As tax time approaches, family business owners are busily undertaking numerous exercises to figure out how to reduce the company's tax burden. Often, these examinations lead to a second inquiry: how to improve benefits to family members and top executives while keeping tax liability to a minimum.
In recent years the IRS has nipped away at the tax advantages of various benefits plans. But benefits consultants have been busy too, developing a range of strategies that can be used to sweeten compensation packages, particularly in two areas: health insurance and pensions.
For a year now, employers have had more flexibility in offering extra medical coverage to specific employees. New strategies began late in 1989, after Congress repealed Section 89 discrimination rules. These rules used taxation to discourage unusually rich health plans for top executives, and to encourage reasonably consistent coverage for lower paid employees.
While no one is advocating a return to shabby provisions for the average employee, there is room again for business owners to use health insurance as an executive perk.
Some insurance companies have been quick to establish extended medical policies. Washington National Insurance Co., for example, recently began offering a major medical package that provides a lifetime maximum of $5 million in benefits for an individual. In the past, even the best policies usually topped out at $1 million. Jonathan Wenger, Washington National's director of sales promotion, says that until a few years ago the company had never encountered anyone who incurred $1 million in medical bills. But recently several people have eclipsed that figure. And, Wenger says,'"I the way medical costs are going now, you can bet that in the next three or four years you will see people approaching the $5 million limit."
With Section 89's repeal, business owners can also once again provide themselves with special health-care favors. They can eliminate deductibles for themselves while requiring employees to pay. Owners can award themselves broader coverage than they purchase for employees. And extra coverage for unconventional items such as outpatient psychiatric care may again be instituted without tax penalties.
Business owners have reason to be pleased, but consultants caution against any premature celebrations. Some members of Congress are already talking about new discrimination rules. In addition, extended medical coverage can be expensive. Too, owners might be wise to consider the psychological ramifications to employees of giving preferential treatment to top family members.
While repeal of Section 89 has reopened the door to preferential health care plans, discrimination laws continue to restrain a company's ability to offer extra benefits through conventional pension plans. Most plans consist of a "qualified" pension; employers contribute to the plan, deduct the contribution from the company's taxable income, and the earnings accumulate tax free for the employee. The tax advantages of qualified plans are still attractive, but under current law no beneficiary of a qualified plan can receive more than about $102,000 a year upon retirement at age 65. Those who retire at age 60 cannot receive more than $67,000 a year. For executives accustomed to six-figure incomes, these pensions may appear skimpy.
Estate planners are beginning to recommend the use of "nonqualified" pensions to augment standard retirement packages. Employer expenditures for these are not fully tax deductible, and benefits to employees are not taxable until they are received, but employers can set up any type they choose. Typically, an employer promises to pay a certain benefit to a retiree, and the payments are made out of operating funds. The task then becomes finding a way to cover the employer's costs. Consultants have come up with several strategies, among them corporate-held life insurance, and universal life policies.
In the corporate-owned life insurance approach,a company purchases life insurance for a key executive and pays the premiums. The money is invested by the insurance company and accumulates tax free. The policy is held by the company as an asset, and can be used as collateral for borrowing.
When the executive retires, the company pays non-qualified benefits to him or her from company funds. When the individual dies the death benefit is paid to the company. Thus the company recoups the costs of the policy, and of the benefits paid out. Of course, it may be years before the company gets its money back, depending on how long the retiree lives. But this approach gives employers a way of recouping extra payments to retirees, payments it might not otherwise be able to make.
The financing of corporate-owned life insurance can be expensive, but it need not be traumatic, as one family owned forest products company has found out. The company has developed a plan to cover two family members and eight key employees, all of whom are over age 40 and earn between $70,000 and $350,000 annually. Under the plan, the company will pay, out of cash now, pensions equal to 50 percent of each person's final salary. As each executive dies, the company will receive the death benefits.
To cover the cash payments and the insurance premiums, the insurance company's actuaries estimated the family firm would need a total of $8.7 million over the next 35 years, by which time all 10 of the recipients would be expected to have died. So the company took out several life insurance policies totaling $8.7 million. The premiums cost the company $150,000 a year. In this way, the costs to the company will be recovered, assuming of course that the company exists for 35 more years, which takes some mettle on the family's part.
In the past, corporate-owned life insurance was widely used since it offered great tax advantages. Companies could deduct the payments to the policy, and then would borrow from the policy and deduct the interest.
In recent years the tax advantages have been cut back. It is now only possible to deduct the interest that results from borrowing up to a maximum of $50,000 from a policy not much money these days. "Corporate-owned life insurance isn't as attractive as it used to be, but it can still provide good returns," said Robert Vial, vice-president of National Madison Group, a tax and benefits consulting firm.
Given this, some consultants are suggesting instead that companies consider no-load universal life policies. Universal plans are more flexible than whole life policies, which require a fixed payment each year. Most universal policies allow a beneficiary to contribute extra money in good years that accumulates earnings tax free. In lean years, the customer may then be able to avoid making an insurance payment.
No-load universal policies are particularly attractive because there are no agent's commissions and other costs built into the plan. Cash value begins accumulating in the policy right away, and the company can borrow against the policy in its early years. In contrast, when a commission is involved, much of the first year's premiums go toward covering it. "With no-load policies you are not paying for the agent's bonus trip to Hawaii," says Kenneth Ingham, who heads Ingham Financial Corp., which administers pension plans.
In a typical universal policy, the recipient can withdraw, upon retirement, an amount equal to the amount paid in premiums without paying taxes, since the withdrawals are treated as advances of the death benefits. The death benefits can be assigned to the company or to an individual, and can be set up so that no estate taxes orincome taxes will be due.
While nonqualified retirement plans, and the use of life insurance to fund them, are a way around the rigidity of discrimination rules, they can be expensive. Companies must be sure they'll have steady cash flow, in order to make regular payments. Seeing the limitations of qualified plans, and the pressure non-qualified plans put on cash flow some business owners have thrown up their hands, deciding to keep their money where they believe it will earn the highest returns: in their businesses.
In some cases this has proved very lucrative. An owner may feel he has so much equity in the family business that he will be able to take out whatever he may need, or sell out. But in tough economic times he may not have the cash flow he thought he would, and might not find the right buyer either. Then what?
Stan Luxenberg, a financial writer in New York, examined health insurance premiums in our October 1990 issue.
Business owners can offer lucrative benefits to employees without incurring heavy taxes or shelling out too much cash. Among the most viable options are:
Extended maximum lifetime health insurance benefits.
Extra medical coverage for unconventional items such as outpatient psychiatric care.
Nonqualified pensions that augment standard retirement packages.