The use of the term “finance” is a reminder that the distinction between financing and funding is an important one. There is a way to finance the employer’s obligations without the tax and ERISA problems associated with a funded plan: keep assets in the fund accessible to the employer and its creditors and provide no explicit security to the employee beyond that provided to other creditors of the employer. Note that, although for many purposes, the definitions of unfunded and funded are the same for both tax and ERISA purposes, in some important situations those definitions will differ.
The term financing implies that, regardless of the investment vehicle used, no money or other asset is placed beyond the reach of the employer or its creditors. Conversely, the term funded has adverse implications under both tax and ERISA law. A plan is funded if the employer has placed money or property credited to the employee’s account in an irrevocable trust or otherwise placed restrictions upon the access to the fund by the employer and its creditors.
There are a number of problems presented by a funded plan.
First, once a plan is considered funded, the value of the employee’s interest in the fund will become taxable to the employee as soon as his interest in the fund is substantially vested.34 With funded salary reduction plans, this is almost always immediately. In other words, an employee could be taxed on benefits years before actually receiving any payments from the fund.
Second, funded plans may be subject to burdensome ERISA requirements, including the vesting and fiduciary requirements imposed on qualified plans.
Thus, the question is, “How can an employee’s security in his benefit be increased without triggering the adverse implications of a funded plan?” The easiest solution is an earmarked reserve account maintained by the employer. This means that the employer sets up an account invested in assets of various types. There is no trust–assets in the account are, at all times, fully accessible to both the employer and its creditors.
The employer could set up an actual reserve account with limited employee investment direction. Under such an arrangement, the employee is given the right to select the investments in the account. That right of direction must be limited to a choice of broad types of investment. If the employee is permitted to choose specific investments, the IRS could argue that the employee had constructive receipt of investment funds. So the employee should be given the right to choose between equities, bonds, a family of mutual funds, etc.
The employer typically purchases, pays premiums on, and is the beneficiary of life insurance. Proceeds can be used to provide a death benefit if the employee dies in the early years of the plan. Employees should not be taxable on the current economic benefit of this type of security, because the insurance is strictly an employer asset.
Three methods are commonly used to help an employer meet its obligations under a nonqualified plan: (1) pay-as-you-go; (2) alternative investments; and (3) corporate-owned life insurance.
Pay-as-you go is, by definition, an obligation for the employer to use the working capital of its business (or draw on its line of credit) every time a payment is due. This approach is simple and postpones the cash outflow as long as possible. The employer accrues a liability on its balance sheet under the category of deferred compensation. Some employers feel that this method makes sense as long as the employer itself can earn more after-tax return by reinvesting the money in its business than could be earned through an alternative investment.
This opportunity cost of capital decision-making tool is another way of saying that the employer expects to finance plan obligations through the future growth of its business. The problem with this thinking is that if expectations are not met, the necessary cash will not be there when needed. The obligation is then shifted to the future management of the business, and may fall due at the worst possible time (in terms of cash flow). It puts the financial security of the covered employees at the risk of the business. It must also be considered that future management may not be willing to make promised payments–even if able to.
Alternate investments are, of course, those investments other than life insurance that can be used to finance the employer’s obligation. These should be long term conservative investments, such as mutual funds, that are highly liquid.
Corporate-Owned Life Insurance (COLI)
Corporate-Owned Life Insurance (COLI) is the preferred financing vehicle for most publicly-held and almost all closely-held businesses. Although there is no one type of contract that is best for nonqualified deferred compensation plans, most planners, after examining plan goals and other factors, tend to favor plans with high premium payment and investment flexibility and low mortality and expense costs. Permanent, rather than term, coverage is indicated where the plan contemplates use of some or all of policy values to finance retirement benefits.
Permanent life insurance is an attractive informal financing vehicle for many reasons, including:
- the cash value acts as a tax-deferred sinking fund to pay benefits (this is important for smaller employers that may not be able to pay benefits from business cash flow)
- costs can almost always be recovered from the death benefit–including the after-tax cost of the use of corporate dollars
- a competitive internal rate of return, as compared with alternative investments
- the ability to offer a pre-retirement death benefit, with no risk to corporate cash flow.
Generally, formally funding a nonqualified deferred compensation plan will result in current income taxation to the employee and will result in the imposition of onerous ERISA rules. Fortunately, a properly designed nonqualified deferred compensation plan will not be considered funded for tax or ERISA purposes merely because it is financed with life insurance.
It is important that the plan document not specifically reference the life insurance or any other asset that is being used to informally finance the plan benefits. To do so could be considered to give a plan participant an exclusive right to the asset. If the intent is to pay a benefit equal to the life insurance cash value at retirement, then a hypothetical account should be used in the plan document which may use the performance of the life insurance policy as a benchmark for purposes of crediting and debiting the hypothetical account value. The amount of life insurance purchased should be a function of:
- the plan benefits promised;
- the Alternative Minimum Tax (AMT), if any, expected to be applied to the proceeds;
- the expected tax leveraging; and
- the employer’s goals with respect to the financial implications of the plan to its business.
The most generous plan, from the employee’s viewpoint, is one in which all plan assets are leveraged with the employer’s tax deduction to produce the maximum benefit. This is, of course, the least favorable to the employer and will result in the highest life insurance cost, since none of the proceeds are used to defray any of the employer’s: (1) premium outlay; (2) after-deduction cost of benefits; or (3) the time value of money during either the premium paying or benefit paying period.
Cost Recovery Plans
It is, of course, appealing to the employer to be able to accomplish all of its recruitment, retention, retirement, and reward objectives without the limitations upon benefits for the highly compensated and owner-employees in a qualified plan. In addition, the employer can pay out all promised benefits to a covered employee and then recover some or all of the costs involved in the plan. These goals can all be accomplished through the purchase of corporate-owned life insurance.
Cost recovery nonqualified plans can be thought of as having at least three levels.
Recovery of the net premiums paid, plus the after-deduction cost of the deferred salary paid to the employee or survivors, plus the cost of the use of money on the net premiums or the deferred benefits. This is the highest level of cost recovery and will therefore require the most life insurance to accomplish.
Recovery of the net premiums paid, plus the after-deduction cost of the deferred salary paid to the employee or survivors. This is the middle level of cost recovery and will require less life insurance.
Recovery of only the net insurance premium outlay or the after-deduction cost of the deferred salary paid to the employee or survivors. This is the lowest level of cost recovery and will require the least amount of life insurance.
Ensuring Plan Security through Guarantees
Security is an important goal for many reasons. Security of promised benefits is endangered by the possibility that the employer will be: (1) unwilling to pay benefits as they come due (either because of a change of heart or a change of management); or (2) unable to pay benefits as they come due.
A surety bond is a contractual agreement by a bonding insurance company to pay the promised benefits in the event that the employer is unable or unwilling to make payments. If the employee purchases a surety bond and pays all premiums personally, and if the insurer requires some form of collateralization agreement with the employer, then, in the authors’ opinion, the plan may be considered secured. As a practical matter, few companies will issue such bonds; they are expensive, and so limited that they are of little interest to most covered employees.
The IRS has indicated that an employee can buy indemnification insurance to protect his deferred benefits without causing immediate taxation. The result is the same even if the employer reimburses the employee for the premium payments, as long as the employer has no other involvement in the arrangement. The employee’s premium payments must be treated as nondeductible personal expenses, and any premium reimbursements must be included in the employee’s income. The consequences of such an arrangement under ERISA are not clear.
A shareholder of the employer corporation can personally guarantee payment under a nonqualified deferred compensation plan without causing the employee to be taxed. A third party guarantee is merely a promise to pay, and, although it may broaden a participant’s protection, it should not require the inclusion of the primary obligation amount in currently taxable income. For example, where a parent corporation guaranteed payments under a subsidiary’s contract with an executive, the IRS held that the guarantees would not cause the plan to be funded. But if the employer’s obligation is backed by a letter of credit from the employer or by a surety bond obtained by the employer, the promise may be considered to be secured, and thus cause current taxation.
Under a third party guarantee, the employer obtains a guarantee from a third party to pay the employee if the employer defaults. This guarantor may be a shareholder, a related corporation, or a bank (through a letter of credit). There is precedent for a favorable IRS position on third party guarantees. Unfortunately, too much employer involvement may cause the IRS to claim that the plan is formally funded for tax purposes. A better course of action is to have the employee, independent of the employer, obtain a third party guarantee.
Ensuring Plan Security with Trusts
One partial answer to the desire for more security is the rabbi trust. Rabbi trusts enhance employee security with minimal threat to the income tax advantages of the nonqualified deferred compensation plan. While there is some uncertainty in the area, the use of a rabbi trust (at least in the context of a nonqualified plan that is maintained for a select group of management or highly compensated employees or that is an excess benefit plan) should not cause the plan to be funded for ERISA purposes.
A rabbi trust holds the assets of the plan apart from the corporation, but not apart from its creditors. The rabbi trust is generally an irrevocable trust that holds assets that will be used, wholly or partially, to satisfy the employer’s obligation. The employer gives up the use of plan investments, so that those assets are dedicated solely to the employees covered under the plan, with one major exception: if the employer becomes bankrupt or insolvent, the assets become available to the general creditors of the employer. This means that covered employees must essentially line up with the employer’s other general creditors.
Factors that would indicate the use of a rabbi trust include:
- a fear that the management or ownership of the business is likely to change before all benefits will be paid;
- a fear that hostile new management might renege on the employer’s contractual obligations to its key employees; and
- a perceived probability that if litigation were necessary, a win by key employees would come at a prohibitive cost.
The three costs of a rabbi trust (aside from the legal costs of creating the rabbi trust and the accounting costs of maintaining it) include:
The employer loses the use of plan assets (i.e., they are not available for a corporate emergency or opportunity).
The rate of return on plan assets in the trust may be less than what could have been earned had the money been invested in the employer’s business.
A rabbi trust does not provide any protection against the ultimate risk of employer insolvency.
A deferred annuity is probably an unsuitable investment for a rabbi trust, because increases in income inside the annuity would be currently taxable to the employer as grantor of the rabbi trust. Tax-advantaged investments, such as municipal bonds, preferred stocks, life insurance or a combination of these, are likely to be a better choice.
Securing or distributing deferred compensation upon the employer’s falling net worth or other financial events unacceptably secures the payment of the promised benefits. This includes hybrid rabbi/secular trust arrangements that distribute assets from nominal rabbi trusts to secular trusts on the occurrence of triggering events indicating the employer’s financial difficulty. Under any such arrangement, otherwise deferred compensation is immediately taxable and subject to a 20 percent additional tax. Interest on the underpayment of taxes is due at the normal underpayment rate plus 1 percent.
Setting aside assets in an offshore trust to directly or indirectly fund deferred compensation also unacceptably secures the payment of the promised benefits. Under any such arrangement, the otherwise deferred compensation is immediately taxable and subject to a 20 percent additional tax. Interest on the underpayment of taxes is due at the normal underpayment rate plus 1 percent.
Like a deferred compensation plan itself, any related rabbi trusts must comply with requirements under Code section 409A, which prohibits securing or distributing deferred compensation upon the employer’s falling net worth or other financial events. This includes hybrid rabbi/secular trust arrangements that distribute assets from nominal rabbi trusts to secular trusts on the occurrence of triggering events indicating the employer’s financial difficulty. Setting aside assets in an offshore rabbi trust to directly or indirectly fund deferred compensation also unacceptably secures the payment of the promised benefits.
Under any such prohibited arrangements, otherwise deferred compensation is immediately taxable and subject to a 20 percent additional tax. Interest on the underpayment of taxes is due at the normal underpayment rate plus 1 percent.
Prior to Code Section 409A, the IRS released a model rabbi trust instrument intended to serve as a safe harbor for employers adopting rabbi trusts and to expedite the processing of requests for advance rulings on these arrangements. The IRS will no longer issue advance rulings on unfunded deferred compensation arrangements that use a trust other than the model trust, except in rare and unusual circumstances.
Prior to Section 409A, the rabbi trust documents that previously received favorable rulings from the IRS generally were irrevocable and:
- required that plan assets be deferred until the participant’s termination of employment;
- precluded investment in employer stock;
- made the assets available to all general creditors of the corporation should the employer become bankrupt or insolvent under state law (i.e., do not give the covered employee greater rights to trust assets than creditors have under state law);
- included a requirement that the employer (specifically, the CEO and the Board of Directors) must notify the trustee if the employer becomes insolvent or subject to bankruptcy proceedings;
- provided that if the employer notifies the trustee of its bankruptcy, the trustee must suspend all payments to covered employees, hold all assets for the benefit of creditors, and provide that no further assets can be distributed to the covered employees until allowed by a bankruptcy court; and
- did not provide an insolvency trigger, that is, a provision that triggers immediate payments to covered employees from the trust should the employer become insolvent or experience a drop in net worth below a specified level. The IRS viewed this type of provision as giving the employee greater rights to the assets than other corporate creditors, so that tax benefits are lost. (This is now explicit in Section 409A.)
Drafters might also consider provisions which:
- Provide that investment authority will automatically shift to the trustee of the rabbi trust in the event of an unfriendly takeover, thus preventing the new management from making investments in illiquid employer-leased real estate or other employer-related ventures.
- Include some type of acceleration provision that enables an employer, upon a change in tax law or an IRS audit with an unfavorable result that makes rabbi trust money taxable to participants, to immediately distribute trust assets. If neither the plan nor the trust has such a provision, the employee may incur a current tax, but have no cash with which to pay it.
- Preclude the addition of new beneficiaries in the event of an unfriendly takeover and restrict the ability to make amendments. This avoids dilution of assets or the insertion of unfavorable provisions, and prevents new management from adding plan amendments that adversely affect already accrued plan benefits.
- Make it clear that liability for promised benefits is joint and several between the trust and the employer. If plan liability is shifted completely to the trust, then aside from the obvious problems that arise if trust assets are insufficient, ERISA problems may also be triggered.
- Do not condition the trustee’s ability to pay benefits upon instructions from the employer.
- Set up separate trusts if employees of both a parent and a subsidiary corporation are to be covered by salary continuation plans. This helps to keep creditors of an insolvent corporation from reaching assets that should go to employees of a financially sound related corporation.
- Make the trust irrevocable, but specify a written procedure as to how the trustee and the employer can amend the trust with the consent of trust beneficiaries.
- Provide that the trust will not terminate until all benefits promised under the nonqualified plan have been paid, and that any remaining trust assets will be returned to the employer at that time.
Creative tax planners have improved the classic rabbi trust with a number of clever drafting concepts, including:
- The carry-on rabbi trust – In addition to paying out deferred retirement benefits, a rabbi trust may hold funds for the purpose of continuing the same approximate level of life insurance, hospitalization, and major medical insurance that the employee enjoyed just prior to retirement. This type of rabbi trust can be used to carry on an executive’s postretirement insurance needs.
- The double duty rabbi trust – A single rabbi trust can be used to fund the assets of multiple deferred compensation plans.
A secular trust is an alternative to a rabbi trust. It is generally an irrevocable trust designed to address the two major drawbacks of both the traditional naked promise by the employer to pay benefits and the rabbi trust: neither the employer’s naked contractual promise nor the rabbi trust provides any protection against the employer’s insolvency nor results in an up-front income tax deduction.
How does the secular trust give the employee protection against employer insolvency, and, at the same time, provide the employer with an immediate income tax deduction? The answer lies in the way that the secular trust is designed. First, the employer’s creditors cannot reach assets placed in a secular trust. Second, as soon as funds are put into a secular trust, the employee is generally immediately taxed. As soon as the employee is taxed on funds placed in a secular trust, the employer can take an immediate income tax deduction.
The purported advantages of the secular trust over the nonqualified deferred compensation plan (with or without a rabbi trust) include:
It is less expensive to create and maintain.
It can result in tax savings, since the contributions may generate an employer’s deduction taken at a higher tax bracket than the bracket in which the contributions are taxed to the employee.
But there are potential problems involved with a secular trust, including:
Covered employees will generally be taxed each year on income that they have not received, so that they may not have the cash on hand to pay the taxes. This means that the employer may have to make additional cash payments, in order to enable the employee to pay the required tax.
A secular trust may create double taxation, (i.e., both the trust and the highly compensated employees may be taxed each year on the trust’s earnings).
A secular trust is considered to be funded for ERISA purposes. As a result, a secular trust may have to satisfy a wide array of ERISA requirements, including reporting and disclosure, participation and vesting, funding, and fiduciary responsibility requirements.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM