A corporation wants to provide additional retirement income to key executives and owns life insurance policies on those executives to fund the promised future payments. This business use of life insurance is best described as:

Why A is correct

In a deferred compensation plan, the employer promises to pay an executive compensation in future years, typically after retirement, and often uses life insurance owned by the corporation to accumulate funds and provide the money needed to meet that obligation. Because the employer owns the policy, pays the premiums, and is the beneficiary, the arrangement is designed to fund the employer's future income obligation to the executive. The death benefit is not primarily intended to cover the employer's own loss but rather to supply the funds to pay the deferred compensation when it comes due.

Why the other options are wrong

• B) Key person coverage protects the business against financial loss caused by the death of a valuable employee; here the purpose is funding a future compensation obligation, not covering a business loss.
• C) Buy-sell funding ensures that surviving owners can purchase a deceased owner's interest; this scenario involves no transfer of ownership interest. No business interest changes hands here, so this funding technique is not a buy-sell arrangement.
• D) Split dollar involves sharing premium payments and benefits between the employer and the employee; here the corporation alone owns the policies and pays all premiums. There is no premium splitting or shared benefit between employer and employee in this scenario.

Memory hook

Deferred comp: employer keeps the policy to pay a promised future paycheck. Key person covers a loss, buy-sell funds a sale.

Why A is correct

Deferred compensation is an arrangement in which an employer promises to pay an employee a specified income in the future, typically at retirement, as a supplement to retirement benefits. To fund that obligation, the employer commonly owns a life insurance policy on the executive's life, pays the premiums, and is the beneficiary. When the executive dies, the death proceeds help the employer meet the promised payments. This is a distinct business use of life insurance, separate from key person coverage or buy-sell funding, and it illustrates how life insurance can guarantee funds for future obligations.

Why the other options are wrong

• B) If the executive owns the policy and names the employer as beneficiary, the employer has no ownership control; deferred compensation funding is structured with the employer as owner. The arrangement described places ownership where it belongs in deferred compensation planning.
• C) A key person policy reimburses the employer for financial loss caused by the employee's death; it does not fund a promised future payment the employer owes the executive. Instead, the coverage exists to pay the executive's promised benefit, not to compensate the employer for a loss.
• D) A buy-sell agreement funds the purchase of a deceased owner's interest in the business; it is not used to fund an executive's supplemental retirement income. The purchase of the executive's interest is a separate transaction outside this plan.

Memory hook

Employer funds a future promise, so the employer owns the policy. Promise money = deferred comp.

Why A is correct

Deferred compensation is a contractual arrangement in which the employer promises to pay an executive income in the future — typically at retirement — in exchange for current services. Life insurance is often used to fund the obligation: the employer owns and pays premiums on a policy on the executive's life, and the death benefit or accumulated values help fund the promised payments. Key person insurance instead protects the company against the financial loss caused by the death of a vital employee; buy-sell funding finances the purchase of a deceased owner's interest; an overhead expense policy pays a business's fixed costs if the owner is disabled.

Why the other options are wrong

• B) Key person insurance is owned by the business and reimburses it for the financial loss caused by the death of a vital employee. It does not fund that employee's retirement income or provide the executive a future benefit.
• C) Buy-sell agreement funding provides cash so a business can purchase a deceased owner's ownership interest from the estate. It serves ownership transfers, not a retirement income benefit for an executive.
• D) A business overhead expense policy pays a business's fixed operating costs during an owner's disability. It is disability protection for the business, not a vehicle for funding an executive's retirement income.

Memory hook

Deferred comp = pay the executive later, fund it now with life insurance on the executive.

Why A is correct

Deferred compensation is an arrangement in which an employer promises to pay an executive income at a future date, usually retirement, in exchange for current services, and uses a life insurance policy on the executive to accumulate the funds. The employer owns the policy and is the beneficiary. Premium payments are generally not currently deductible to the employer, but the deferred amounts are deductible when actually paid to the executive.

Why the other options are wrong

• B) Key person insurance protects the employer against the financial loss caused by the death of a valuable employee; the death benefit goes to the employer, not to fund retirement income.
• C) Buy-sell funding provides the money for the remaining owners to buy out a deceased owner's interest, a very different purpose from retirement income.
• D) Salary continuation usually pays income to the executive's family after death, not supplemental retirement income to the executive while living.

Memory hook

Deferred comp = pay the executive later, at retirement. The life policy quietly builds the fund in the meantime.

Why A is correct

In a deferred compensation arrangement the employer promises to pay benefits in the future, typically at retirement, and life insurance on the executive is used to accumulate funds. The employer owns the policy and is the beneficiary; premiums are not currently deductible, but the benefits paid to the executive become deductible compensation when actually paid. This nonqualified arrangement is used to retain and reward key talent without running afoul of qualified plan contribution limits. Unlike key-person coverage, the funds are earmarked to pay benefits to the executive rather than to indemnify the company for a financial loss caused by the executive's death.

Why the other options are wrong

• B) Key-person insurance indemnifies the business for the financial loss caused by a vital employee's death; the company keeps the proceeds and uses them for its own recovery, not for retirement benefits to the employee. Here the funds are directed to the executive, which is a deferred compensation design.
• C) Buy-sell funding provides cash for surviving owners to purchase a deceased owner's business interest, which is a different purpose from funding future benefits for a living executive. The proceeds are used to buy out ownership, not to fund retirement promises.
• D) The instant estate concept describes the immediate creation of a death benefit estate at the insured's death, not the accumulation of funds to pay retirement benefits to a living employee. This arrangement funds a living benefit promise, not an estate at death.

Memory hook

Deferred comp: company saves today with insurance, pays the executive tomorrow, deducts when paid.

Why A is correct

A nonqualified deferred compensation arrangement is often funded with life insurance: the employer owns the policy on the key employee, pays the premiums, and is the beneficiary. Premiums are not currently tax-deductible, but the cash value grows tax-deferred and the employer receives the death benefit income-tax-free to fund the promised payments. Because the plan is nonqualified, the employer can choose which employees participate, unlike qualified plans that must meet broad coverage and nondiscrimination rules.

Why the other options are wrong

• B) In a nonqualified deferred compensation arrangement the employer, not the executive, is the owner and beneficiary; the executive holds only an unsecured contractual promise.
• C) Premiums on employer-owned life insurance are generally NOT deductible as a current business expense.
• D) The plan is nonqualified and outside ERISA's qualified plan requirements, and there is no rule mandating whole life funding.

Memory hook

Employer owns, pays, and collects. The executive gets a promise; premiums fund tax-deferred cash value.

Why A is correct

Deferred compensation is a business use of life insurance in which the employer promises to pay an executive benefits at a future date, usually retirement, and purchases life insurance on the executive's life to fund that obligation. The employer is the owner and beneficiary of the policy. If the executive dies before receiving the promised benefits, the death benefit helps the employer recover the cost of the arrangement. The arrangement creates a liability for the employer and a future income for the executive, and the life insurance provides a tax-efficient funding vehicle. This is a distinct use from key person coverage, which protects the employer against its own loss from a key employee's death.

Why the other options are wrong

• A key person policy protects the employer against its own economic loss from the death of a key employee; it is not tied to a promise of future retirement benefits to the executive.
• Business overhead expense coverage pays the ongoing expenses of a business during an owner's disability; it is a disability product, not a vehicle for funding retirement benefits.
• A split-dollar arrangement splits the premium payments and the benefits between the employer and the employee; it is a sharing device, not a promise to pay retirement benefits.

Memory hook

Deferred compensation means pay later; life insurance is the funding engine that makes the later payment possible.