[IMGCAP(1)]In the current business and economic climate, the value of being a pro-active tax and financial advisor for your business owner clients cannot be understated.
The more options, or arrows, we can have in our tax and retirement planning quiver the better value we can deliver to our clients. Due to legislative changes over the past decade we have seen our arrows in the non-qualified plan arena dramatically reduced. One time-tested arrow that can still deliver tremendous value to specific business owner clients is the Section 79 plan.
These plans can be utilized in place of qualified plans or stacked on top of qualified plans as Section 79 plan benefits do not impact the benefits provided under qualified plans. An employer may find they have maximized their existing defined contribution plan. Another common issue is that they may have too many employees, or perhaps the employees are highly paid and/or older and therefore the use of a defined benefit pension plan becomes problematic.
This occurs quite frequently in industries such as the medical profession. With a defined-benefit pension plan, the cost to provide substantial benefits to the employees will diminish or even negate the business owner’s tax savings and in many cases just does not make economic sense.
Most CPAs and tax advisors are familiar with Section 79 of the Tax Code in regard to a group term plan. This code section sets forth the rules for employer-sponsored group life, health, and medical insurance in which an employer may provide up to $50,000 of group term life insurance for its employees without any cost to the employee. The employer can deduct the cost under Section 162. However, the employee does not have to include the cost as taxable income in that year.
What is not as well-known is the ability for the owners and the employees to purchase permanent insurance through this plan. This is a powerful option which gives the owners and employees who participate the following tremendous advantages:
• They enjoy a tax deduction, or reduction, as not all of the monies contributed under the Section 79 plan to permanent insurance have to be included as taxable income in the year each contribution is made.
• They can benefit from the tax-deferred saving feature of the policy.
• There is the ability to generate tax-free income through policy loans.
• There is a significant amount of long-term life insurance protection.
• Contribution amounts can be adjusted annually, if needed, to provide flexibility for the business owner.
There are specific requirements that must be met when utilizing permanent life insurance to fund benefits under Section 79. There must be a general death benefit excludable from gross income under Section 101a. Also the benefits must be based on a formula that precludes individual selection. The formula for calculating the amount reportable by the participant as taxable income is found in Treasury Regulation 1.79 and is the sum of the cost of the “permanent benefit” plus the cost of the “deemed death benefit.”
In most cases, the cost of the $50,000 of the death benefit may be excluded from income. In a properly designed plan, the participant’s reportable income can be only 60 to 80 percent of the premium actually paid by the corporation. So, not only does the corporation get a 100 percent tax deduction for the contribution, but the individual reduces his/her taxable income as well!
As Section 79 plans do not have the same minimum participation rules as qualified plans, there is an ability to tailor the plan for companies with multiple owners and/or highly compensated employees in which not all may participate or may participate at different funding levels. In a non-discriminatory plan ancillary employees are entitled to receive permanent insurance funded by the employer. However, most will choose not to participate on this level. The long-term benefits must be adequately and properly explained to the employees.
Yet, due to the fact the participant has to include “phantom income” in each year a contribution is made and pay taxes on that income as well as go through medical and possibly financial underwriting, most will elect to opt out. If they choose to opt out they receive a group term benefit up to $50,000, which is the “free” benefit. Thus the cost for employees in most cases is extremely low. Furthermore the Section 79 plan is a tremendous tool for attracting and retaining highly compensated employees.
One planning area to note is the corporate entity structure. For an owner’s contribution to be deductible at the corporate level the sponsoring entity must be a C corporation, or an LLC that files as a C corporation. If the entity is a pass-through entity, such as an S corporation, the owner must own less than 2 percent of that entity. In many cases where the main company is a pass-through entity, a second entity that is a C Corporation can be utilized as the sponsoring entity, as long as it is a real and viable entity with a distinct business purpose. Unlike the pension area where brother-sister control group rules and/or affiliated service group rules could make this type of planning problematic, for Section 79 plans this is a non-issue as the employees in the main entity will be covered, not excluded.
One area of confusion is in regard to Section 79 plans and listed transactions under Section 6707A. There has been at least one instance in which an advisor has grossly misreported that Section 79 plans may be considered a listed transaction. At the time of the writing of this article, Section 79 plans have never been, nor are currently considered an item on that list. For a complete listing of transactions covered under 6707A, please refer to the IRS Web site at www.irs.gov.
In specific planning situations a Section 79 plan is a powerful option for providing tax savings at the corporate and personal level, significant tax-free supplemental retirement income, and substantial survivor benefits for the successful business owner or professional. The value it can deliver cannot be
Brian D. Hartstein, MSFS, CLU, ChFC serves as CEO and principal of Economic Concepts, Inc. in Scottsdale, Ariz. He concentrates primarily on working with CPAs, financial advisors, successful business-owners, and affluent clients in the qualified and non-qualified plan markets, estate planning and financial and investment planning. He is currently on the advisory board of the Phoenix Tax Workshop, a member of the Society of Financial Service Professionals, a member of the Arizona Business Leadership Association, and served as president of the Financial Planning Association of Greater Phoenix.
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