There are questions surrounding nonqualified deferred compensation in life insurance. Life insurance is a big deal in any household. Without it, you’d have to worry about your loved ones. There are many options to choose from when it comes to buying life insurance. Our experts answer some questions revolving around this topic.
Question – Where does life insurance fit in a nonqualified deferred compensation plan?
Answer – Life insurance is the tool of preference to finance an employer’s promises under a nonqualified plan. Typically, the employer purchases a life insurance policy on the life of each covered employee. The employer owns each policy and names itself the beneficiary. The employee is given no rights in the policy and no right to name or change the beneficiary of the policy. In essence, the policy is held as a key employee contract (see Chapter 35), and will be subject to the same tax rules applicable to all such policies. In order to avoid both tax and ERISA problems, the agreement between the employer and the employee should not mention the life insurance.
Question – How have recent changes in pension law affected nonqualified deferred compensation?
Answer – The trend of tax law in the qualified retirement plan area is one of increasing costs, increasing limitation on the amount of benefits that may be provided to highly paid and owner-employees, and decreasing employer discretion and control.
Planners should point out that each of the following points pertaining to changes in the qualified retirement plan area makes nonqualified plans an appealing alternative:
First, regardless of how much the retiree was earning prior to retirement, the amount that can be paid to that person from a defined benefit pension plan is severely restricted. As of 2012, the maximum yearly benefit that can be distributed from a defined benefit plan is only $200,000 (indexed for inflation), or, if lower, 100 percent of the participant’s average three years’ compensation. Furthermore, a reduction must be made if the plan under which the payments will be made contains a pre-age sixty-five normal retirement age, or if the plan participant has fewer than ten years of service.
Second, as of 2012, the ceiling on the annual additions that can be added by an employer to the account of a plan participant in a qualified defined contribution (e.g., money purchase) plan—regardless of how much he or she is earning–is only $50,000 (indexed for inflation), or, if less, 25 percent of compensation.
Third, all qualified retirement plans are limited with respect to the maximum compensation that can be used in computing either benefits or contributions. As of 2012, the maximum compensation that can be considered in computing a plan’s permissible benefit distribution or annual additional contribution for an individual is the first $250,000 (indexed for inflation) of his annual compensation.
The result of these rules is a severe restriction upon the benefits that may be provided to the highly paid and owners of the business—the people who work the hardest and add the most to the profits of the employer. Consequently, these same individuals will receive the least of all employees as a percentage of average pay before retirement. For example, an executive earning $500,000 a year who is covered under a 10 percent money purchase plan is credited with not 10 percent of $500,000, but only 10 percent of $250,000. He receives no credit for the other $250,000 of salary earned—even though he’s taxed on all $500,000!
Fourth, participants in most qualified plans must become fully vested twice as quickly as was required under pension law just a few years ago. While this means fewer forfeitures from an employee viewpoint, benefit costs have increased significantly from an employer’s perspective.
Fifth, tougher nondiscrimination rules place additional restraints on an employer’s discretion with respect to who can be excluded from plan participation. This not only increases costs, but also reduces the employer’s ability to direct cash flow to those who make the greatest contribution to it.
Sixth, Social Security integration rules (now referred to by the IRS as permitted disparity) have been changed to further favor rank and file employees, which further adds to employer costs.
Question – What is the economic benefit theory?
Answer – Under the economic benefit theory, an employee is currently taxable whenever he receives something of value that is the equivalent of cash. In other words, if a compensation arrangement provides a current economic benefit to an employee, the employee must include the value of the benefit in income, even if there is no current right to receive cash or other property. The employee need only receive the equivalent of cash—something with a current, real, and measurable value–from his employer. As soon as such an event occurs, even if the employee cannot currently take possession of either the asset or the income it produces, he is taxable on the value of the benefit.
Question – How may Code section 83 cause the covered employee to be taxable on compensation even before it is actually received?
Answer – Code section 83 provides that the person who performed the services must include in income the amount by which the fair market value of property transferred in connection with the performance of such services exceeds the amount paid for such property. That amount is includable in the first taxable year in which the property becomes transferable or is no longer subject to a substantial risk of forfeiture.
The use of a rabbi trust will not cause the covered employee to be taxed under section 83.72 The claims of participants and their beneficiaries to funds held in a rabbi trust are unsecured and the funds held in the rabbi trust can be reached by the employer’s creditors. Because a rabbi trust does not cause the employer’s promise to be other than unfunded and unsecured, the IRS has repeatedly held that the adoption of a nonqualified deferred compensation plan and the creation of a related rabbi trust do not result in a transfer of property in connection with the performance of services.73
In the case of a life insurance policy, the plan should give no interest in the policy to the employee. The policy should remain on the employer’s books as a corporate asset (i.e., subject to the claims of the employer’s creditors) and the employer should be the sole applicant, owner, and premium payor. All of the favorable income and estate tax rulings in this area involve plans in which the employer owns the sole interest in the policy. Some authorities feel that the ability to defer taxation might, therefore, be threatened if the plan contemplates the use of split dollar contracts as an asset reserve.
Question – Is there a certain size or financial strength of the employer beyond which a naked promise is nevertheless viewed as secured?
Answer – Size of the employer makes no difference. A plan is not considered funded, even if a corporate employer as large as Microsoft makes a contractual promise to make payments in the future—as long as that promise is neither negotiable nor assignable. Such a promise is considered incapable of valuation and therefore not currently taxable because—regardless of the size or financial condition of the employer—the promise is subject to the hazards of economic and business conditions. There should be no taxation of the employee unless and until funds are placed beyond the reach of the employer or its creditors and the employee no longer runs a substantial risk of forfeiture.
The solution is to give an employee no greater rights than those of a general creditor. The earmarking of assets by the employer in order to meet its obligations under the plan will not cause the employee to be taxable. Even if cash or other property has been physically transferred to an irrevocable trust, the economic benefit theory will not apply, so long as the employee’s rights to that asset remain subject to a substantial risk of forfeiture.
Question – Does it make sense in today’s changing tax and economic environment to voluntarily defer compensation?
Answer – Many attorneys and accountants have asked just this question. In most cases, the answer is a very emphatic “YES!”
Here are some of the factors to consider:
- Corporate tax rates may go up. When tax rates go down, the value of a corporate level tax deduction and the leverage it can produce when benefits are paid out is reduced. However, when rates go up, so does the employer’s leverage. Higher tax brackets at distribution mean more benefits can be paid with the same post-deduction outlay, or that the same payments can be paid out at a lower net corporate cost.
- A reduction in tax rates reduces the value of tax deferral to participating employees. However, when rates go up, so does the value of deferring next year’s bonus.
- The value of tax deferral is lower at a 36 percent bracket than at a 50 percent bracket. But as personal rates rise, so does the value of a deferral. From the employee’s standpoint, deferral is advantageous even if rates rise to 40 percent (or even 45 percent), provided that the deferral period is long enough.
- In a few situations, the employee may be better off taking the money, paying tax on it and investing on his own rather than risking being a general creditor of the employer for many years. But few employees would, year after year, invest the after-tax difference. If they did, and if they never touched the investment, and if it never suffered a capital loss, and if it always earned a specified after tax rate of interest, then they might be better off.
- The mathematics of the deferral issue show that the benefit of deferral varies according to three factors: (a) the tax rate when the funds are distributed (if rates increase, the value of the interest-free loan from the government is offset by the amount of the increased tax that must be paid); (b) the length of the deferral; and (c) the interest rate that the deferred funds earn.74 At what point will the deferral of current taxation offset the increase in tax rates? Under almost any scenario, a key employee is better off deferring compensation, assuming that tax rates will increase, if the deferral period exceeds six years and the interest rate is 6 percent or greater.75
- When top corporate rates drop, the employer’s cost of deferral can still be significant. In fact, the cost of deferral to the corporate employer can actually be greater than the value of deferral to the employee.
On the other hand, the employer can use the money it has on hand but is not paying out. It can put the earmarked investments to work at the corporation’s earnings level, both during the accumulation period and during the distribution period. It could earn a rate of return sufficient not only to put the employee in a better position than he would have been had he taken current salary and invested it, but it can also retain a portion of the earnings to offset the cost of deferral.
With a salary continuation plan, the corporate client can set up the plan so that the employer maintains control and achieves its business purpose, or else it gets its money back. And, unlike the current payment of a salary, earmarked funds can be available for a corporate emergency or opportunity.
Question – How are benefits paid under a nonqualified deferred compensation plan?
Answer – At retirement, benefits are generally paid either in a lump sum, or more often, in a series of annual payments. For instance, payments for a fixed number of years (for example, ten years) are common, as are life annuities and survivor annuities.
Question – Can nonqualified deferred compensation plans be used by a partnership or Limited Liability Company (LLC) taxed as a partnership?
Answer – A partnership or LLC, for tax purposes, is essentially a conduit through which the income and deductions of the business flow directly to the owners. Income tax is imposed on each individual owner’s distributive share of the business’ income at the tax rate payable by each owner as an individual. The key point to note is that income tax is imposed whether or not that share is, in fact, distributed by the business to the owner.
The general taxation of partnerships or LLCs results in the absence of the tax deferral for owners, which is a major reason for the deferral of compensation. To summarize:
No deduction is allowed to the partnership or LLC for any premiums paid on life insurance used to finance the nonqualified deferred compensation plan (the partnership or LLC is the beneficiary of the policy, and therefore, deductions are not allowed under Code section 264(a)).
Amounts used to pay premiums remain part of the taxable income of the partnership or LLC, since they cannot be deducted by the partnership or LLC. This means that amounts used to pay premiums will be currently taxable to the owners. Each owner will pay, at his or her personal tax rate, tax on those amounts divided between the owners according to his or her distributive share. As a result, a deferred compensation plan makes little sense for owners, with the possible exception of minority owners (employer contributions used to fund the plan may exceed what the minority owners would otherwise be entitled to receive via their distributive share, and the tax brunt is born primarily by the majority owners). However, a deferred compensation plan may make sense for nonowner key employees of a partnership or LLC.
Because the character of items of income is carried through from the partnership or LLC to its owners, when tax free life insurance proceeds are received by the partnership or LLC, it remains income tax free to the owners.
A reduction in basis must be made by each owner for the amount of the (undistributed) premiums paid. Total premiums paid each year are allocated to each owner according to his or her distributive share.
Each owner’s adjusted basis is increased when the partnership or LLC tax conduit distributes those life insurance proceeds.
Question – Can an S corporation use a nonqualified deferred compensation plan?
Answer – Like a partnership or LLC taxed as a partnership, an S corporation passes through directly and immediately all the income, losses, and deductions of the firm to its owners. This means that on a per-share, per-day basis, each shareholder of an S corporation is taxed on the income of the business. So, as is the case with partnerships or LLCs, the ability of a shareholder in an S corporation to defer tax liability on income is lost (but only if the shareholder in question owns more than 5 percent of the corporation’s stock). However, a deferred compensation plan may make sense for nonowner key employees of an S corporation.
Question – Can a tax-exempt organization implement a nonqualified deferred compensation plan?
Answer – Yes. However, nonqualified deferred compensation plans of tax-exempt organizations are subject to special rules per Code section 457(f). This Code section stipulates that ineligible deferred compensation plan benefits are included in gross income in the first taxable year in which there is no “substantial risk of forfeiture” of the rights to such compensation. Thus, these plans are subject to more onerous requirements than plans of for profit employers, in which benefits aren’t currently taxed as long as they are subject to a substantial limitation on the employee’s ability to reach the plan assets.
Why are plans of tax-exempt organizations subject to more onerous rules? Because they are tax exempt, there is no disincentive for them to limit the amount of compensation that a participant can defer (i.e., the loss of the upfront tax deduction is meaningless to a tax-exempt employer). Thus, there would be nothing stopping a participant from deferring 100 percent or his or her compensation. Realizing this, Congress implemented special rules for tax-exempt organizations by creating Code section 457(f).
From a practical standpoint, the requirement of a substantial risk of forfeiture (in addition to a substantial limitation on the right to access the benefits) for tax-exempt plans has the following consequences:
Salary deferral plans are rarely implemented, because few employees desire to put their own money at risk of being forfeited.
Plan benefits are generally not vested until retirement. Vesting them earlier causes immediate income tax consequences at the time of vesting (i.e., the lapse of the substantial risk of forfeiture), regardless if the benefits have actually been paid out.
Plans benefits are generally paid out lump-sum at retirement. This is due to the fact that at retirement the substantial risk of forfeiture lapses, resulting in the benefits being subject to income taxation. Therefore, it generally makes sense from the participant’s perspective to pay out the benefits lump-sum. Note that if the benefits will be paid out over a period of years, the present value of the periodic payments will be taxable in the year of retirement.
One final comment regarding nonqualified deferred compensation plans of tax-exempt organizations deserves mention. The use of life insurance to finance the plan benefits loses one of its main advantages because of the fact that the employer is tax-exempt–namely; using permanent life insurance (which grows tax-deferred) as an alternative asset to avoid taxation of the investment income if the employer were to instead accumulate taxable assets for the purpose of paying plan benefits. However, the other benefits of using life insurance, such as cost recovery and the ability to provide a pre-retirement death benefit, still apply.
Question – Are there securities regulation issues with respect to nonqualified deferred compensation plans?
Answer – The answer is uncertain. At a meeting of the Securities and Exchange Commission (SEC), an SEC spokesperson stated that the SEC considered all nonqualified deferred compensation plans (with certain exceptions noted below) to be register able and indicated that the SEC would be issuing a formal statement on its position. As of the date of this printing, that statement has not been issued. It is possible that the SEC may require the registration of nonqualified deferred compensation plans as securities, but only if the plan involves employee contributions and the employees are motivated by investment rather than tax deferral. If the employees making the contributions have investment motives (i.e., the plan involves investments in underlying securities whose return is credited to the employee), registration appears to be required. On the other hand, if employees are making contributions because of tax deferral motives (i.e., primarily to save income taxes), no registration with the SEC is necessary. In other words, an investment motivated nonqualified deferred compensation plan will be considered to be a security, while a nonqualified deferred compensation plan motivated by tax deferral need not be registered, because the plan will not be considered to be a security. In making its decision, the SEC will look at all the facts and circumstances. In the authors’ opinion, most businesses which establish nonqualified deferred compensation plans for twenty or fewer key executives will probably qualify under one of the three safe harbor exemptions noted below, but plans covering a very large number of individuals or exceptionally large amounts of money may have to register. Certainly, no employer can ignore the issue and all should obtain competent legal advice on the registration issue.
The key registration exemptions that would apply to most small corporation plans are for intrastate exemptions (securities offered and sold only to persons resident within a single state), small offerings, and nonpublic offerings. Regulation D, Rules 505 and 506 are safe harbors which define the latter two exemptions, as follows:
Offers and sales of securities with a total offering price of $5,000,000 or less, in which there are no more than thirty-five purchasers and which meet certain other rules will be protected from registration requirements.
Offers and sales of securities which do not involve more than thirty-five purchasers are protected from registration requirements (regardless of the dollar amount of the offering) if every purchaser who is not considered an accredited investor is considered capable of evaluating the merits and risks of the prospective investment.82
Question – What is the impact of a nonqualified deferred compensation plan on the benefits payable under a qualified pension or profit sharing plan?
Answer – There is authority that might allow and authority that might disallow the inclusion of amounts deferred under a nonqualified deferred compensation plan in computing the amount that can be contributed to a qualified retirement plan on behalf of an employee. In the authors’ opinion, the IRS is most likely to argue that qualified retirement plan benefits discriminate in favor of the highly compensated where the qualified retirement plan takes into consideration amounts deferred under a nonqualified deferred compensation plan.
Question – How does the Medicare surtax affect beneficiaries of nonqualified plans?
Answer – Because benefits are considered wages when they are distributed, they will generally be considered as earned income and may be subject to the Medicare surtax at the time of distribution, depending on the recipient’s other tax attributes.
Question – Can life insurance be used as a financing mechanism with respect to nonqualified deferred compensation plans for bank executives and directors?
Answer – Yes. The Office of the Comptroller of the Currency (OCC) has stated that life insurance purchased on the lives of executives and directors of banks is an appropriate investment when purchased as a funding mechanism for nonqualified deferred compensation plans. The OCC has held in an opinion letter that there were two legitimate justifications for banks to purchase insurance in this context. The first legitimate justification is to meet the bank’s contractual obligation to make payments upon early, normal, or late retirement, as well as to families of covered employees at their deaths. The second legitimate justification is to serve as an actuarial cost recovery vehicle. In the opinion of the authors, the bank should own and name itself total beneficiary of the insurance. We feel it is essential for the parties to document (prior to the purchase of the life insurance) that the bank’s obligation to make payments under the nonqualified deferred compensation plan would have existed with or without the presence of the insurance, and that the insurance was purchased to reduce or eliminate that previously existing liability.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM