New Page 1

"As originally published in National Underwriter, November, 2000."

How to Choose an Appropriate Non-qualified Plan
By Ed Sanchez and Thomas F. Streiff - ILona Financial Group

Non-qualified insurance based plans, that is, executive bonus, split dollar, and deferred compensation plans, continue to have great appeal in today's insurance market, primarily because of their selective nature and various tax benefits. A real challenge to presenting these plans is choosing an appropriate plan based on a particular set of client facts. Let's look at some of the criteria that can help you make that choice.

Non-qualified insurance benefits usually possess some form of tax benefit. The benefit may come from the ability to defer a participant's benefit taxation until some later date, currently report less income than the full amount paid into a plan, or, obtain a current business tax deduction in a high tax bracket and report the benefit in another, lower tax bracket (tax leverage).

Let's start with a client who is the majority shareholder of a C corporation, the corporation is in a 34 % income tax bracket, and the client is in a 31% Federal tax bracket ($105,950 to $161,450 of taxable income filing jointly). From a tax perspective, which non-qualified plan makes sense?

An executive bonus plan has some marginal tax leverage benefit because the corporation will currently deduct an insurance premium as additional compensation in the 34% bracket and the client will report it in a 31% bracket. However, state income taxes and phase outs of deductions and exemptions may cause the personal bracket to be the same or higher than the corporate bracket, eliminating any differential between brackets and any particular tax benefit to a bonus plan.

Split dollar is an appropriate alternative in this case. It allows the client to receive a corporate paid insurance benefit and currently recognize only the economic benefit amount attributed to the split dollar plan. This amount, of course, is normally just a small fraction of the total premium, say 3-5 cents for every dollar of premium paid by the employer. The higher my current personal bracket, the better the current tax benefit of split dollar looks because of the low current benefit reported. Also, think split dollar when an employer likes the idea of getting all of its money back.

A non-qualified deferred compensation plan differs from both executive bonus and split dollar in that it normally defers both the employer's deduction of the funding mechanism (life insurance) and the employee's recognition of the benefit until retirement. Can we assume that our majority shareholder will remain in the same or a lower tax bracket upon retirement? If yes, then the employee's tax deferral is a significant leveraging benefit because it allows the full insurance premium to grow within the policy until retirement undiminished by taxes.

Deferred compensation plans for controlling shareholders are more likely to be scrutinized by the IRS than plans for non-controlling shareholders or key persons and
should probably be undertaken with counsel from an employee benefit planning specialist. Thus far we see that: 1) for executive bonus, the higher the employer's tax bracket and the lower the participant's, the greater the current tax benefit, 2) in split dollar or deferred compensation, the higher the participant's personal tax bracket, the greater the benefit of the tax deferral for the participant, and 3) if the employer wants its money back, choose split dollar. Owners of C corporations could participate in any of these plans.

What about owners of S corporations, LLC's, partners, or sole proprietors? Since there is only one tax entity in each of these cases, there is no leverage or deferral; that is, a benefit is not paid by one tax entity and recognized, in whole or in part, in another. Thus, non-qualified insurance plans do not possess the same tax benefit for owners of these businesses that they would had there been two separate taxing entities.

This does not mean that these entities don't have a need for life insurance. In fact, the need for funded buy sell plans, key person insurance, or supplemental accumulation might even be more important to them. It simply means that majority owners of those entities don't benefit from non-qualified plans as they would if they were majority shareholders of C corporations. Minority shareholders or key persons of any business benefit from participating in a non-qualified insurance plan. This is because money spent on premiums is employer money, and is in addition to cash compensation. And, unlike controlling shareholders, a key person may not be able to opt for cash in lieu of the benefit.

Which plan to choose for the key person? Because of their simplicity, executive bonus plans are often a good choice. Unlike split dollar or deferred compensation, executive bonus plans require very little documentation. The double bonus form of executive bonus can eliminate the key person's cash outlay and a restrictive endorsement of the policy may temporarily restrict the employee's cash value access and give the employer some plan control.

Split dollar might be offered to the key person where the employer wants to limit its contribution to a benefit or the employer wants to eventually get its money back. Deferred compensation might be used where the employer is actually funding a supplemental retirement benefit and does not require a return of its money, or, the key person is currently in a high tax bracket and does not want any currently reportable income.

This is some of the thought process you can use in choosing among non-qualified insurance based benefits. Remember that the form of business, relative tax brackets, and the employer's benefit goals all matter in arriving at an appropriate choice.

Ed Sanchez CLU ChFC MBA MSFS is Director of Training and Advanced Sales, ILONA Financial Group, Oak Brook, Illinois and may be reached at Ed.Sanchez@fvl.com. Thomas F. Streiff , CFP CLU ChFC CFS is the President off First Variable Life, IAC Securities, and Money Matters Exchange, Oak Brook, Illinois. He may be reached at Tom.Streiff@mmexchange.com.