Business Use of Life Insurance: Death Benefit Only Plans

A death benefit only (DBO) plan is one form of a group carve-out plan. An employer uses a group carve-out plan to remove highly compensated employees from the company’s group term life insurance plan and obtains individual life insurance policies. Selective benefits that employees receive under the alternate arrangements are usually more generous than those provided under the group term life insurance plan.

A DBO plan is an employee benefit plan that provides a death benefit to the employee’s family or a named beneficiary (other than the employer) at the employee’s death. However, the employer, as policy owner, retains the right to designate the policy beneficiary, amend, revoke, or terminate the policy. Because of this structure, the employee does not have sufficient interest in or control over the related policy to require its inclusion in his or her estate.

When can you use it?

To provide an attractive benefit to highly compensated employees at a reasonable cost: An employer can use a DBO plan to offer highly compensated employees an attractive benefit that could not otherwise be provided under a group life insurance plan. Since DBO plans are based on individual policies, they may be offered at a reasonable cost as a result of reduced rates on individual term policies and lower minimum premiums on permanent policies. Also, because DBO plans are based on individual policies, they are portable, which makes them attractive to the highly compensated employees who are selected to participate. (In contrast, group life insurance benefits cannot be continued after an employee leaves the company except through conversion.)

How does it work?

An employer carves out a high-level executive or employee/owner from the group term life insurance plan, purchases key person insurance on the selected employee, and designates a beneficiary. The insured employee may not have any direct rights over the policy. Instead, the employer promises to pay a death benefit to the employee’s beneficiary at the employee’s death. Upon the employee’s death, the plan beneficiaries receive the death benefit under the DBO plan.

Strengths

Avoids estate taxes: By structuring the arrangement so the employee does not have sufficient interest in or control over the related policy, it is not included in his or her estate, and thus should not be subject to potential estate taxes.

Tax considerations

Premiums are not tax deductible: Premiums are not deductible by the employer/policyowner if the employer retains some controlling interest in the policy, such as the right to make changes to the policy beneficiaries, or obtain loans against the policy’s cash value. There are exceptions to this general principle Consult with your tax advisor or financial professional concerning the deductibility of premiums paid.

Premiums are not included in the insured key person’s income: Premiums may not be taxable as income to the employee/insured if the employee has no interest in the policy, and the employer retains control over naming policy beneficiaries. However, like the deductibility of premium payments, the determination of whether premiums paid by the employer are taxable as income to the employee is somewhat complicated. You should seek the advice of your tax advisor or financial professional.

Taxation of the death benefit: For contracts entered into before August 17, 2006, the general rules applicable to life insurance indicates that the death benefit is received income-tax free by the beneficiary. There are exceptions and situations where the death benefit in fact, may be taxable as income. Consult with your tax advisor or financial professional for more information. For life insurance contracts entered into after August 17, 2006, the death benefit on an employer-owned life insurance policy is not taxable to the employee if certain specific requirements are met before the issuance of the policy. First, there must be proper notice and consent by the employee to be insured. Then, an exception must apply for the death benefit to be received income-tax free. One exception is that the insured is an employee of the policyowner-employer at any time in the 12 month before death, or that the employee is either a more than 10% owner of the business, or highly compensated, or in the top 35% of all employees ranked by pay. A third exception relates to the beneficiary of the life insurance. The death benefit must be paid to qualifying members of the insured’s family or a named beneficiary (other than the employer), or the proceeds must be used by the employer to buy the insured’s interest in the business from qualifying family members of the employee.

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