Internal Revenue Code Section 79 has typically been thought of in connection with group term insurance. Now that is changing. Ironically, recent IRS pronouncements that removed some of the tax benefits of Section 79 may have increased awareness of its potential as a planning strategy.
Overview of technical issues
Under a nondiscriminatory Section 79 plan, employees can receive up to $50,000 of term life insurance income tax-free. Employers may provide employees term life insurance in excess of $50,000, so long as they report the value of the excess coverage on the employee’s W-2 as compensation. For tax reporting purposes, these values are determined under Table I of the Treasury Regulations, which sets forth uniform premiums computed on the basis of 5-year age brackets.
So long as the employer is not directly or indirectly a beneficiary of the insurance, employer contributions to the plan are tax-deductible in virtually all cases.
The regulations under Section 79 also permit these plans to provide permanent benefits, which are defined as “an economic value extending beyond one policy year (for example, a paid-up or cash surrender value) that is provided under a life insurance policy.” The actuarial formula for valuing permanent benefits is set forth in the regulations and is based on such factors as the age of the employee and the type of insurance contract used. Only specially designed life insurance contracts will produce favorable tax results under this formula.
Section 79(d) contains nondiscrimination rules as to eligibility and benefits. Certain types of employees can be excluded from consideration based on such factors as union membership, length of service and whether they work part-time or seasonally.
A plan is non-discriminatory as to benefits if “the type and amount of benefits available under the plan do not discriminate in favor of participants who are key employees.” A well-designed plan requires that all eligible participants be offered the option to elect the same type of benefits offered to key employees (e.g., permanent benefits). Such a plan also requires that all employees be offered a non-discriminatory amount of benefits, by mandating that all participants be offered life insurance in an amount that represents a uniform percentage or multiple of W-2 compensation.
Because the options that involve coverage in excess of $50,000 of term insurance will result in an increase in an employee’s income tax liability, employees are permitted to decline coverage in excess of $50,000. Consequently, rank and file employees typically elect the free (to them) $50,000 of group term life insurance and waive their right to higher amounts of insurance or permanent benefits.
Employees who do elect to receive permanent benefits must include the value of the permanent benefits in their gross income, reduced by any amounts they contribute from their own funds for the permanent benefits. Additional rules apply when the plan covers fewer than 10 employees.
Although a Section 79 plan can be used to benefit non-owner employees in any type of entity, owner-employees can participate only if they are employed by a C corporation. Depending on the tax situation, an owner of an S corporation, partnership, LLC, or sole proprietorship may elect to add a C corporation into the business model. Owners who receive W-2 compensation from the C corporation may participate in the plan, along with non-owner employees of the other entity.
A Section 79 plan that includes permanent benefits offers several important features:
? Corporate contributions to the plan are tax deductible in virtually all cases.
? Only a portion (generally 60%-70%) of these amounts is includable in the participant’s income.
? Because participants who elect permanent benefits own cash value life insurance policies personally, the rules governing employer-owned life insurance do not apply, and there is no need for a “rollout” upon plan termination.
? The plan and the underlying contract are designed to be fully funded in 5 years.
? The usual tax characteristics of cash value life insurance apply to these contracts.
(1) Policy cash values accumulate tax-deferred.
(2) Death benefits are generally received income tax-free.
(3) Once the plan is terminated, insurance cash values can provide tax-free income, as long as the contract is kept in force and withdrawals do not exceed cost basis.
? Administrative fees are modest, as is the typical cost for rank and file employees.
Life insurance applications
Although initial interest in a Section 79 plan is often driven by tax considerations, the core of the strategy is a need for life insurance. Life insurance contracts purchased under Section 79 can be used to address a variety of planning and protection needs. Among them:
Income replacement/capital needs for survivors. The participant names beneficiaries just as he or she would in the case of other personally owned insurance.
Supplementary retirement income. The participant can take income from the policy as described above to supplement other sources of retirement income. The death benefit can replace this income for a surviving spouse.
Charitable giving. If income from the contract is not needed for retirement, in can be used to make tax-deductible charitable gifts.
Cross-purchase buy-sell funding. Each participant can use withdrawals or loans from the personally owned contract to help fund a lifetime buyout. Because policies are at least initially owned by the respective insureds, death benefits should be used for buy-sell purposes only if transfer for value issues can be avoided. Otherwise, cross-owned term insurance may be more appropriate to cover death contingencies.
Estate tax planning. The participant can transfer the contract to an irrevocable trust immediately after issue. The participant is deemed to receive compensation of approximately 60-65% of each premium payment, and is deemed to make a gift of that amount to the trust. The 3-year rule applies from the date the contract is transferred to the trust.
Rated cases. The participant’s includable income remains the same even if the premium contains a substandard extra premium, thus increasing the income tax leverage.
Section 79 plans are not for every business, but for those closely held businesses and professional practices where there’s a, fit they provide an exciting, tax-advantaged opportunity for both owners and their key employees.