The Death Benefit Only Plan for Non-Profits

The Death Benefit Only (DBO) Plan for Non-Profits is an arrangement in which the employer, a 501(c) non-profit organization, agrees to pay the actuarially determined cost of the current death benefit on a permanent life insurance policy to be owned by the employee or employer. The employer and employee enter into a written agreement that ordinarily requires the employer to make premium payments as long as the employee works for the employer. The employment agreement also requires the employee to execute a “co-ownership” or “restrictive endorsement” at the time the policy is purchased.

The co-ownership agreement would set forth the terms of the restrictive endorsement and the timing of its release. The employee will own the policy, the co-ownership agreement of the Plan will provide access to the policy by the employee, and the actuarial cost of the current death benefit will be deductible by the employer and not taxable to the employee. The economic benefit of the death benefit coverage will also be taxable to the employee. Any monies contributed by the employee or otherwise taxable to the employee will be a credit against the employee's economic benefit taxation. The Non-Profit executive bonus received by the employee is in the form of permanent life insurance owned by the employee. The life insurance policy can be continued after the employee's disability or retirement. The employee's named beneficiary may receive the life insurance proceeds income tax-free.

The cash value of a permanent life insurance policy grows on a tax-deferred basis. Because the Co-Ownership Agreement will lapse at, or prior to, the employee's retirement, the executive will have access to the policy's cash value during retirement. Withdrawals from the policy can be made on an income-tax free basis up to cost basis. Policy loans can also be taken without income tax consequences.

Unlike most forms of traditional non-qualified deferred compensation, the employee receives immediate benefits under the DBO Plan. The employee can immediately name the beneficiary of the death benefit. In addition, the policy's cash value is usually immediately vested in the employee ' although subject to the restrictive endorsement. The DBO Plan requires the employee to reimburse the employer for some or all of the premiums paid if the employee terminates employment early.

Qualified retirement plans are subject to restrictions on the amount of money that can be contributed by (or on behalf of) an employee. When distributions are taken from a qualified plan, they may be subject to certain penalties, such as the 10% penalty tax on early (prior to age 59.5) withdrawals.

The DBO Plan is not a qualified plan. Once a participant is no longer in the Plan, access to the policy's cash value (by withdrawal up to basis or by loan) is not ordinarily subject to income or penalty taxes. The DBO Plan is in compliance with the deferred compensation rules under '409A as it is defined as a welfare benefit plan under Treasury Reg '31.3121.

The DBO Plan can play a very important role in a compensation package by combining the advantages of current death benefit protection and immediate vesting of the policy's cash value. Immediate vesting of the policy's cash value differentiates the DBO Plan from traditional non-qualified deferred compensation plans where the employee usually receives little more than the employer's promise to pay future benefits. Moreover, the tax-favorable growth of policy cash values make permanent insurance an attractive source of supplemental retirement dollars.

One major disadvantage of qualified plans is the strict rules pertaining to participation that require an employer to make the plan available to most (or all) employees. The DBO Plan is not a qualified plan, therefore, the employer can select which employee, or group of employees, to cover. The DBO Plan can be tailored to fit each employee's needs and can reflect each employee's value to the employer. The use of the Plan also complies with '409A, Notice 2005-01 and the Final Regulations covering deferred compensation. Unlike qualified plans and some types of traditional non-qualified deferred compensation plans, once established, minimal annual reports and administration should be required. The ERISA implications of the DBO Plan are discussed below. As long as the employee's total compensation package is “reasonable,” the employer's premium payments providing the current death benefit should constitute compensation and be a currently deductible expense. This differs from traditional non-qualified deferred compensation arrangements where benefits are not deductible to the employer until paid to the employee.

Tax Consequences of the DBO Plan for Non-Profits

Section 61 Taxation. Premium payments made by the employer are generally believed to be compensation to the employee under IRS '61. Therefore, subject to “reasonable compensation” limitations, the likely tax treatment should be current income for the employee equal to the premium paid, and a corresponding current deduction for the employer. When a “double bonus” arrangement is utilized, the employer will also bonus the employee an amount necessary to cover the employee's income tax liability. This additional bonus should also be subject to current income taxation.

Section 457 Taxation. Notice 2002-8 and Prop. Reg. 1.457-11 dealing with '457(f) deferred compensation set forth the permissible benefit areas, and the DBO Plan complies with those rules. As a '457(e)11 death benefit plan it is not required to have a risk of forfeiture contingency as required under '457(f). Additionally, when the Plan is integrated into a group-carve out arrangement, the Final Regs permit treatment under '79 and specifically exclude benefits from being affected by '1.61 (b)(2)(ii). The IRS ruled in Technical Advice Memorandum (TAM) 200002047 that the rules of '79 will apply to coverage provided to certain employees as covered under the DBO Plan and DOL A.O. 2003-08A (June 26, 2003).

Section 409A Taxation. Notice 2005-1 and the Final Regulations gave bright line test for exceptions to complying with the deferred compensation rules. '31.3121

Tax Shelter Issues. The Plan is not a “listed transaction” under Treas. Regs. ”1.6011-4(b)(2) and 301.611-2(b)(2), Notice 2007-83, a “tax shelter” under IRC 6111(c) and 6111d) and Treas. Reg. 301.6111-1T, Q&A 4, a “potentially abusive tax shelter” under 6112(b) and Treas. Reg. 301.6112-1(b) or a “reportable transaction” under Treas. Reg. 1.6011-4(b). Additionally the Plan does not violate the Economic Substance Doctrine as codified in new Internal Revenue Code '7701(o).

Tax Circular 230 Issues. Because the Plan is not a listed transaction, there are no conditions of confidentiality or contractual protection, and the covered opinion requirements of 10.35 do not apply. Because the employer is not subject to income tax as a non-profit employer, the principal purpose or significant purpose is not that of tax avoidance or tax evasion.

ERISA Implications of the DBO Plan for Non-Profits

Title 1 of ERISA covers all employee benefit plans and divides them into welfare plans and pension plans. To be covered by ERISA, there must be a “plan.” If the DBO Plan is a negotiated arrangement between an employer and a single employee, there is a strong argument that there is no “plan” and ERISA does not govern the arrangement. However, if there are multiple employees covered by the DBO Plan, it is more likely that there is a “plan” for ERISA purposes. In the event the DBO Plan is considered a “plan,” it may qualify as a “top hat” plan if it only covers select management or “highly compensated” employees. ERISA reporting requirements for “top hat” plans are limited. Whether the DBO Plan is subject to ERISA must be determined on a case-by-case basis. In any event, if so it is subject only to the reporting and disclosure requirements then it is not an ERISA plan for income tax purposes.

Conclusion

For non-profit employers looking for a relatively simple way to reward key employees and recruit prospective employees, the DBO Plan may be an answer. The DBO Plan offers many of the best features of a '162 bonus plan with less costs ( e.g. , current death benefit, current employer tax deduction, and immediate employee vesting), while serving as a “golden handcuff” that encourages employee loyalty. In addition to providing an employee with current death benefit protection, the insurance policy's cash value may be available as a source of supplemental retirement income.

The chart below compares a DBO Plan with other benefit plans:

[IMGCAP(1)]

Here's an example of how the DBO PLan works:

[IMGCAP(2)]

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A and Benefit Planning.

The Death Benefit Only (DBO) Plan for Non-Profits is an arrangement in which the employer, a 501(c) non-profit organization, agrees to pay the actuarially determined cost of the current death benefit on a permanent life insurance policy to be owned by the employee or employer. The employer and employee enter into a written agreement that ordinarily requires the employer to make premium payments as long as the employee works for the employer. The employment agreement also requires the employee to execute a “co-ownership” or “restrictive endorsement” at the time the policy is purchased.

The co-ownership agreement would set forth the terms of the restrictive endorsement and the timing of its release. The employee will own the policy, the co-ownership agreement of the Plan will provide access to the policy by the employee, and the actuarial cost of the current death benefit will be deductible by the employer and not taxable to the employee. The economic benefit of the death benefit coverage will also be taxable to the employee. Any monies contributed by the employee or otherwise taxable to the employee will be a credit against the employee's economic benefit taxation. The Non-Profit executive bonus received by the employee is in the form of permanent life insurance owned by the employee. The life insurance policy can be continued after the employee's disability or retirement. The employee's named beneficiary may receive the life insurance proceeds income tax-free.

The cash value of a permanent life insurance policy grows on a tax-deferred basis. Because the Co-Ownership Agreement will lapse at, or prior to, the employee's retirement, the executive will have access to the policy's cash value during retirement. Withdrawals from the policy can be made on an income-tax free basis up to cost basis. Policy loans can also be taken without income tax consequences.

Unlike most forms of traditional non-qualified deferred compensation, the employee receives immediate benefits under the DBO Plan. The employee can immediately name the beneficiary of the death benefit. In addition, the policy's cash value is usually immediately vested in the employee ' although subject to the restrictive endorsement. The DBO Plan requires the employee to reimburse the employer for some or all of the premiums paid if the employee terminates employment early.

Qualified retirement plans are subject to restrictions on the amount of money that can be contributed by (or on behalf of) an employee. When distributions are taken from a qualified plan, they may be subject to certain penalties, such as the 10% penalty tax on early (prior to age 59.5) withdrawals.

The DBO Plan is not a qualified plan. Once a participant is no longer in the Plan, access to the policy's cash value (by withdrawal up to basis or by loan) is not ordinarily subject to income or penalty taxes. The DBO Plan is in compliance with the deferred compensation rules under '409A as it is defined as a welfare benefit plan under Treasury Reg '31.3121.

The DBO Plan can play a very important role in a compensation package by combining the advantages of current death benefit protection and immediate vesting of the policy's cash value. Immediate vesting of the policy's cash value differentiates the DBO Plan from traditional non-qualified deferred compensation plans where the employee usually receives little more than the employer's promise to pay future benefits. Moreover, the tax-favorable growth of policy cash values make permanent insurance an attractive source of supplemental retirement dollars.

One major disadvantage of qualified plans is the strict rules pertaining to participation that require an employer to make the plan available to most (or all) employees. The DBO Plan is not a qualified plan, therefore, the employer can select which employee, or group of employees, to cover. The DBO Plan can be tailored to fit each employee's needs and can reflect each employee's value to the employer. The use of the Plan also complies with '409A, Notice 2005-01 and the Final Regulations covering deferred compensation. Unlike qualified plans and some types of traditional non-qualified deferred compensation plans, once established, minimal annual reports and administration should be required. The ERISA implications of the DBO Plan are discussed below. As long as the employee's total compensation package is “reasonable,” the employer's premium payments providing the current death benefit should constitute compensation and be a currently deductible expense. This differs from traditional non-qualified deferred compensation arrangements where benefits are not deductible to the employer until paid to the employee.

Tax Consequences of the DBO Plan for Non-Profits

Section 61 Taxation. Premium payments made by the employer are generally believed to be compensation to the employee under IRS '61. Therefore, subject to “reasonable compensation” limitations, the likely tax treatment should be current income for the employee equal to the premium paid, and a corresponding current deduction for the employer. When a “double bonus” arrangement is utilized, the employer will also bonus the employee an amount necessary to cover the employee's income tax liability. This additional bonus should also be subject to current income taxation.

Section 457 Taxation. Notice 2002-8 and Prop. Reg. 1.457-11 dealing with '457(f) deferred compensation set forth the permissible benefit areas, and the DBO Plan complies with those rules. As a '457(e)11 death benefit plan it is not required to have a risk of forfeiture contingency as required under '457(f). Additionally, when the Plan is integrated into a group-carve out arrangement, the Final Regs permit treatment under '79 and specifically exclude benefits from being affected by '1.61 (b)(2)(ii). The IRS ruled in Technical Advice Memorandum (TAM) 200002047 that the rules of '79 will apply to coverage provided to certain employees as covered under the DBO Plan and DOL A.O. 2003-08A (June 26, 2003).

Section 409A Taxation. Notice 2005-1 and the Final Regulations gave bright line test for exceptions to complying with the deferred compensation rules. '31.3121

Tax Shelter Issues. The Plan is not a “listed transaction” under Treas. Regs. ”1.6011-4(b)(2) and 301.611-2(b)(2), Notice 2007-83, a “tax shelter” under IRC 6111(c) and 6111d) and Treas. Reg. 301.6111-1T, Q&A 4, a “potentially abusive tax shelter” under 6112(b) and Treas. Reg. 301.6112-1(b) or a “reportable transaction” under Treas. Reg. 1.6011-4(b). Additionally the Plan does not violate the Economic Substance Doctrine as codified in new Internal Revenue Code '7701(o).

Tax Circular 230 Issues. Because the Plan is not a listed transaction, there are no conditions of confidentiality or contractual protection, and the covered opinion requirements of 10.35 do not apply. Because the employer is not subject to income tax as a non-profit employer, the principal purpose or significant purpose is not that of tax avoidance or tax evasion.

ERISA Implications of the DBO Plan for Non-Profits

Title 1 of ERISA covers all employee benefit plans and divides them into welfare plans and pension plans. To be covered by ERISA, there must be a “plan.” If the DBO Plan is a negotiated arrangement between an employer and a single employee, there is a strong argument that there is no “plan” and ERISA does not govern the arrangement. However, if there are multiple employees covered by the DBO Plan, it is more likely that there is a “plan” for ERISA purposes. In the event the DBO Plan is considered a “plan,” it may qualify as a “top hat” plan if it only covers select management or “highly compensated” employees. ERISA reporting requirements for “top hat” plans are limited. Whether the DBO Plan is subject to ERISA must be determined on a case-by-case basis. In any event, if so it is subject only to the reporting and disclosure requirements then it is not an ERISA plan for income tax purposes.

Conclusion

For non-profit employers looking for a relatively simple way to reward key employees and recruit prospective employees, the DBO Plan may be an answer. The DBO Plan offers many of the best features of a '162 bonus plan with less costs ( e.g. , current death benefit, current employer tax deduction, and immediate employee vesting), while serving as a “golden handcuff” that encourages employee loyalty. In addition to providing an employee with current death benefit protection, the insurance policy's cash value may be available as a source of supplemental retirement income.

The chart below compares a DBO Plan with other benefit plans:

[IMGCAP(1)]

Here's an example of how the DBO PLan works:

[IMGCAP(2)]

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions. He authors articles and speaks nationally about Decision Trees on COLI Best Practices, 409A and Benefit Planning.