Buyout Funding and Death Benefits

At a recent meeting with the managing tax partner and the former managing partner of an accounting firm, they shared these concerns with me. We worked out an arrangement that met both the death buyout needs and provided a platform to currently address their lifetime buyout goals. In designing the solution we had to be cognizant of:

• Deferred compensation issues;
• COLI best practices and IRC '101(j);
• Application of split dollar rules;
• Possible reporting compliance requirements; and
• Economic benefit rules.

We used a multi-disciplinary approach to solve the problem. The methodology used actuarial, accounting, legal and tax building blocks to create a liability driven investment (LDI) program that allows economically efficient funding and matching the creation of the revenue with the timing of distributions to withdrawing principals. For purposes of assumptions, we looked to a return that would be less than a 20 year rolling average of the S&P 500 (6.5%). If the rolling average were to be reached, the program would actually generate over a 7.5% return, a 15.4% increase. A guaranteed issue policy is obtained on the Principals. The policy has a high early cash value so the transaction is balance sheet neutral. Here is how the arrangement works:

• Employer owned policy provides Principal with the right to name a beneficiary as long as Participant is with the Employer. COLI Best Practices and '101(j) compliant. No regulatory filing required. Exception Regs. '6039I-1.6039I-6039I-1T Form 8925 & Instructions, Notice 2009-48, 2009-24 I.R.B.1085.
• An Executive Group carve out arrangement complying with group life rules and provides economic benefit (Table I) taxation to employees of provided death benefit. PLR200652043, PLR200704017, TAM 200502040, '79 (e) 3.
• The Split Dollar Rule '61.22(b)(2)(ii)(A) permits this application. Safe Harbor (b) and Rev. Rul 75-9 are followed.
• The Restricted Property rules of '83 do not apply. See, '83(e)(3). Because the policy is not deemed restricted property under '83, only the government-supplied table of current Economic Benefit is income to the Principal.
• Economic Benefit ends with Employer ending funding of policy on Participants. Rev. Rul. 66-110, Reg.1.79-3(c) Period of Coverage.
• Section 409A applies to any arrangement that postpones payments of compensation to subsequent years. Notice 2005-1 spells out what is and is not deferred compensation, Single-person Plans, “defined benefit” non-qualified plans, Supplemental Executive Retirement Plans (SERPs) and arrangements for non-employees (directors, trustees and independent contractors). See, Q&A3.
• Group Benefit Segment actuarially determined annually. Complies with definitions of Treas. Regs '31.3121,1.79-0 Safe Harbor (c), Rev Rul 2007-65, Notice 2007-83 & 84.
• There are also specific statutory exceptions to the application of these new non-qualified deferred compensation rules. Question 3 of the Notice spells out what benefit arrangements do not have to comply with '409A's rigorous tests; a death benefit plan and a disability plan that comply with the definitions of Tax Regulations '31.3121(v)(2)-1(b)(4)(iv)(C). These definitional requirements provide a bright line mechanical test that will permit compliance with the laws. The language in these safe harbors indicate that where there is more life insurance death benefit or funding available upon a disability than the present value of any forum of additional benefit, i.e., cash value available if a person doesn't die or is not disabled, then the program complies. These provisions will permit compliance with '409A.
• The accounting treatment for a corporate-owned life insurance policy under this approach should be handled in a very similar manner as a traditionally owned permanent policy. The slight difference is due to the fact that the Group Term Life segment payment (from an accounting standpoint) should be treated like a group term life insurance premium payment, i.e., the full premium payment should be shown as an expense each year. Nevertheless, as with all accounting issues, it is up to the company accountant to interpret FASB statements and opinions, and make the final decision as to how individual transactions are reflected on the company's financial statements.
• Under the arrangement, the accounting for the Group Term Life coverage is straightforward. The Group Term Life premium would be shown as an expense on the company's income statement. Since the Group Term Life amount represents the cost of the death benefit and does not increase the cash value, the accounting treatment should be the same as a group term life insurance policy. The journal entry below is an example of how an employer would record the payment of the group term life premium (e.g., where the premium is $85,000, total premium is $100,000). Although account titles will vary from company to company, since the company is not the beneficiary of the group term life death benefit, the account title for the expense should reflect that the expense was incurred for an employee benefit. Since the employer cannot be beneficiary of the Group Term Life premium, an account title such as “Expense ' employee benefits” is appropriate.
• |
  • Expense ' Employee Benefits $85,000
  • Cash $85,000
• The journal entry for the group term life premium may change each year. The amount contributed, and thus recorded, is based on the amount that is actuarially determined each year. Though we do not expect drastic changes in this amount, the contribution may not be exactly the same from year to year.
• The employer-owned policy with a high early cash value follows Financial Accounting Standards Board (FASB) Technical Bulletin (TB) 85-4 and EITF 06-05.

The arrangement is available for pass thru entities as set forth in IRC '707(a)(1), meeting the three requirements as further articulated in the Senate Explanation (S. Rpt. No. 169, Vol. I, 98th Cong., 2d Sess. 227-228 (1984)). Further, see, Pratt v. Commisioner, 64 TC.203 (1975) aff'd 550 F2 1023 (Fifth Circuit 1977).

Conclusion

The compensation arrangement reflecting the death buyout and lifetime buyout provides a parallel approach to fund the liabilities created for the Principals.

The illustrations below are provided on both the individual coverage as well as a composite (Figures 3 and 4).

• 'A Guaranteed Issue product was obtained that requires no medical underwriting
• The coverage also uses a high early cash value rider so at the end of Year 1 the Cash Value is 105% of the amount contributed. This will make the funding of the liabilities balance sheet neutral
• We provide the rank and file with death benefit to meet the actuarial equivalency tests. The costs will be minimal in proportion to the benefits of using the arrangement as described and' implemented.
• The illustrations have been run at a 6.5% IRR. This is below the historic 7.74%.' We believe this is prudent and any increase over the duration of the program will only provide more funds or reduce the costs.
• Using the approach as we discussed provides an ROI rate of 9.43%. The plan will fund 102% of the buyout liabilities from the 9th year on at the illustrated 6.5%. We believe this is the most economically efficient approach to meet the goals for the buyout opportunities at death and during life.

Figure 1
[IMGCAP(1)]

Figure 2
[IMGCAP(2)]

Figure 3
[IMGCAP(3)]

Figure 4
[IMGCAP(4)]

The entire approach is best reflected in Figures 1 and 2. Figure 1 tracks revenue streams to meet the liabilities and Figure 2 tracks the Participant payouts.

The clients goals are met with the most economically efficient method to fund for both a death and lifetime buyout in a regulatory compliant approach.

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.

Professional service organizations traditionally have elected a pass thru entity status (S Corp., LLC, LLP, partnership) in order to reduce double taxation at the principal's level. Similar additional taxation may occur with C Corps. and accumulated earnings tax as well as other confiscatory grabs. These issues create an impediment for the current accumulation of funds to satisfy a principal's buyout in future years.

The most senior principals do not have the security of knowing the money will be there for their buyout in the future ' and they are not happy.

The junior principals and associates see the buyout money as having to come from future earnings that will be due to their hard work after the senior principals are no longer generating revenue ' and they are not happy.

At a recent meeting with the managing tax partner and the former managing partner of an accounting firm, they shared these concerns with me. We worked out an arrangement that met both the death buyout needs and provided a platform to currently address their lifetime buyout goals. In designing the solution we had to be cognizant of:

• Deferred compensation issues;
• COLI best practices and IRC '101(j);
• Application of split dollar rules;
• Possible reporting compliance requirements; and
• Economic benefit rules.

We used a multi-disciplinary approach to solve the problem. The methodology used actuarial, accounting, legal and tax building blocks to create a liability driven investment (LDI) program that allows economically efficient funding and matching the creation of the revenue with the timing of distributions to withdrawing principals. For purposes of assumptions, we looked to a return that would be less than a 20 year rolling average of the S&P 500 (6.5%). If the rolling average were to be reached, the program would actually generate over a 7.5% return, a 15.4% increase. A guaranteed issue policy is obtained on the Principals. The policy has a high early cash value so the transaction is balance sheet neutral. Here is how the arrangement works:

• Employer owned policy provides Principal with the right to name a beneficiary as long as Participant is with the Employer. COLI Best Practices and '101(j) compliant. No regulatory filing required. Exception Regs. '6039I-1.6039I-6039I-1T Form 8925 & Instructions, Notice 2009-48, 2009-24 I.R.B.1085.
• An Executive Group carve out arrangement complying with group life rules and provides economic benefit (Table I) taxation to employees of provided death benefit. PLR200652043, PLR200704017, TAM 200502040, '79 (e) 3.
• The Split Dollar Rule '61.22(b)(2)(ii)(A) permits this application. Safe Harbor (b) and Rev. Rul 75-9 are followed.
• The Restricted Property rules of '83 do not apply. See, '83(e)(3). Because the policy is not deemed restricted property under '83, only the government-supplied table of current Economic Benefit is income to the Principal.
• Economic Benefit ends with Employer ending funding of policy on Participants. Rev. Rul. 66-110, Reg.1.79-3(c) Period of Coverage.
• Section 409A applies to any arrangement that postpones payments of compensation to subsequent years. Notice 2005-1 spells out what is and is not deferred compensation, Single-person Plans, “defined benefit” non-qualified plans, Supplemental Executive Retirement Plans (SERPs) and arrangements for non-employees (directors, trustees and independent contractors). See, Q&A3.
• Group Benefit Segment actuarially determined annually. Complies with definitions of Treas. Regs '31.3121,1.79-0 Safe Harbor (c), Rev Rul 2007-65, Notice 2007-83 & 84.
• There are also specific statutory exceptions to the application of these new non-qualified deferred compensation rules. Question 3 of the Notice spells out what benefit arrangements do not have to comply with '409A's rigorous tests; a death benefit plan and a disability plan that comply with the definitions of Tax Regulations '31.3121(v)(2)-1(b)(4)(iv)(C). These definitional requirements provide a bright line mechanical test that will permit compliance with the laws. The language in these safe harbors indicate that where there is more life insurance death benefit or funding available upon a disability than the present value of any forum of additional benefit, i.e., cash value available if a person doesn't die or is not disabled, then the program complies. These provisions will permit compliance with '409A.
• The accounting treatment for a corporate-owned life insurance policy under this approach should be handled in a very similar manner as a traditionally owned permanent policy. The slight difference is due to the fact that the Group Term Life segment payment (from an accounting standpoint) should be treated like a group term life insurance premium payment, i.e., the full premium payment should be shown as an expense each year. Nevertheless, as with all accounting issues, it is up to the company accountant to interpret FASB statements and opinions, and make the final decision as to how individual transactions are reflected on the company's financial statements.
• Under the arrangement, the accounting for the Group Term Life coverage is straightforward. The Group Term Life premium would be shown as an expense on the company's income statement. Since the Group Term Life amount represents the cost of the death benefit and does not increase the cash value, the accounting treatment should be the same as a group term life insurance policy. The journal entry below is an example of how an employer would record the payment of the group term life premium (e.g., where the premium is $85,000, total premium is $100,000). Although account titles will vary from company to company, since the company is not the beneficiary of the group term life death benefit, the account title for the expense should reflect that the expense was incurred for an employee benefit. Since the employer cannot be beneficiary of the Group Term Life premium, an account title such as “Expense ' employee benefits” is appropriate.
• |
  • Expense ' Employee Benefits $85,000
  • Cash $85,000
• The journal entry for the group term life premium may change each year. The amount contributed, and thus recorded, is based on the amount that is actuarially determined each year. Though we do not expect drastic changes in this amount, the contribution may not be exactly the same from year to year.
• The employer-owned policy with a high early cash value follows Financial Accounting Standards Board (FASB) Technical Bulletin (TB) 85-4 and EITF 06-05.

The arrangement is available for pass thru entities as set forth in IRC '707(a)(1), meeting the three requirements as further articulated in the Senate Explanation (S. Rpt. No. 169, Vol. I, 98th Cong., 2d Sess. 227-228 (1984)). Further, see, Pratt v. Commisioner, 64 TC.203 (1975) aff'd 550 F2 1023 (Fifth Circuit 1977).

Conclusion

The compensation arrangement reflecting the death buyout and lifetime buyout provides a parallel approach to fund the liabilities created for the Principals.

The illustrations below are provided on both the individual coverage as well as a composite (Figures 3 and 4).

• 'A Guaranteed Issue product was obtained that requires no medical underwriting
• The coverage also uses a high early cash value rider so at the end of Year 1 the Cash Value is 105% of the amount contributed. This will make the funding of the liabilities balance sheet neutral
• We provide the rank and file with death benefit to meet the actuarial equivalency tests. The costs will be minimal in proportion to the benefits of using the arrangement as described and' implemented.
• The illustrations have been run at a 6.5% IRR. This is below the historic 7.74%.' We believe this is prudent and any increase over the duration of the program will only provide more funds or reduce the costs.
• Using the approach as we discussed provides an ROI rate of 9.43%. The plan will fund 102% of the buyout liabilities from the 9th year on at the illustrated 6.5%. We believe this is the most economically efficient approach to meet the goals for the buyout opportunities at death and during life.

Figure 1
[IMGCAP(1)]

Figure 2
[IMGCAP(2)]

Figure 3
[IMGCAP(3)]

Figure 4
[IMGCAP(4)]

The entire approach is best reflected in Figures 1 and 2. Figure 1 tracks revenue streams to meet the liabilities and Figure 2 tracks the Participant payouts.

The clients goals are met with the most economically efficient method to fund for both a death and lifetime buyout in a regulatory compliant approach.

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.