Sole Prop with an insurance policy

[SteveH]

So an insurance broker asks me to take a look at this client's DB plan. He is a sole prop and has a smallish $200,000 whole life insurance policy in the plan for a number of years. He wants to increase the death benefit and is wondering how high he can go.

While playing around, I come across a few sources that indicate an owner-employee can not deduct the current cost of life insurance. **Screeech** (that is me slamming on my imaginary brakes)

Ok so I do some thinking about this. Typically a corporation can deduct the entire premium and then the individual pays the taxes on the Table 2001 rate or some other equivalent. In essence the individual is paying the taxes for the insurance coverage for the current year. This gets me thinking that the reason an owner-employee of a sole prop can not deduct the premium is because by paying the Table 2001 rate you are in essence taking a deduction on the schedule C and then paying the tax on the 1040. In essence they are just canceling each other out right? So we are really doing the same thing as the corporation just skipping a step because we aren't taking the deduction on the schedule C for the cost of the current life coverage. If this is correct, it is kind of a pain, because I have to indicate to the client what his total contribution is and then indicate what his deductible amount is. Plus explain the difference. I guess I won't hav eto explain why he is receiving a 1099, but I think his exisiting actuarial firm has been treating this like it was a corp and issuing the 1099 all along.

The client wants to do a 1035 exchnage on his current policy into a UL with some no lapse guarantee. I think it stems from a term policy he holds outside the qualified plan that is getting too expensive and he wants to let it lapse, and pick up the death benefit coverage inside the plan for the deduction. The UL policy is fairly inexpensive so I figure the investment part of the policy is minimal. The way I see things, he may only be able to deduct about $4,000 of the $15,000 premium. I guess that is better than nothing though.

There may not be enough information here to make a thorough review of the situation, but if someone could concur or disagree with my analysis of the reasoning behind the sole prop losing the deduction for insurance that would be a good start for me. I already started the conversation with the broker and it was going down a bad path. I'll don't mind going there, I just don't want to be proven wrong later.

[Guest flogger]

If the sole proprietor wants to include life insurance in his DB plan, he may. However, the policy should be purchased by the DB plan as owner, the participant as insured, and the participant may choose the beneficiary. The life insurance must remain "incidental". There are several ways to measure whether a death benefit from a life insurance policy is incidental, and certainly the type of policy (eg, a whole life, UAL or term) and the premium payment pattern make a difference in the measurement thresholds. Incidental is another discussion.

The participant must report imputed income for the death benefit each year.

In most likelihood, providing the insurance in the DB Plan will increase the contribution levels (min and max) due to cash value performance being less than you would assume on the other assets that will help to fund the retirement benefit.

The deduction for the insurance comes in the increased contributions to the DB Plan. If properly structured, the contributions to the DB Plan would be the premium and a deposit to a side fund (Split funded plans). The best logistical way to do this is to make the contributions for the year to the DB Plan's trust, then have the premiums paid to the insurance company from the DB Trust.

This is NOT an endorsement for the use of life insurance in a plan--which I have rarely thought was a good idea.

[Guest RI Consultant]

flogger, believe the PLAN should be the beneficiary of the life insurance policy and the participant should complete a beneficiary designation so the plan knows who to pay. Most likely, a technicality in your scenario. Those more into estate planning and qualified plans can shed light on this. I too am not a big believer in life insurance in retirement plans having experienced more complications from it than benefits.