Tax-Free Insurance with 419 DBO Plans

E2E: Tax-Free Insurance with 419 DBO Plans

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Participants gain death benefit protection and current tax deductions.

By Richard A. Pope

Voluntary Employees Beneficiary Associations (VEBAs) and their cousins, taxable welfare arrangements, are gaining in popularity. In an era of high taxes and high employee benefit costs, the ability to provide this benefit to families and employees with pre-tax dollars is unique. Here's why.

The 419A(f)(6) plan should only be considered when there is a need for life insurance on a tax-deductible basis.

When structured as multiple employer plans (consistent with the Internal Revenue Code 419A(f)(6) exception for 10 or more employer plans), these plans can provide long-term death benefit protection with current tax deductions. When properly structured, participants may avoid income and estate taxes on the death benefit and minimize or eliminate gift tax exposure. This makes these plans perfect for business and estate-planning use.

For example, a chiropractor earns $300,000 a year and has one employee, who earns $40,000. He wants a welfare plan to provide him with a $3-million permanent death benefit.

A plan would be designed with a death benefit of 10 times the compensation level: $3 million of coverage for the chiropractor and $400,000 for his employee.

In most cases, the cost of insurance for rank-and-file employees in a plan is a few hundred dollars annually, making this quite appealing for the insured employer.

Tax-free life insurance

A properly designed 419A(f)(6) DBO plan is a multiple employer, death-benefit-only plan and trust, as defined in Section 419A(f)(6) of the IRC.

The 419 plan should only be considered when there is a need for life insurance on a tax-deductible basis. It should not be established to supplement an existing retirement savings plan.

Its primary benefit is to provide employees with tax-free life insurance for business, personal, tax- and estate-planning purposes.

A key benefit of a 419A(f)(6) plan is that it enables qualified, closely held business owners to obtain life insurance for themselves and key employees with pre-tax dollars. With proper planning, the life insurance proceeds obtained through certain 419A(f)(6) plans may pass to heirs free of federal estate tax.

To deduct life insurance premiums, business owners must join a master trust, written and administered under the guidelines of IRS Code Section 419A(f)(6).

This section requires certain criteria to achieve tax deductibility. Some of the major requirements are:

The trust must consist of 10 or more participating employers, none of whom should have more than a 10 percent interest in the trust.

Gains or losses within the trust must be uniformly applied to each participant in the plan.

Compensation paid to the individual participants in the program, taking into account benefits provided under the program, must be reasonable under Internal Revenue Service guidelines.

A risk must exist that participants will forfeit benefits sometime in the future, such as upon future termination of employment.

It must not be a deferred compensation plan (a retirement savings plan).

Eligibility

The employer must meet the following additional guidelines for plan eligibility:

The employer may be a C or S corporation, a limited liability corporation or a general partnership (This is subject to certain conditions.)

The employee must provide bona fide services to the employer and must have performed 1,000 hours of service during that year.

Benefits may be provided to a select group of employees, but must be provided to at least one nonshareholder employee.

Certain types of employees are not eligible for the plan. They generally include:

Employees who have been with the company for less than three years

Employees under the age of 21

Seasonal employees

Employees who work less than half time (less than 1,000 hours per year)

Benefits

It should be noted that survivor benefits are the only benefits offered in certain 419A(f)(6) DBO plans. The plan offers employees life insurance protection of up to 28 times their annual compensation. It should be structured to provide survivor benefits for active employees only and not to offer a benefit similar to that provided under a retirement savings plan, such as a severance benefit. This conservative approach restricts the types of benefits that are available to employees to ensure the tax-deductibility of contributions.

However, 419A(f)(6) plans are not subject to certain qualified retirement plan limitations as outlined in ERISA. This makes them a favorable option to wrap around existing qualified retirement plans.

Control

The control of the 419A (f)(6) DBO plan is strictly guided. An employer must not control the plan under any circumstances; a court decision in 1990 held that strong employer control over a VEBA would put its tax-exempt status in jeopardy. It should be controlled by one of the following: its members, an independent trustee (often, a bank) or trustees -- at least some of whom are designated by the membership. Generally speaking, it's wise to have an independent bank trustee.

If an employer terminates the plan, assets attributable to funding its employees' benefits (i.e., the life insurance policies) are distributed to the employees.

The life insurance contracts are converted to paid-up, individual policies. Cash benefits are not distributed when a plan is terminated; only the cash-value life insurance policies are distributed to the participant employees proportionately.

Differences

How does a DBO plan compare to other 419 benefit plans?

The 419 DBO plan eliminates the two aspects of most other multiple employer welfare benefit plans that render deductibility of contributions aggressive: post-employment termination benefits (e.g., severance) and direct experience allocation.

The 419A(f)(6) DBO plan eliminates these features while preserving the economic and tax aspects. In addition, the plan provides tax deductibility, deferred income taxation and estate tax efficiency, without tax aggressiveness.

Costs

Costs to start up and administer a 419 DBO plan vary. The plans are administered by outside third-party administrators, much like qualified retirement plans, and have a trust department of a major bank involved in recordkeeping. (Please note that this is their only similarity to any type of qualified retirement plan.)

The average cost of administration for a plan is approximately $2,000 to $2,500 for the basic plan document, along with an additional fee of $35 to $50 per participant. This is the basic plan administration cost only and excludes any of the associated premium payments. Additionally, the standardized legal and accounting opinion letters are included in these costs. Costs can significantly increase, however, if the employer wishes to have outside counsel provide an opinion letter.

Properly structured and in the right circumstances, a 419A(f)(6) DBO plan offers many benefits to employers who seek increased benefits, employee retention and tax deductions.

Richard A. Pope is president and CEO of Applied Financial Group in Woodbury, N.Y. You can reach him at 516-677-6212.

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