Page 295 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

Chapter 6. Employee Benefits and Perquisites 281

All COLI plans are long-term commitments and reflect long-term assumptions that may
or may not turn out to be true. They include no unfavorable changes in tax treatment,
assumed interest rates, and mortality experience. Furthermore, COLI benefits must be com-
pared with alternative forms of investment income available to the employer. It is important
to remember that the cost of the benefit provided is the total of benefits paid plus expenses
less investment return on allocated assets. Insurance does not eliminate the cost. It is simply
one way of meeting the expenses.

Key Employee (Key Person) Insurance. With key employee (also known as key person)
insurance, the company is the owner and the beneficiary. It typically covers the loss by death
of a key person, ensuring the ongoing success of the organization and either indirectly
reflecting the person’s value or directly providing the funds necessary to buy out the
deceased’s ownership in the company. Premiums are not tax deductible, but proceeds are tax
free. Other than any psychic value of knowing one’s life is worth several million to the
company, there is no value to the executive for key person insurance. Broad-based key
employee insurance is sometimes referred to as janitors’ insurance with the company receiving
the death benefit. Employees do not understand why the company and not the person’s
family receive the death benefits.
A variation of key employee insurance is one in which the company is still the owner and
beneficiary, but upon death of the executive, the proceeds are paid to the designated bene-
ficiary. The tax treatment is the same as with key person insurance up to the point the
proceeds are paid to the beneficiary. At that time, the company takes a tax deduction for the
amount paid, and the beneficiary has a like amount of taxable income. The amount is also
most likely includable in the estate and subject to estate taxes. Because of the heavy taxes, the
company may decide to gross up for taxes, thereby increasing its cost net of tax deductions.
Thus, key employee life insurance takes one of three approaches: the proceeds are paid
to the company (1) as recompense for the value of the deceased executive, or (2) to provide
monies for a deferred compensation agreement with the executive, or (3) to provide the
money needed to buy out the deceased executive’s ownership in the company. The third
approach is more prevalent among smaller companies and partnerships.
Under such insurance, the company has ownership rights to the policy, although it can
take no tax deduction on the premiums paid [Internal Revenue Code Section 264(a)(1)].
However, the beneficiary does not have an income tax liability on the death benefit proceeds
[Section 101(a)(1) of the IRC].
Provisions can be made for the executive to buy out the policy at the time of retirement:
the assumption is that, by that point, the company has developed a suitable replacement and,
therefore, no longer needs insurance to cover the loss. The value to the executive is that per-
manent insurance protection is obtained to replace the group term insurance in effect during
employment. If the key employee insurance is transferred for whatever reason, it is probably
best to transfer directly to the insured (perhaps for an amount equal to the cash value). Then
the executive can transfer the policy to the spouse if desired. If transferred directly from the
company to the spouse, the proceeds in excess of the death proceeds may be subject to
income tax.
In addition, the company should structure the policy so that it can transfer coverage from
executive A to another should the first leave the company. An adjustment on the premium
will be required because of differences in the executives’ ages and the length of time the
initial policy was in effect.