CLU Business Insurance Planning Practice Questions
Question 1
A company has three shareholders with an insurance-funded cross-purchase agreement. If each shareholder individually insures every other shareholder, how many policies are generally needed?
- A. Three
- B. Two
- C. Six
- D. Nine
Show answer and explanation
Correct answer: C. Six
A cross-purchase agreement needs each owner to insure every other owner, so n(n-1) policies: 3 x 2 = 6.
- A. Three counts one policy per owner, but each owner must insure two others.
- B. Two counts only the other owners once, not the policies each owner must hold.
- C. Correct: each of three owners buys a policy on the other two, giving 3 x 2 = 6 policies.
- D. Nine is n squared, which wrongly includes each owner insuring himself or herself.
Question 2
In a collateral assignment split-dollar arrangement taxed under the loan regime, the employee owns the policy and collaterally assigns it to the employer to secure repayment of the employer's premium advances. If the employer's premium payments are treated as below-market loans, how are they generally taxed under IRC §7872?
- A. The employee recognizes no income because the loan is fully secured by the policy's cash value, and the arrangement is taxed only when the policy is surrendered or the insured dies
- B. If the arrangement has a fixed repayment schedule, the loans are typically treated as term loans, producing imputed compensation income to the employee equal to the excess of the applicable federal rate (AFR) interest over the actual (often zero) interest charged, generally recognized in the year the loan is made
- C. The employer must recognize interest income at the AFR each year, but the employee has no income inclusion because the imputed interest is treated as a nontaxable fringe benefit under the loan rules
- D. The premium advances are treated as taxable bonuses to the employee in full each year, similar to an executive bonus plan, with the collateral assignment disregarded for tax purposes
Show answer and explanation
Correct answer: B. If the arrangement has a fixed repayment schedule, the loans are typically treated as term loans, producing imputed compensation income to the employee equal to the excess of the applicable federal rate (AFR) interest over the actual (often zero) interest charged, generally recognized in the year the loan is made
Under the loan regime (Notice 2002-8 and the final split-dollar regulations), employer premium advances under collateral assignment split dollar are treated as loans between employer and employee under IRC §7872. If the loan has a specified repayment schedule, it's generally a 'term loan,' and the imputed income (foregone interest equal to AFR minus actual interest, often zero) is generally taxed to the employee up front in the year the loan is made. If there is no fixed schedule, it may instead be treated as a demand loan, with imputed interest recalculated annually. Collateral security does not eliminate imputed interest (A is wrong); the employer doesn't have an automatic AFR income inclusion divorced from the loan characterization (C is wrong); and loan-regime treatment is distinct from the bonus/economic-benefit characterization in D.
- A. Incorrect — being secured by cash value doesn't eliminate imputed income; below-market loan rules under §7872 still apply, and the foregone interest is taxed as compensation rather than deferred to surrender or death.
- B. Correct. A fixed repayment schedule generally makes these term loans, so the employee recognizes imputed compensation income upfront (in the year the loan is made) equal to the excess of AFR interest over the actual interest charged.
- C. Incorrect — the foregone interest on a below-market compensation-related loan is treated as compensation to the employee, so it is not a nontaxable fringe benefit; the mechanics follow the loan's actual terms.
- D. Incorrect — this describes an executive bonus plan's tax treatment; under the loan regime the advances are characterized as loans, with only the foregone interest imputed, and the collateral assignment is respected.
Question 3
In a Section 162 executive bonus arrangement funding life insurance:
- A. The employer owns the policy and loans the executive the money to pay premiums, with the loan repaid from the cash value or death benefit and the executive taxed on imputed interest, and the employer deducts the premiums paid
- B. The arrangement requires ERISA plan documents, nondiscrimination testing, and IRS qualification like a qualified plan, with contributions deductible through a plan trust
- C. The death benefit is paid to the employer as key person coverage, and the employer deducts the premiums and receives the proceeds to offset the loss of the executive
- D. The employer pays a bonus (often equal to the premium) to the executive, who individually owns the policy; the bonus is deductible to the employer as compensation and taxable income to the executive
Show answer and explanation
Correct answer: D. The employer pays a bonus (often equal to the premium) to the executive, who individually owns the policy; the bonus is deductible to the employer as compensation and taxable income to the executive
A Section 162 bonus plan is a simple, unfunded, non-qualified way to reward a select executive: the employer treats the premium-equivalent payment as ordinary bonus compensation (deductible as reasonable compensation), the executive includes the bonus in income, and the executive owns the policy and controls the cash value and death benefit, typically naming their own beneficiary.
- A. Incorrect — this describes a loan-regime split-dollar arrangement, not a 162 bonus plan, and the employer would not deduct premiums on a loan arrangement.
- B. Incorrect — 162 bonus plans are unfunded, non-qualified arrangements and are not subject to ERISA qualified-plan documentation, testing, or trust rules.
- C. Incorrect — the executive, not the employer, owns the policy and controls the death benefit; key person coverage is a different arrangement.
- D. Correct — this is the defining structure of a Section 162 executive bonus plan.
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For purposes of setting a buy-sell agreement's purchase price, an appraiser values a closely held business using the capitalization of earnings method. The business's normalized average annual earnings are $180,000, and the appraiser applies a capitalization rate of 12%. What is the resulting business value under this method?
- A. $1,500,000
- B. $2,160,000
- C. $216,000
- D. $1,080,000
Show answer and explanation
Correct answer: A. $1,500,000
The capitalization of earnings method divides normalized average earnings by the capitalization rate: $180,000 / 0.12 = $1,500,000. Multiplying instead of dividing produces $2,160,000; multiplying earnings by the rate as a decimal produces $216,000; and using half the correct value (a rate-doubling error) produces $1,080,000 — all common calculation missteps with this formula.
- A. Correct. Under the capitalization of earnings method, value = earnings ÷ cap rate = $180,000 ÷ 0.12 = $1,500,000.
- B. $2,160,000 results from multiplying earnings by 12 rather than dividing by the 0.12 cap rate.
- C. $216,000 results from multiplying earnings by 1.2 instead of dividing by 0.12 — an order-of-magnitude error.
- D. $1,080,000 doesn't follow from the capitalization formula with the given inputs (e.g., dividing by roughly 1/6 instead of 0.12) and understates the correct value.