Part I and Part II have focused on the tax planning possibilities of small business owners and owners of professional corporations utilizing an exemption for collectively bargained plans. This exemption allows the business owner to cover employees under the benefit plans of a union. This arrangement allows the business owner to establish benefit plans that discriminate for the business owner and his family.
The top marginal bracket for taxpayers with more than $400,000 (single and $450,000 married) has increased to 39.6 percent. Taxpayers with adjusted gross income in excess of $250,000 will pick up an additional 3.8 percent on unearned income raising the top marginal bracket to 43.4 percent. Married Taxpayers with more than $250,000 of AGI will pay an additional 0.9 percent in Medicare tax.
These same taxpayers will also be exposed to the phase out of personal exemptions and miscellaneous deductions. These phase outs effectively raise the marginal bracket by 1-2 percent. High income states such as New York and California add an additional 8-10 percent bringing taxpayers to a combined marginal tax bracket of 50-53 percent. Additionally, taxpayers face an additional 3.8 percent federal tax on unearned income if AGI exceeds $250,000 for married taxpayers.
Section 79 plans are generally known as group term life arrangements. These arrangements are “old school” techniques that have largely disappeared from the arsenal of planners. However, Section 79 plans have the potential to be a tax advantaged retirement planning vehicle for business owners through the use of permanent insurance as a funding vehicle in the Plan.
Unlike qualified retirement plans which provide for a complete tax deduction for plan contributions; tax deferral on investment earnings, and taxation at ordinary rates on distributions, Section 79 provides the potential for tax-free distributions at retirement for the business owner along with tax deferral on investment growth, but with a partial tax benefit.
This article is designed to outline the use of a Section 79 plan and the requisite tax authority.
Tax and Legal Authority
IRC Sec 79 provides the tax authority for group term life arrangements. These group term life arrangements are employer sponsored ERISA-based welfare benefit plans. Group term life is an employee benefit program in which the employer provides death benefit coverage for a group of employees. Benefits under the program are determined by a formula that precludes individual selection.
Under a Section 79 Plan, the premiums are tax deductible under IRC Sec 162. The employee as a participant is taxed on the amount of coverage in excess of $50,000. The economic benefit to the employee is measured using Table I. The term costs under Table I are measured in five year brackets. Additionally, permanent benefits are taxed to the participant under IRC Sec 79.
Section 79 plans are offered on a guaranteed issue basis or with simplified underwriting depending upon the size of the group. The benefits formula usually uses a percentage of compensation or is based on coverage brackets.
These arrangements must cover employees. Under the tax law definition of “employee”, a sole proprietor, more than 2 percent shareholder of an S corporation, member of a LLC, and partner are not considered common law employees. Therefore, a business owner who operates his company as an S Corp, or LLC must create a C Corp so that the business owner has W-2 income for purposes of determining Plan benefits.
Employees covered under the Plan may be excluded if they have less than three years of service, or are part-time or seasonal workers. Employees that are covered under a collective bargaining agreement are also excluded from the Plan. Part time employees are those employees who work less than twenty hours per week or less than five months per year for the Employer. Employees who have been employed for less than six months may also be excluded. Employees who are older than age 65 may be excluded.
Under the ERISA coverage requirements, the Plan must benefit at least seventy percent of all eligible employees and 85 percent of the participants must not be key employees. A key employee is generally an officer of the Employer making more than 150,000 per year, a five percent owner of the Employer or a one percent owner making more than $150,000.
Section 79 Plans are also subject to the Controlled Group and Affiliated Service Group rules. These are the complex rules that you know from the pension world that keep business owners from structuring their businesses to exclude employees from benefit plans.
The Section 79 rules require that benefits offered to key employees must be available to all participants – (1) Same type of Benefit and (2) The same amount of benefits by formula.
Having said that, the ERISA discrimination and participation requirements are eliminated through the business’ collective bargaining arrangement with a labor union.
Collectively Bargained Arrangements under IRC Sec 410(b)(3)(A)
What is a collectively bargained agreement? IRC Sec 410(b)(3)(A) states the following in its exemption:
“employees who are included in a unit of employees covered by an agreement which the Secretary of Labor finds to be a collective bargaining agreement between employee representatives and one or more employers, if there is evidence that retirement benefits were the subject of good faith bargaining between such employee representatives and such employer or employers,”
As a result, company employees pursuant to a collective bargaining agreement become union members and the business makes contributions to the union retirement and health plans instead of the company plans. These contributions to the union plan are tax deductible. As a result, these employees are no longer part of the company pension plan or benefits program. The business owner is free to establish a define benefit plan as well as a medical reimbursement plan. The only remaining employees eligible for participation in the business owner’s plan are the business owner and family members. Benefit plan contributions can be optimized for the business owner.
Strategy Example #1
Dr. John Doe, age 48, is radiologist. His income is $650,000 per year. He has four employees in his practice that cannot be excluded from the Sec 79. The medical practice, Radiology Associates, is a limited liability company. Here is a census for the group
The medical practice has a substantial investment in sophisticated medical equipment that is used in the treatment and evaluation of patients.
The practice enters into a collective bargaining agreement with a local chapter of the A.F.L.-C.I.O. The employer will make contributions into the benefit programs available through the union plan – health insurance, 401(k) and group term life.
As previously stated, a member in a LLC is not treated as a common law employee. As a result, some corporate structuring is necessary to facilitate the program. Radiology Associates forms a subsidiary company, and transfers the radiology equipment to a new C Corporation, Medical Equipment Leasing, Inc. Dr. Doe will receive W-2 income of $100,000 per year from the new company.
The two companies are part of the same affiliated service group and are treated as a single plan and company for benefit planning purposes. The proposed plan provides for death benefit coverage equal to (10 x W-2 income). The third party administrator for the Plan proposes three different scenarios.
John adds his wife to the payroll of Radiology Associates and pays her a salary of $100,000 per year. She will become eligible for pension benefits, medical reimbursement plan, health insurance plan and Group term life insurance plan.
The plan will provide a combination of group term coverage for $100,000 and permanent life insurance. John is able to transfer an existing universal life policy of $1 million to the plan as well as purchase some new coverage.
The entire premium is deductible for corporate tax purposes. The total premium for the group is $350,000. Dr. Doe and his wife are personally taxable on approximately sixty percent of the premium allocated for his benefit under the Plan.
The Plan will be funded for five years. At the end of the 5th Plan year, Dr. Doe can elect to terminate the Plan. At the end of the Plan, the policy is transferred to Dr. Doe personally without any tax consequence. The projected cash value is $1 million. The potential tax-free loan available from the policy is $100,000 per year. The policy death benefit is also tax –free.
In Dr. Doe’s resident state, the policy is not subject to the claims of his personal or business creditors. After terminating the Plan in Year 5, Dr. Doe could commence funding a new Plan.
Plan Considerations favor using a permanent policy that has low account values during the first five years but also has competitive long term values beyond the funding period. The policy choice results in lower imputed taxable income. The permanent policy is also designed not to be a Modified Endowment Contract (MEC).
Unlike a qualified plan, the Section 79 only provides a partial tax benefit in that funding the Plan with permanent insurance coverage results in a taxable benefit. The premium is fully deductible for corporate purposes, but result in personal taxable income based upon the specific facts (sixty percent in the example).
However, upon Plan termination, the transfer of the policy to the taxpayer does not result in taxable income. The policy is taxed at that point just like any other life insurance policy – (1) Income tax-free death benefits (2) Tax –free buildup of cash value (3) Tax-free policy loan.
Section 79 plans using permanent life insurance funding can serve as an integral part of a business owner’s retirement planning. Qualified retirement plans have their limitations. They are costly to the business owner due to the requirement to contribute for employees. At the same time, qualified retirement plan funding and benefit limits also can limit the usefulness for the business owner and professional.
The use of the collective bargaining exemption allows the business owner to use an assortment of benefit arrangements on a discriminatory basis as the employees are covered under union benefit programs.
While the program provides a full tax deduction for the business, the business owner has a partial tax benefit (35-45%). Nevertheless, the combination of the tax benefits of life insurance along with the ability to access lifetime distributions for supplemental retirement income compensate for the tax treatment to the business owner. More importantly, virtually all of the premium payments under the Sec 79 Plan benefit the business owner. Sec 79 is an “old school” plan with “new school” benefits.