Loophole Defers Company Taxes

Internal Revenue Code Section 419 offers companies a little-known tax strategy. Considered a welfare benefit plan, the code gives corporations a discriminatory employee life insurance benefit while significantly lowering the business’ income taxes.

Excluding sole proprietorships, businesses are eligible for the welfare benefit trust if a minimum of two people — both of whom must be employed by the company — enroll in the plan. At least one participant must be a non-owner, and major shareholders are also eligible.

It’s a great way to make Uncle Sam pay for employee life insurance premiums while investing tax-deferred money.

One Fayetteville accounting firm, Ervin & Co. CPAs, helps establish the trust plan for area businesses. Company owner John Ervin said the best aspect of the plan is that it allows employers to select specific groups of employees to include in the plan rather than requiring an umbrella offer.

Under the code, corporations can insure the participant for up to 15 times their annual salary. However, the trust usually requires annual premiums to be lower than 25-30 percent of the employee’s salary, said Michael Casey, the Arkansas and Oklahoma regional manager for Penn Mutual Life Insurance Co.

For example, if an employee made $100,000 per year, the company could insure him for up to $1.5 million if the annual premium for the insurance totaled less than $25,000. In a 39.6 percent tax bracket, the firm would save $9,900 of income tax by paying the $25,000 tax-deductible premium.

Participants chosen for the trust must be treated equally within the plan, Casey said, and the company must invest the same proportional amounts for each employee.

Assets tucked into the death benefit trust are 100 percent tax-deductible, Ervin said, and the money earns interest on a tax-deferred basis. Also, the company’s creditors cannot access the funds.

Insured employees must file an IRS PS-58 on their annual W-2 tax form — meaning employees must report a small portion of taxable income if the firm’s group term life insurance policy tops $50,000, Ervin said.

The plan benefits the business by eliminating some taxable cash flow, Ervin said, but the policy owner also receives a tax-sheltered insurance policy with deductible premiums and a build up of cash value.

“This is conservative. I don’t think there’s a lot of risk in this,” Ervin said. “It’s a very safe way to put a lot of money away in a short time.” Administrative costs for the plan run about $1,250 per year, Casey said.

In the event that the insured employee dies, the policy’s tax-free proceeds go to the employee’s selected heir. Some companies design the policy to finance a buy/sell agreement in case an owner dies. Then, the remaining owner uses the proceeds of the policy to buy the rest of the business from the deceased owner’s spouse.

Because the trust owns the policy, the proceeds from the policy become estate and income-tax free if the insured employee dies.

An insured participant who gets fired or quits the company could have several options, depending on the initial agreement. The employee’s policies might be purchased for the cash value, distributed to others within the trust, transferred to another insurance plan, or forfeited altogether.

Retiring employees also have several choices. Usually, the participant will be allowed to tender the cash value and pay one-time income taxes on the funds. The employee could also possibly roll the proceeds into another insurance policy.

The tax strategy remains fairly rare, but both Ervin and Casey noted that Congress change the tax laws at any time.