Non-Taxable Income Plan

Under the Internal Revenue Code, certain forms of income are taxable while others are not. Income that isn't taxed may include:

  1. Income from personally-owned disability insurance policy;
  2. Employer-paid health insurance premiums;
  3. Gifts falling within permitted limits;
  4. Sale of principal residence;
  5. Up to $3,000 of income offset by capital gains;
  6. Income earned in any of 9 states which do not impose a state income tax;
  7. Income earned in any of 5 states which do not impose a corporate income tax;
  8. Inheritance income within the permitted limits ($5.43 million for 2015); and
  9. Municipal bond interest.

Another category of non-taxable income involves life insurance, and this is the basis for the Nontaxable Income Plan ("N-TIP" or the "Plan"). Under this arrangement, insurance is provided as an employee benefit plan primarily governed under IRC §83 of the Internal Revenue Code ("Property Transferred in Connection with Goods and Services"). The employer may cover only key employees, owners, or partners of the business (collectively the "Executive"). The Plan is not subject to the non-discrimination rules set forth in IRC §505(b).

This design makes the N-TIP an attractive alternative to deferred compensation plans as the N-TIP allows for a current tax deduction by the employer, while only a portion of the contribution is currently included in the Executive's personal income. This design allows the Plan to provide for current tax arbitrage that is not allowed in plans governed by IRC §409A.

The N-TIP must be set up for no less than five (5) years prior to the Executive's becoming vested; The five-year commitment is necessary for the Plan rightly to be considered IRC §83 property and exempted thereby from IRC §409A.

The N-TIP provides two potential benefits:

     i) A current benefit is coverage by a life insurance policy, in which the Executive may name the beneficiary of the Death Benefit Trust in the event of death;

    ii) A potential future benefit involves vesting in the restricted property. Should the Executive vest in the policy held inside the Property Trust, the policy will be transferred in-kind to him/her and will constitute taxable income to the extent the cash value exceeds the Executive's basis.

The Executive will have full access to the life insurance cash value to pay the taxes due at that time. The Executive will also have all the rights and benefits of the whole life insurance policy and can choose to maintain the death benefit, surrender the policy, set the policy up for systematic withdrawals, or exchange the policy for another life insurance product under IRC §1035.

Terms of the Non-Taxable Income Plan

  • Trusts: "Death Benefit Trust" and "Property Trust".
  • Trustee: Aligned Partners Trust Company, an independent third-party trustee.
  • Purpose of Death Benefit Trust: To provide a source of funding for estate taxes, business buyout, etc.
  • Purpose of Property Trust: To provide to the Executive an appreciating property interest, (subject to a substantial risk of forfeiture prior to vesting date).
  • Tax treatment of contributions: Contributions are tax-deductible to the employer; taxable in part to the Executive by election.
  • Maximum contribution to Death Benefit Trust: Contribution may not exceed the base policy premium, dependent on employer's available cash and Executive's continuing employment. Prepayment of subsequent year premiums is not permitted.
  • Minimum amount of contributions: Trustee must receive for each year following the effective date of the Death Benefit Trust a contribution that is not less than the base policy premium with respect to the life policy insuring the Executive.
  • Failure to make annual contribution: In event the contribution is not paid (and the Executive has not previously died), the life insurance policy will lapse, causing forfeiture of the entire cash value of the policy to a charity designated by the Executive. The Death Benefit Trust provides that the entire cash surrender value is paid to the Property Trust if the Trustee does not receive a contribution sufficient to pay the base policy premium. This will satisfy the Nontaxable Income Plan's security interest.
  • Legal owner and beneficiary: The Trustee of the Death Benefit Trust holds legal title to the policy, but has no right to access the cash value.
  • Beneficial owner of the Death Benefit Trust: Either the beneficiary designated by the Executive or the Property Trust.
  • Beneficial owner of the Property Trust: the Executive, if a forfeiture does not occur, or an IRC §501(c)(3) charity, in the event of a forfeiture or of a failure to pay the annual premium (lapse).
  • Automatic Premium Loan rider: not permitted. Likewise, the Trustee of the Death Benefit Trust cannot borrow from the cash surrender value to fund base policy premium obligations.
  • Use of funds in Death Benefit Trust: The Trustee must use the contribution to the Death Benefit Trust to pay the required base premium under the policy.
  • Use of funds in Property Trust: Contributions to the Property Trust are invested by the Trustee in paid-up additions under the life insurance policy owned by the Death Benefit Trust. In no event can the investment by the Property Trust be used by the Death Benefit Trust to fund the base policy premium for the current year or any future years.
  • Vesting: If the employer makes the base policy premium contributions to the Death Benefit Trust for the term of the Nontaxable Income Plan (i.e., 5 years or more), then the Executive vests in the assets of the Property Trust (the cash surrender value of the policy).
  • Taxable to Executive: At this time, the Trustees of the Property Trust and Death Benefit Trust execute such documents as necessary to transfer the policy (inclusive of its cash value) to the Executive and the entire value of the Property Trust potentially becomes taxable to the Executive, in accordance with IRC §83.
  • Amounts previously taxed (basis): While the entire amount is potentially taxed to the Executive at this time, amounts which have previously been taxed pursuant to the Executive's election will be excluded from taxation.
  • Security Interest: To secure the Nontaxable Income Plan's investment in the Death Benefit Trust, the Death Benefit Trust shall grant to the Property Trust a security interest covering the entire cash value of the whole life insurance policy.
  • Substantial Risk of Forfeiture: The Executive's rights with respect to the amounts in the Property Trust (i.e., the paid-up additions plus the entire cash surrender value) are subject to a substantial risk of forfeiture within the meaning of IRC §83. In other words, if either (i) the Executive terminates employment with the employer; or (ii) if the employer does not make the necessary contribution to the Death Benefit Trust to pay the base policy premium during the term of the Property Transfer Agreement, or (iii) if the employer terminates the Death Benefit Trust, then the whole life insurance policy will lapse and the cash surrender value proceeds shall be transferred by the Trustee, in accordance with the express language of the Nontaxable Income Plan, to an IRC §501(c)(3) charity named by the Executive and the Executive will not be entitled to receive the cash surrender value of such policy.