August 23, Tax Treatment Of A MoneyGuard Reserve Life Insurance Policy Owned By A C Corporation. Scope

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1 Dean Chatlain Director Of Technical Concepts Lincoln Financial Distributors Post Office Box Greensboro, NC Telephone Number: Telecopier Number: August 23, 2011 Tax Treatment Of A MoneyGuard Reserve Life Insurance Policy Owned By A C Corporation IRS Circular 230 Disclosure: This material was prepared to support the promotion and marketing of life insurance products. Lincoln Financial Group affiliates, their distributors, and their perspective employees, representatives, and/or insurance agents do not provide tax, accounting, or legal advice. Any tax statements contained herein were not intended or written to be used, and cannot be used for the purpose of avoiding U.S. federal, state or local tax penalties. Clients should consult their own independent advisor as to any tax, accounting or legal statements made herein. This paper is intended to guide a tax advisor s research into the various IRS rules that govern the tax treatment to a corporation, and the insured employee, when a C corporation purchases MoneyGuard to provide long-term care protection for a key employee. This paper is not intended to represent a formal or informal tax opinion under the IRS Rules of Practice. Scope MoneyGuard Reserve and MoneyGuard Reserve Plus are universal life insurance contracts that include long-term care riders (hereafter, referred to as a MoneyGuard contract or policy). A corporation may choose to provide life insurance and long-term care protection to an employee (and spouse). The corporation could choose to pay the premiums as additional compensation to the employee, with the employee as the owner of the policy. Based on the actual facts in a given situation, the parties may find that an executive bonus arrangement is the better solution for all of the parties. A corporation may also conclude that it would like to be the owner of the MoneyGuard policy, and provide the long-term care protection to the employee as an additional fringe benefit. This paper is focused on this second approach where the corporation wants to be the owner of the policy and provide the long-term care benefits as a fringe benefit to an employee. Long Term Care Benefits Provided By MoneyGuard Contract Are Accident & Health Benefits Employers have provided accident and health benefits to employees for many decades. In fact, a recent Congressional Research Study noted that excluding employer provided medical benefits from income costs the Government about $143 billion a year in tax revenues. If a corporation purchases a MoneyGuard contract to provide long term care protection for an employee, any long term care

2 benefits provided will be received income tax free by the employee (including former employees and spouses of current or former employees). IRC 105(b) excludes from an employee s income employer reimbursements or payments of medical expenses for the employee or spouse that would otherwise be deductible under IRC In Rev. Rul the IRS specifically stated that the exclusion from income was also available to retired employees. The legislation that authorized contracts like MoneyGuard specifically states that any long term care expenses reimbursed by a combination life insurance and long term care contract will be treated as medical care expenses. Therefore, under IRC 7702B(a)(2) any long term care reimbursements provided by a MoneyGuard contract will be considered the reimbursement of medical expenses that would be deductible under IRC It should be noted, however, that the exclusion for employer provided medical benefits only applies to employees. The IRS does not consider a non-employee corporate director to be an employee (they are considered to be independent contractors). 3 Treas. Regs (a) does not require that the accident and health plan be in writing, or even that the employee s rights to benefits be enforceable. 4 Regardless of the technical requirements, it is recommended that a corporation formally agree to provide MoneyGuard long term care benefits to an employee, and communicate that commitment to the employee. MoneyGuard Long Term Care Benefits Can Be Offered To Selected Key Executives Under current law, a corporation is permitted to purchase MoneyGuard contracts to provide long term care benefits under a plan available only to selected key employees. IRC 105(h) has historically prohibited an employer from providing tax free reimbursement of medical expenses under a discriminatory self-insured plan. Although the Affordable Health Care Act 5 expanded the non-discrimination rules applicable to group health plans, separate long term care plans continue to be excluded from its scope. 1 See also, Treas. Regs IRC 105(b) also excludes from an employee s income reimbursement of medical expenses of dependents of the employee. 2 IRC 7702B(a)(2) states that amounts received under a qualified long-term care insurance contract shall be treated as amounts received for personal injury and sickness and shall be treated as reimbursement for expenses actually incurred for medical care (as defined in section 213(d)) 3 See, IRS Pub. No. 15-A (2010), p If an employee s rights are not enforceable, medical expense reimbursements are excluded from income only, if on the date the expenses were incurred, the employee was covered by a plan or program and notice and knowledge of the plan was reasonably available to the employee. However, if the plan is subject to ERISA, there is a written plan requirement. See, the annotations in the Federal Tax Coordinator 2d, paragraphs H-1133 and The Patient Protection and Affordable Care Act, Pub. L , was enacted March 23, 2010.

3 Medical reimbursement plans that discriminate in favor of highly compensated individuals are only tax free if they are fully insured. A plan is considered to be self-insured unless reimbursement is provided by an accident and health insurance contract issued by a licensed insurance company. 6 In a series of private letter rulings, the IRS has consistently stated that a plan will be considered to be self-insured if the insurance policy does not result in a shifting of risk to a third party (i.e., the insurer). 7 MoneyGuard contracts involve a clear shifting of the long term care risk to Lincoln. Depending upon the age and sex of the insured, total long term care benefits could be three to five times the total premium paid for the contract. Therefore, a corporation that purchases a MoneyGuard contract to provide long term care protection for a key employee does not have a self-insured medical reimbursement plan subject to nondiscrimination rules. The Affordable Health Care Act added a new section 2716 to the Public Health Service Act. This new section (42 USC 300gg-16) clearly prohibits a group health plan from establishing eligibility rules that have the effect of discriminating in favor of higher wage employees. Although IRS Notice delayed enforcement of this non-discrimination rule, and the related penalties, pending the release of regulations or generally applicable guidance, employers would obviously be hesitant to offer MoneyGuard to key executives on a discriminatory basis if the rules might prohibit it in the future. 42 USC 300gg-91 has always excluded long term care benefits as an excepted benefit in the definition of a group health plan. However, the complexity of the Affordable Health Care Act created questions about whether 42 USC 300gg-91 continued to exclude long term care benefits. Fortunately, in Treasury Decision 9489, the IRS stated that the definition of a group health plan would continue to exclude excepted benefits such as long term care. 8 Again, MoneyGuard is a life insurance contract with a long term care rider. This design is specifically permitted by IRC 7702B(e)(1), which treats the rider as a separate long term care contract. Therefore, an employer who offers long term care protection with a MoneyGuard contract is allowed to limit the eligibility for the benefit to selected key employees. Tax Rules For Deducting The Cost Of Welfare Benefit Plans IRC 419 defines a welfare benefit very broadly, excluding only (1) transfers of property subject to IRC 83(h), (2) deferred compensation under IRC 404, and (3) foreign deferred compensation under IRC 404A. In PLR the IRS 6 See, Treas. Regs (b)(1)(i). 7 See, for example, IRS Private Letter Rulings , , and which show that the IRS is consistently requiring that there be a shifting of risk to the insurer. 8 Treasury Decision 9489 released interim final rules under the Affordable Care Act relating to the status of existing plans. Nevertheless, it is important to note that the IRS stated that neither ERISA 715 nor IRC 9815 will apply to excepted benefits.

4 stated that welfare benefits include major medical, hospitalization, death benefits, accidental death and dismemberment, prescription drugs, dental benefits, short and long term disability benefits, holiday and sick pay benefits, vacation pay benefits and post-retirement medical and death benefits. As noted earlier, IRC 7702B provides that the long term care rider that is part of the MoneyGuard policy will be treated as an accident and health insurance contract. Therefore, the timing and amount of tax deductions for a corporate owned MoneyGuard contract will be governed by IRC 419 and 419A. The Corporate Owner Cannot Deduct The MoneyGuard Premiums Paid An employer that purchases MoneyGuard to provide long term care protection to a key employee cannot deduct the premiums paid. Under the IRC 419 rules, the employer is entitled to deduct the long term care benefits provided to the employee, in the year the benefits are provided. In order to understand the tax treatment of premiums paid on corporate owned MoneyGuard policies, you have to examine the interplay between the IRC 419 rules and the IRC 264 rules. One of the best descriptions of how these rules operate is in Rev. Rul , which attempted to explain why no tax deduction was available when cash value life insurance was purchased to fund welfare benefits. Even though Rev. Rul was targeting abusive corporate sponsored life insurance arrangements owned by trusts, the analysis is relevant to corporate owned MoneyGuard contracts because MoneyGuard is cash value life insurance. 9 Because the corporation is the owner of the MoneyGuard contract, it is assumed to have access to the cash values, thereby bringing the prohibition of any deduction for the premiums paid on any life insurance contract described in IRC 264. The second holding of Rev. Rul specifically notes, However, the fund s qualified direct cost includes amounts paid as welfare benefits by the fund during the taxable year for claims incurred during the year. The general design of IRC 419 and 419A is that an employer should receive a deduction for the benefits actually provided during a year, on a cash basis. Since the long term care benefits are a welfare benefit, the employer is entitled to a deduction for the actual long term care benefits provided to an employee during a taxable year. Rev. Rul also makes it clear that the IRC 419 rules apply to the timing and amount of the employer s tax deductions. The tax treatment of the benefits being provided to the employee will depend upon other provisions of the Internal 9 To a certain extent, interpreting Rev. Rul requires an understanding of the concept of the direct cost of a welfare benefit plan in IRC 419. Except for additions to welfare benefit funds recognized in IRC 419A, an employer s deductions are generally limited to the actual benefits provided during the year, determined on a cash basis.

5 Revenue Code. For example, in both Situation 1 and Situation 2, the deduction was allowed when the welfare benefit would be includible in the gross income of the employees if provided directly by C (or would be includible in income absent some provision of the Code excluding them from income). In the case of MoneyGuard, the underlying welfare benefit being provided is medical expense reimbursement, which, as explained previously, is tax free to the employee. There appears to be some concern that the MoneyGuard benefits should be taxable to someone either the employer or the employee. Somehow it does not seem right that the employer can receive the MoneyGuard benefits tax free, receive a deduction for the benefits paid to the insured, and then have the insured receive them tax free. However, this is exactly the way the IRC 419 rules are structured. IRC 419(c)(5) states that no item can be taken into account more than once in determining the direct cost of the welfare benefit plan. Had the employer deducted the premiums (e.g., for a group term life insurance plan), the employer would not be entitled to deduct the group term benefits paid to the employee s beneficiary. However, because the IRC 419 rules deny any deduction for the MoneyGuard premium, the LTC benefits become deductible when provided. Consider, for example, the tax treatment of traditional long term care premiums payable by a corporation to secure long term care protection for a key executive. To the extent that the employer is paying annual premiums throughout the lifetime of the insured, the annual premiums may be deductible as the direct cost of the plan each year. In this case, the employer cannot deduct the benefits paid because that would be taking into account the same item twice. By analogy, consider life insurance purchased to provide deferred compensation benefits to an employee. Because the employer is the owner of the contract, the premiums are non-deductible. If the deferred compensation benefits became payable because the employee died, the employer would receive the death benefits tax free under IRC 101, and would receive a tax deduction for the deferred compensation benefits paid. The fact that the deferred compensation is taxable to the employee or his or her beneficiary is simply because it is a taxable fringe benefit. Options For The Death Benefit Of Corporate Owned MoneyGuard As the owner of the MoneyGuard life insurance contract, the employer can decide to allow the insured executive to name the beneficiary of the death benefit, or the employer can name itself as the beneficiary of the death benefit. In some cases, the employee will name the beneficiary because the MoneyGuard policy is viewed as a fringe benefit for the long term performance of a key employee, and the value of both the long term care benefit and the life insurance death benefit are part of the total compensation package. In other cases, the insured may be a majority owner of the corporation and the corporation regards the death benefit as part of its key man coverage. Or, the

6 primary focus of the arrangement is to provide long term care protection, and the employer wants to retain the death benefit as a form of cost recovery. Tax Treatment If The Employee Names The Beneficiary Of The MoneyGuard Death Benefit In many cases, the employee will be allowed to name the beneficiary. If everyone wants the death benefit to be tax-free, the employee will need to report as income each year the value of the death benefit protection. This approach is technically an economic benefit split dollar arrangement. IRS Table 2001 can be used to value the death benefit protection provided each year. The Table 2001 rates vary by age, but are unisex. As an example, if the insured is age 60, and the MoneyGuard death benefit is $200,000, the value of the death benefit protection for that year will be $1,302 ($6.51 per thousand of coverage). When the insured is age 80, the value of the death benefit protection will be $10,912 ($54.56 per thousand of coverage). 10 An employer can choose to have the Money Guard death benefit represent taxable income to the designated beneficiary. Under the split dollar regulations, if the employer does not report the value of the death benefit protection each year, the death benefit will be taxable to the employee. 11 Having a taxable death benefit may be a viable option when it is recognized that the Money Guard death benefit is reduced by any long term care benefits actually paid for the benefit of the insured. For example, an employee could report taxable income for a number of years for a $200,000 death benefit, and then have the death benefit reduced to $20,000 if the employee incurs over $180,000 of long term care expenses. By having the death benefit be taxable, the employee avoids annual economic benefit reporting on a death benefit that might be reduced dollar-for-dollar by long term care benefits actually received. Tax Treatment If The Employer Is The Beneficiary Of The MoneyGuard Death Benefit As the owner of the Money Guard contract, the employer may want to retain the policy death benefit. As noted earlier, the employer may want to keep the death benefit as key man coverage and/or cost recovery. In order for the death benefit to be eligible for the IRC 101(a) exclusion from income, the employer will have to comply with the additional notice and consent requirements of IRC 101(j). First, the employee needs to satisfy one of the definitions of a highly compensated employee. 12 Second, the employee has to receive notice, and 10 See, Treas. Regs for the split dollar regulations and IRS Notice for guidance regarding Table 2001 and a carrier s alternate term rates. 11 See, Treas. Regs (f)(3) for the provisions that link the reporting of the economic benefit received each year with the ability to receive the death benefit tax-free under IRC 101(a). 12 IRC 101(j)(2) refers to the IRC 414(q) definition includes a 5% owner or an individual receiving compensation in excess of $110,000 (2011), and the IRC 105(h)(5) definition which includes any employee in the top 35% of pay.

7 consent, to the employer being the owner and beneficiary of the policy. The notice must advise the employee of the maximum amount of the policy death benefit at the time the policy is issued. Since the employee will be signing the Money Guard application, this requirement will be satisfied. However, IRC 101(j)(4)(B) requires that the employee specifically consent to the employer continuing the coverage after the employee has terminated employment. Because of this last requirement, it is generally recommended that the insured employee sign a separate notice and consent. It should be noted that IRC 101(j) allows a tax free death benefit to the employer only if the insured is an employee or director. Therefore, even if the notice and consent requirements are satisfied, if Money Guard is purchased for a spouse who is not an employee the death benefit will be taxable to the employer. An employer that wants to retain the death benefit as a form of cost recovery simply needs to recognize that the amount of the death benefit in excess of the employer s investment in the contract will be income to the employer. Plan Documentation Although the IRS rules do not require that an accident and health plan be in writing for the exclusion from income to apply, 13 both the employer and the employee will generally want to document the terms of the long term care plan. If the employee insured owns 100% of the stock of the C corporation, there is obviously little concern that the corporation will unilaterally terminate the employee s long term care arrangement. However, an employee who does not control the corporation ideally wants an enforceable right to the promised long term care benefits. If the insured employee has an employment contract, then one approach would be to add the Money Guard benefits to the employment contract. If the insured employee does not have an employment contract, the board of directors could adopt a resolution granting the Money Guard benefits to the employee (or class of employees being covered). In a public corporation, the compensation committee of the board would presumably also need to approve the additional fringe benefit being provided. Regardless of what specific actions the corporation takes to grant the benefits to the executive, care should be taken to make sure that the contract or resolution reference the benefits being provided by the Money Guard policy. You want it to be clear that the corporation is promising only those benefits that will be provided by the Money Guard contract. 13 See the annotations at footnote 4, above.

8 Final Comments This paper is intended to guide a tax advisor s research into the various IRS rules that govern the tax treatment to a corporation, and the insured employee, when a C corporation purchases Money Guard to provide long term care protection to a key employee. Dean F. Chatlain