How Life Insurance-Based Executive Benefits Can Motivate Loyalty

By H.L. Vogl

As the economy emerges from the pandemic, attracting and retaining top talent has emerged as a high priority for businesses of all sizes and industries. Working at home and in hybrid models has loosened ties to the office and made employees more mobile, putting employers around the country in competition for top talent, wherever they live. And a few weeks ago, President Joe Biden issued an executive order asking the Federal Trade Commission to develop regulations to “curtail the unfair use of non-compete clauses and other clauses or agreements that may unfairly limit worker mobility.”

Carrots, Not Sticks

Regardless of whatever limitations the FTC may impose on non-compete agreements, carrots are more effective than sticks when it comes to retaining employees who are motivated to contribute their best. “Non-qualified” benefits for selected employees — with value that is conditional on extended years of service — are great ways to create “sticky” employment relationships in this highly mobile environment.

Traditional non-qualified deferred compensation plans can be challenging to administer, due to the complicated requirements of Tax Code § 409A and the Employee Retirement Income Security Act. They also often involve non-compete requirements that could ultimately be targeted by FTC regulations. As a result, a number of executive benefit designs using life insurance have emerged as popular, simpler alternatives.

Three Common Options For Structuring Executive Benefits

Low interest rates make “loan regime split dollar” particularly attractive today. Select key employees are given the opportunity to own a permanent life insurance policy insuring themselves, with the employer paying the premiums and booking them as loans to the employees. The employees only pay taxes on the small amount of imputed loan interest, rather than the full premiums paid. If covered employees leave the business prematurely, they will have to pay back the loan principal to the employer, and cover any future premiums owed to the insurance company out-of-pocket. (They may prefer to surrender the policy for its cash value to cover their repayment obligation.)

Employees who stay long-term and make continued contributions to the success of the business may be rewarded by forgiving loan principal (in lump sum or gradually), at which time the forgiven amount is recognized as taxable income. The cash value of the policy can provide liquidity to cover taxes due, and what is left can be used to supplement retirement income, cover estate planning needs, and more.

Certain employers are not allowed to make loans to some employees, or want more control over the life insurance policy. (Sarbanes-Oxley prohibited loans to specified executives of publicly traded companies, and some state non-profit corporation laws prohibit loans to officers and directors.) In these cases, “endorsement split dollar” provides an alternative design. The employer owns and pays for the life insurance policy and “endorses” some of the death benefit to the employee. The employee pays tax only on the “economic benefit,” an amount roughly equivalent to the term insurance cost of the endorsed amount. If the employee leaves prematurely, the business retains the policy or surrenders it for its cash value. Similar to loan regime split dollar, the business can decide to reward long-term employees by transferring ownership of the policy to them down the road.

If the employee wants a legally enforceable right to loan forgiveness or policy ownership at some time in the future, that type of split dollar arrangement is considered deferred compensation subject to § 409A requirements. Typically, these arrangements will be designed to utilize the “short-term deferral exception” and provide income recognition within two and a half months after the year in which that right vests.

For employers more interested in taking an immediate deduction for premiums paid, a “Section 162 bonus” arrangement may be preferred. Here the employee owns the policy and the employer pays the premiums, but those premium payments are immediately treated as compensation to the employee, not loans. Since the employee is recognizing the income, the employer takes a corresponding deduction. This is particularly attractive for “pass-through” entities with non-owner key employees, since the owner is typically in a higher tax bracket than the employee.

Employers retain less control over Section 162 arrangements, but they can still maintain some “stickiness” with a Restricted Executive Bonus Arrangement. The REBA is an agreement to restrict the employee’s rights over the life insurance policy — particularly access to the cash value — for a period of time. A REBA may establish a vesting schedule, but employers need to watch out for terms that unintentionally bring the arrangement under requirements such as ERISA or the split dollar regulations. In all of these situations, competent legal and tax advisors should be consulted regarding the design and documentation of these benefits.

Life Insurance Enhances Value

The protective value of life insurance is an integral part of all of these arrangements. Long-term care riders or hybrid policies may also be utilized to provide additional protection benefits. For key employees with life insurance underwriting challenges, a number of insurance carriers offer simplified or guaranteed issue for employer-owned or -sponsored policies that cover a minimum number of qualified employees.

You can demonstrate your value as an insurance professional by bringing these ideas to your business owner clients. Working with an advanced insurance sales team enhances your ability to explain these options to your clients and coordinate with their tax and legal advisors to implement.

H.L. Vogl, JD, CFP, is director, advanced sales, Crump Life Insurance Services. They may be contacted at [email protected].