Incidental Rule in Regard to Key Employee Insurance

[Guest MJO]

I have been unable to locate any specific revenue rulings which state whether key-employee insurance is subject to the limitations of the "Incidental Rule" required for life insurance coverage in defined contribution plans. Does anyone have any suggestions? Thanks!

[MGB]

Why would key employee (I assume you are referencing the types of insurance used to buyout a partner, owner, etc. by other owners) insurance be different than any other insurance? The requirement is that benefits other than retirement benefits, including death benefits, be incidental. It doesn't make any difference who the beneficiary is.

[david rigby]

Is it possible that the original post has somehow confused "key employee", which is defined (for the most part) with respect to the top-heavy rules of IRC 416, with "key-man" insurance, in which the employer is usually the beneficiary?

[Mike Preston]

I don't believe there are any limitations. The incidental benefits rules relate to the provision of benefits to participants. The type of insurance being contemplated here, it seems to me, is an investment of the plan, essentially providing for advance funding should the plan sponsor's management team take a direct hit.

As long as the existence of the insurance doesn't create a specific benefit increase under the terms of the plan, the incidental limits should not hinder you in any way.

OTOH (you KNEW there had to be one, right?), whether or not this sort of investment makes any sense is something that should be reviewed by ERISA counsel, IMO.

[mbozek]

As Mike stated this is about apples and oranges. IRC 264 limits the deduction that an employer can take for interest on loans used to fund key man life insurance and death benefit only type plans which are not qualified plans. IRC 264 presumes that the plan is invested in LI on the key employee's life. The incidential rules for qualfied DC plans refers to limits on the amount of the annual contributon that can be used to purchase LI on an employee's life that is an part of the employees account. The incidential rules are stated in varous IRS rulings which restrict the amount of the payments for LI to no more than 50% of the contributions. The specifics can be found in Tax Facts on LI published by the National Underwriter Co.

[Mike Preston]

Actually, I'm going to change my response a bit. I think my response is more suited to a defined benefit arrangement. Although it is possible to have key-man insurance in a defined contribution plan, it is very rare. It would have to be a pooled fund, I would think and not directed investments.

But with that small modification, my response stands. That is, the incidental benefit rules have nothing to do with insurance on an individual where the trust is the beneficiary of the policy and all the participants share in the gain and/or loss.

[mbozek]

Mike: Are you thinking of a LI policy owned by the plan on the life of the employee where the plan is the beneficiary as key man insurance? I though all LI used to fund DB plans was subject to the 100 to 1 rule. I have seen DB plans that use such ins to fund benefits under the plan (retirement life policies?) but DC plans usually let the participant name the beneficiary. I have not seen a dc plan that owns LI on the participant which is also the benficiary of the death proceeds because it would be a very poor investment decision if the insured does't die. By the way using LI to fund a DB plan is also a very poor funding mechanism because the rate of return on the cash value of the LI is lower than the rate assumed by the actuary under the minimum funding standards.

[Mike Preston]

Are you thinking of a LI policy owned by the plan on the life of the employee where the plan is the beneficiary as key man insurance?

Yes.

I though all LI used to fund DB plans was subject to the 100 to 1 rule.

I don't believe that the rule you are quoting, which is a portion of the indicental benefit limitations, applies to key man insurance.

I have never seen a DC plan hold key man life insurance, either. I can't say for certain, however, that there aren't circumstances where the investment loss associated with paying premiums on policies that do not mature is not more than compensated by the elimination of the risk associated with management loss. I'll leave that argument to be made by others.

By the way using LI to fund a DB plan is also a very poor funding mechanism because the rate of return on the cash value of the LI is lower than the rate assumed by the actuary under the minimum funding standards.

I think this statement doesn't look deeply enough into the pros and cons of life insurance protection. Long term programs, as opposed to short term plans, can see a dramatic increase in return rates if mortality gains are factored in. If the program is short-sighted, however, it is unlikely that mortality gains will mean anything at all. Even in those circumstances, though, the mere fact that it is unlikely doesn't necessarily eliminate the potential risk/reward equation. Just like any business deal can benefit from key-man insurance, so can a qualified plan if the trustees believe that there will be a significant reduction in future funding ability should a key member of management depart this earth.