Corporate-owned life insurance is a type of policy that pays benefits to a company in the event that an insured employee passes away. There are many ways these policies can be used to help a business protect its interests and finances. If certain conditions are met, the death benefits may be tax-free.
Corporate-Owned Life Insurance: The Basics
Corporate-owned life insurance, also known as company-owned life insurance, is a policy that businesses can obtain for critical employee or employees. The company will pay the insurance premiums on the policy, and they will receive the death benefit if that employee dies.
This strategy can be used for minimizing the company’s tax burden, financing employee benefits, raising after-tax net income, and covering the expenses involved in replacing insured employees when they die. In some cases, these policies may continue to cover the employee for up to a year after leaving the company.
What Are The Requirements For Corporate-Owned Life Insurance?
There are certain conditions that must be met in order for the company to receive a tax-free death benefit. The Internal Revenue Service put these requirements in place to discourage businesses from using these types of policies to exploit loopholes in the tax code.
The first requirement is that the company may only purchase this type of policy for an individual who is within their top 35% of employees in terms of compensation. Moreover, when they obtain this policy, they must inform the employee in writing that they are doing so, outline its terms, and obtain written consent from the employee before moving forward.
In addition, businesses are required to report their company-owned life insurance policies to the IRS each year using form 8925.
Main Uses Of Corporate-Owned Life Insurance Policies
Here is a look at the main ways businesses can use corporate-owned life insurance policies to protect their interests and finances.
Funding Employer-Sponsored Benefits Plans
A corporate-owned life insurance plan can be used to fund an employer-sponsored benefits plan. Also known as a nonqualified benefits plan, this is a type of plan that gives the employees of a company benefits at a later time, such as in the form of a retirement plan. Nonqualified plans are typically tax-deferred if they are funded using corporate-owned life insurance plans.
Another way in which corporate-owned life insurance plans can be used to benefit a business is as a buy-sell agreement. Also known as a cross-purchase agreement, this sees one of the company’s executives purchasing a life insurance policy for a different key executive and paying the premium on it. The second (insured) executive will do the same for the first executive. Should one of these two executives pass away, their family or another dependent of their choosing will receive the proceeds of the life insurance policy, while the surviving executive who paid the premium on the policy will be given the beneficiary’s shares in the company under an agreement that is decided prior to taking out the policy.
When small businesses take out a loan, their lender will often require that they obtain life insurance for key individuals at the company for the duration of the loan. Even in cases where this is not required, it is considered good practice to obtain a policy. Otherwise, the person’s estate could be held liable for any outstanding debts that the business is unable to pay. In addition, having life insurance can make it easier for businesses to obtain financing.
Estate Tax And Equalization
One specific scenario where this approach may be wise is when it involves a family-owned corporation that forms a significant portion of the owner’s estate and the estate has several beneficiaries, not all of whom participate in running the business. Shares of the family business would normally be left to the family members who are involved in the business in these cases, with the remaining assets of the estate being divided among the other family members.
However, there is not always enough cash to pay for the taxes on the disposition of shares or provide an equivalent value to the beneficiaries who are not involved in the business. Therefore, some individuals in this situation will choose to have the proceeds of such a policy paid to the estate through a capital dividend in order to fund tax liabilities and equalize value among the owner’s beneficiaries.
Learn More About Corporate Owned Life Insurance Policies
To find out more about how a corporate-owned life insurance policy can benefit your business and help you meet your financial goals, get in touch with the associates at Vector Benefits today. We offer professional guidance on all of your life insurance needs and create tailored policies that protect your interests. Contact us today to discuss your needs and request a quote.