. An endorsement split dollar agreement is drafted and signed.
Black Star can continue the term insurance policy or potentially convert it to a cash value policy. If Joe dies while still an employee, the policy death benefit will be split. Black Star will receive an amount equal to the greater of the policy’s cash value or the total premiums it has paid. Joe designates his spouse to receive the balance in a lump sum, which generally is income tax-free. Each year Joe will include the economic benefit value of the life insurance protection in his taxable income.
Year 4—REBA. Black Star has fully recovered from the recession and Joe has remained a loyal and productive key employee. Black Star agrees to fund the purchase of a new life insurance policy to be owned by Joe as part of a REBA.
Black Star and Joe execute a supplemental employment agreement in which Black Star agrees to pay Joe annual bonuses in exchange for Joe’s promise to remain an employee of Black Star for an additional 10 years. The supplemental employment agreement includes a “liquidated damages” provision requiring Joe to reimburse Black Star in the event he breaches the contract.
The parties also file a “modification of ownership” form with the insurance company, which restricts Joe’s access to the policy’s cash value for 10 years. During the term of the arrangement, Black Star will continue to pay premiums on the policy, which will be treated as taxable income to Joe. After 10 years, when the restrictions have been lifted from the policy, Joe may be able to use the policy as a potential source of retirement income.
Year 6—Double Bonus REBA. Under the REBA, Joe is responsible for paying income taxes on the bonuses used to pay the policy premiums. Black Star wants to reduce Joe’s cost for the arrangement and agrees to pay additional bonuses which Joe can use to pay for the income taxes generated under the REBA.
Year 9—Unrestricted Bonus Plan. Because of Joe’s loyalty and continued good performance, Black Star agrees to lift the restrictions that require him to get its consent before accessing cash values from the life insurance policy. These restrictions were established in year four when the endorsement split dollar agreement was revised to become a REBA. Under their agreement, these restrictions were due to end after 10 years. Black Star is lifting them five years early because it wants to display its confidence in Joe and because to do so doesn’t cost it anything.
Conclusion
In today’s tough economic times, small business owners need to find ways to retain, reward and motivate their most valued employees. Executive benefit ladders offer employers the chance to fund benefits at a level they can afford now while offering potential increases in benefit levels in the future. Designing the ladder as a “restricted bonus ladder” provides incentives for key employees to stay with a business while potentially allowing an employer to have “golden handcuffs” and to take deductions for some of the costs of funding the benefit.
Each taxpayer should seek advice from an independent tax advisor. The ING Life Companies and their agents and representatives do not give tax or legal [or accounting or lending] advice. This information is general in nature and not comprehensive, the applicable laws change frequently, and the strategies suggested may not be suitable for everyone.
Footnotes:
1. Proceeds from an insurance policy are generally income tax-free (e.g., absent a transfer for value) and, if properly structured, may also be free from estate tax.
2. This description of a REBA assumes that income taxation is pursuant to IRC sections 61 and 162 and is not subject to IRC sections 409A or 83. A REBA may also be subject to ERISA plan requirements. Clients should seek advice from their tax and legal advisors.
3. A portion of the policy’s surrender value may be available as a source of supplemental retirement income through policy loans and partial withdrawals. Policy loans and partial withdrawals may vary by state, reduce available surrender value and death benefit or cause the policy to lapse. Generally, policy loans and partial withdrawals will not be income taxable if there is a withdrawal to the cost basis (usually premiums paid), followed by policy loans (but only if the policy qualifies as life insurance, is not a modified endowment contract and is not lapsed or surrendered).
