Picture this scenario: You’re meeting with Sean, president of Widgets Inc., to talk about the compensation package for Ian, one of Widgets’ top sales people. Ian is 45 years old and in excellent health, married with 2 young children. Since Ian is one of Widgets’ top salespeople, Sean does not want to lose him to the competition. Ian’s income has risen as he has increased his sales, and Sean wants to add to Ian’s benefits package.
The two of you discuss, among other things, 2 possible plans. One is an executive bonus plan, with Ian owning a life insurance policy on his own life and Widgets paying the premiums. The other is a deferred compensation plan to pay Ian a lump sum at his retirement. Sean says he likes both ideas and wonders which one he should choose.
Why not do both? Why not offer Ian a life insurance policy that pays a death benefit if he dies during the level premium-paying period or a bonus when he retires? This is how it could work, using a term life insurance policy with a return-of-premium (ROP) feature.
Widgets pays the $3,293 annual premiums for a $1 million term life insurance policy that Ian owns on his life. The policy with an ROP feature pays a refund of premiums at the end of the level premium-paying period (i.e., until Ian’s retirement or 20 years). Widgets pays the premiums directly to the life insurance company.
As long as the premium payments are reasonable compensation for Ian, Widgets may deduct them. Ian, of course, must report the premium payments as ordinary income and pay tax on them. Since Widgets is in the 35% tax bracket but Ian is in the 25% bracket, Widgets may deduct more for its payments than Ian must pay in tax.
If Ian dies while the policy is in-force, Ian’s beneficiary will get a $1 million income tax-free death benefit. But if Ian lives until retirement age, the life insurance company will pay him all the policy premiums paid on his behalf: $65,860. After retiring, Ian could keep the policy in force, but would have to pay the premiums himself. Furthermore, premiums will rise substantially after the level premium-paying period ends, and will continue rising each year.
A substantial benefit to Ian from this arrangement is that the $65,860 should come to him income tax-free. While the IRS has yet to rule specifically on this issue, the reasoning is straightforward. Each year Ian pays income tax on the premiums paid for his policy. As a result, the premiums become Ian’s basis in the policy.
Under current law, life insurance policy withdrawals are deemed to come from basis first, and then gain. Basis is not taxed (because it comes from money that has already been taxed), while gain is taxed as ordinary income. Since the money Ian gets from the policy will exactly equal the premiums paid (in other words, his basis), that money should not be taxed.