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Retain Key Employees With a Life Insurance Funded DBO Plan

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What can your business clients offer their key employees who already have everything? A Death Benefit Only Plan funded with life insurance.

Employees are often the key to a business’s success. A top performing sales person, for example, may generate millions for a business and have access to sensitive customer lists. Retaining these employees is essential, but what can your business clients offer their key employees who already have everything?

They’re already set up with a pension or profit sharing plan and supplemental nonqualified deferred compensation. They draw an impressive salary and have the best health insurance money can buy. How about offering them a plan that promises to pay their families a portion of the key employee’s salary for a period of time, say ten years? And how much more attractive is the plan if it’s receivable by the employee’s family estate tax free?

Under a DBO Plan an employer promises to make a payment, or payments, to the employee’s named beneficiaries if the employee dies while employed by, or retired from, the company. Payments to beneficiaries may be made as a one-time payment or as periodic payments.

A lump sum payment may be calculated as a multiple of the employee’s annual salary (e.g. six times the employee’s annual salary). In contrast, a periodic payment obligation may be calculated as a percentage of salary and may continue for a definite period of time (e.g. an obligation to pay beneficiaries 75 percent of the employee’s salary for ten years after the employee dies.)

DBO Plans are typically funded with a life insurance policy. The policy is owned by the company and the company is named beneficiary.

After the employee dies, the policy death benefit is paid to the company. Generally, the death benefit is received by the company income tax free. The company will either pay the amount of the benefits to the employee’s beneficiaries from the policy’s death benefit or invest the cash in a tax-free investment that will generate income sufficient to pay the periodic benefit.

Beneficiary’s Tax Treatment of DBO Payments

Formerly, up to $5,000 of amounts received by an employee’s family from the employer were exempted from income tax. But in 1996 the exclusion was repealed. Now, amounts received from a DBO Plan are taxed to beneficiaries as ordinary income if they were received from the company as compensation for the employee’s services. If the payments are a gift, the beneficiaries receive the payments income tax free.

Despite the promising conclusion to the last paragraph, payments received by beneficiaries from a DBO Plan are highly unlikely to be properly classified as nontaxable gifts. In fact, since the 1960s, every published case that’s considered the taxability of death benefit payments by a company to the employee’s surviving spouse has held that the payments are taxable.

Estate Taxation of DBO Payments

DBO payments typically won’t be included in the deceased employee’s estate for estate tax purposes if the employer paid the benefit “voluntarily.” On the other hand, if the obligation to make the payments is contractual, they usually will be taxed in the employee’s estate. Contractual DBO payments are typically included in the employee’s estate because the employee had the right to change the beneficiary during his or her lifetime. If the plan names a standard or otherwise irrevocable beneficiary, the payments probably won’t be included in the employee’s estate.

Deductibility of DBO Payments by the Corporation

Payments are deductible by the corporation only if they are shown to give rise to an economic benefit to the corporation; they are then deductible to the extent that they are “reasonable in light of that purpose.” Salary continuation payments usually will satisfy the requirements and deductibility by the company is a fairly safe assumption. Contractually owed death benefit payments are often deductible as deferred compensation.

In the unlikely event that death benefit payments are properly classified as a gift to the beneficiaries, the company will not be entitled to deduct the payment.

Selling the Insurance Funded DBO Plan

In the typical case, a DBO plan is indicated where the company is looking to enhance key employee benefits without a massive immediate outlay of cash. Deductibility of the eventual benefit payments may also be a central concern.

The beauty of a DBO plan is that an impressive benefit can be funded with relatively small payments. The company doesn’t need to take the chance that the covered employee will die an early death and leave the company liable for a significant death benefit. Although premiums paid into the policy won’t be deductible, the company will receive the death benefit tax free and may even be able to deduct payments made of the tax-free fund created by the policy.

For the employee, a DBO plan represents security in knowing that his or her family has a security net to help soften the financial blow when the employee dies. And the benefit is received estate tax free, further enhancing its attractiveness to highly paid executives whose estates are already in estate tax territory.

Also beneficial for the company are the options available if the employee leaves the company’s employment. The company has the option of continuing to make payments on the policy, surrender it, or sell it to the employee.

For additional coverage of this issue and similar ones, we invite you to sign up with AdvisorOne’s Summit Business Media partner, AdvisorFX, for a free trial.

You may also be interested in signing up for a free trial with another Summit Business Media partner, Tax Facts Online.

See also The Law Professor’s blog at AdvisorFYI.


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