What is it? Plan by which an employer defers employee compensation and pays it to the employee’s designated beneficiary at the employee’s death No benefit payable in any form to employee during lifetime
When is it indicated? • When highly compensated employee expects • to have a large estate • to face significant federal estate tax liability because estate payable to non-spouse beneficiary • As supplement to qualified retirement plan benefits • As a replacement for a split dollar plan • To defer compensation for younger employees with need for insurance
Advantages • With proper design, DBO benefits can be excluded from employee’s estate for federal tax purposes • Death benefit provides estate liquidity and cash to beneficiaries • Benefit not taxable to employee during life • Employer can avoid tax if finance plan via purchase of insurance
Disadvantages • Entire benefit taxed as ordinary income to beneficiary even if funded with life insurance • Keeping death benefit out of employee’s estate requires careful planning, limiting plan flexibility • Employer-corporation’s tax deduction for the plan is deferred until benefit paid and beneficiary includes proceeds in income
Design Features Several design options exist: • Fixed dollar amount • Average compensation over period of time • Benefits can be loosely related to death benefit under insurance policy on employee’s life purchased and owned by employer
Tax Implications • Death benefit excluded from employee’s estate if • plan does not provide any benefits payable during employee’s lifetime • employee does not have right to change beneficiary after plan established • Benefits paid to employee’s beneficiary are taxable in full to beneficiary as ordinary income
Tax Implications • Benefit payments deductible to corporation when paid if for “reasonable compensation” for services of deceased employee in prior years • IRS scrutiny likely when • deceased employee was majority shareholder • no written agreement prior to employee’s death
ERISA Requirements • Not clear if DBO is welfare or pension plan; exemption from ERISA requirements depends to some degree on plan structure. Plans serving exclusive group(s) typically exempt from most ERISA provisions e.g. unfunded plan for ‘top hat’ group should be exempt from most ERISA provisions • Plan covering broad group of employees is subject to full scope of ERISA requirements
Alternatives • Group term life insurance • Life insurance in a qualified plan • Split dollar life insurance • Individually-owned life insurance
How to Install a Plan • Written plan • Adopted under corporate resolution by board of directors before payments made under plan • Specify • amount of benefit • which employee or employee group is entitled to it • Whether benefit intended as compensation for services rendered by employee
True or False? • A DBO plan can replace a split dollar plan for an older employee. • A DBO plan benefit is not taxable to the employee during his or her lifetime. • An advantage of a DBO plan is that it will incur no income tax and no estate tax. • a DBO plan for a select group of employees must comply with most of the provisions of ERISA. • A DBO plan must be filed with the government.
Discussion Question What mistakes in plan design or other circumstances would cause an employer death benefit to be included in the employee’s estate?