Second-to-Die Insurance In a Profit Sharing Plan

Assets in qualified plans are subject to several taxes at the death of the participant (or at her spouse's death if funds are rolled over to a spousal individual retirement account [IRA] at the participant's death): federal and state estate taxes can reach a marginal rate of 60 percent. Assets in a qualified plan are deemed to be income in respect of the decedent and are subject to federal and state income taxes, after the appropriate deduction is taken for the net federal estate tax paid. In addition, qualified plan assets may be subject to a federal excess retirement accumulations tax of 15 percent.

The combined effect of all these taxes is to reduce, in certain cases, the qualified plan assets passing to the next generation by as much as 90 percent. Acquisition of life insurance in a qualified plan may significantly increase the net amount of assets available for the family upon the death of the parents.

Therefore, individuals with substantial qualified plan accounts who decide to buy second-to-die life insurance should consider utilizing the cash and/or assets in the qualified plan as a source of funds to pay the life insurance premiums.

Profit sharing plans have more liberal rules for the purchase of life insurance than pension plans (money purchase and defined benefit plans) and afford participants with the unique opportunity to buy second-to-die life insurance with pre-income tax dollars. IRAs do not allow for the purchase of life insurance.

The profit sharing plan must contain language authorizing the trustees to purchase life insurance for each participant out of her account. Further, the plan must provide that the trustees will purchase insurance only when so directed by the participant. The participant may direct the investment of her account balance in a policy on her life, or on the life of someone in whom she has an insurable interest.

In order for a profit sharing plan to remain qualified under Code 401 (a) any insurance death benefit purchased by the plan must be "incidental" to the payment of retirement benefits. In order to be considered "incidental," no more than 50 percent of the company's contributions to the plan on behalf of the participant may be used to purchase whole life insurance or, no more than 25 percent may be used to purchase term insurance. However, there is no limit if the life insurance is purchased with funds accumulated under a profit sharing plan for two or more years. The plan document must contain language incorporating the incidental death benefit rule and the two-year exception. If not, the exception will not be available.

The cost of the life insurance protection provided under a qualified profit sharing plan must be included in the employee's gross income for the year in which deductible employer contributions or trust income is applied to life insurance protection.

Only the cost of the pure amount at risk is treated as a currently taxable distribution. The amount of taxable income is determined by multiplying the one-year premium term rate at the insured's age by the difference between the policy's face amount and the cash value at the end of the year.

The one-year term rate used is the lower of the rate published by the Internal Revenue Service (so called P.S. 58 rates) or the insurance company rate for one year term insurance available to standard risks.

The one-year term rate for survivorship policies is based on joint life mortality rates in U.S. Life Table. For example, the one year term premium rate for a survivorship policy covering a pair of 65 year old insureds is $0.993 per $1,000 of insurance.

If the policy has a face amount of $1 million and a cash value of zero in the first year, then the amount of taxable income is $993 (0.993 x 1 million/1,000). The amount of income is small compared to the annual premium for the policy, $29,610 in this example, because only the term insurance element is taxable (not the cash value) and the term rate for a joint life policy (which measures the risk of both lives dying in the same year) is so low.

The life insurance policy is owned by the profit sharing trust and the participant retains the right to choose the beneficiaries. If the participant dies first then the policy is included in her estate because the employee possessed an incident of ownership, the right to change the beneficiary.

The value of the policy for estate tax purposes is its cash value at the employee's death because it does not mature until the second spouse dies. The cash value is also deemed to be income in respect of the decedent and will be subject to income tax, after taking the deduction for the net federal estate tax paid (if any).

Excess Retirement Tax
It also may be subject to the 15 percent excess retirement accumulations tax. For example, Mr. and Mrs. Jones are insured for $1 million under a survivorship policy, owned by a profit sharing trust in which Mrs. Jones is a participant. Mrs. Jones dies 10 years after the policy was purchased. The policy's cash value at the death of Mrs. Jones is $300,000. The $300,000 of cash value is subject to estate tax and income tax (income in respect of the decedent) in Mrs. Jones's estate.

If the profit sharing assets, including the life insurance policy, were bequeathed to the surviving spouse the life insurance would be included in that spouse's estate at its face value. To avoid this, the participant should consider naming an inter vivos irrevocable life insurance trust as the beneficiary of the life insurance policy and her spouse as the beneficiary of all other funds held in her profit sharing account.

In order for this designation to be effective, the participant's spouse must waive his rights to a qualified pre-retirement survivor annuity as to the life insurance policy's cash value.

The cash value of the policy is subject to estate tax in the participant's estate when she dies if the beneficiary of the policy is an insurance trust. In addition, the life insurance trust, as the beneficiary of the policy, will have to pay income tax on the cash value because it is deemed to be income in respect of the decedent.

The trust can borrow from the policy's cash value to pay this tax if there are no other assets in the trust. When the participant's spouse dies (assuming the participant predeceased), the policy's death benefit will not be subject to estate tax because it is owned by the irrevocable insurance trust and the surviving spouse has no incidents of ownership in the policy.

For example, Mr. and Mrs. Jones are insured for $1 million as described above. When Mrs. Jones, the plan participant, dies the policy is directed to be distributed to a life insurance trust created by Mrs. Jones during her life. The policy's cash value of $300,000 is subject to estate tax and income tax, payable by the trust.

The trust is allowed an income tax deduction for the estate tax paid on the "income in respect of the decedent" namely, the $300,000 of cash value. When Mr. Jones dies some time later, the policy's death benefit will not be subject to income tax or estate tax (because it is owned by the trust and Mr. Jones does not possess any incidents of ownership in the policy). The three year rule does not apply because a gift of the policy was never made by Mr. Jones.

Sell to the Children
If the participant's spouse dies first, the policy must be removed from the profit sharing plan to prevent subsequent inclusion of the death benefit in the participant's estate when she dies. Assume the same facts as in the above example, except that Mr. Jones, the participant's spouse, dies first. Mrs. Jones now has an incident of ownership (i.e., the right to change beneficiaries) in a policy on her life.

If she were to die with the policy in the profit sharing trust, the full face value of the policy would be included in her estate for estate tax purposes. To avoid this result, the policy should be sold, at the death of the participant's spouse, to the children. The sale must meet certain requirements to avoid being characterized as a prohibited transaction under ERISA.

First, the policy would, but for the sale, be surrendered by the plan (the profit sharing plan must contain such language). Second, the "relative" who purchases the policy must be a member of the insured's family (spouse, ancestor, descendant and any spouse of a descendant).

Third, the amount received by the plan as consideration for the sale must be at least equal to the policy's cash surrender value.

The sale of an insurance policy for valuable consideration generally causes the death proceeds to be taxed as ordinary income. However, the sale of a policy to partners of the insured is exempt from this rule. To qualify for this exception the family members should create a partnership, preferably for some valid business purpose, when this estate plan is created (well before the death of either spouse).

The plan's sale of the policy to the insured's children removes the death benefit from her estate. Furthermore, it escapes the gift-in-contemplation-of-death three year rule because it is a sale, not a gift.

For example, assume the same facts as above with Mr. Jones (the participant's spouse) dying first. At his death the children, who are members of the Jones Family Limited Real Estate Partnership, purchase the policy from the profit sharing trust for $300,000, the policy's cash value. The children own the policy and, at no time after Mr. Jones' death, did Mrs. Jones possess any incident of ownership in the policy. When Mrs. Jones dies the death benefit is not included in her estate for estate tax purposes and the children receive the death proceeds free of all estate and income taxes. If the participant retires before any death occurs, the policy can be purchased by the children in the manner described above.

Protective Language
If the insured and her spouse were to die in a common disaster, the estate tax exclusion can be protected through language in the insurance contract.

The life insurance application, which is part of the contract, should provide that, in the event of a simultaneous death, the participant spouse is presumed to have predeceased the non-participant spouse. The same procedures described above, namely the transfer of the policy to an irrevocable insurance trust, can then be fol- lowed, as if the participant did die first.

Buying second-to-die life insurance on the lives of the participant and his or her spouse with profit sharing plan assets avoids current income (apart from the relatively small U.S. 38 amount) and gift taxation on the life insurance premiums.

Policy ownership can be structured to avoid estate taxation of the death benefit when the second spouse dies. Offsetting these benefits are the costs of transferring the policy out of the plan at the first death. The costs and benefits will have to be compared to determine the suitability of this planning technique for any client.