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PART 2COURSE READING
NONQUALIFIED DEFERRED-COMPENSATION PLANS Kenn B. Tacchino, JD**Kenn B. Tacchino, JD, is a consultant in taxation at The American College and director of the Tax Institute at Widener University.
I. AN OVERVIEW OF NONQUALIFIED PLANS
One housekeeping detail needs to be discussed before we start to explore the nonqualified market. Nonqualified deferred-compensation plans are sometimes referred to as salary continuation plans, deferred-compensation plans, and nonqualified plans. These aliases, however, can be misleading because they all have other meanings too. For example, the term salary continuation plan is sometimes used to refer to sick days and disability benefits. Likewise, deferred compensation sometimes refers to qualified pension and profit-sharing plans. The term nonqualified plans can refer to a myriad of plans that fail to meet various qualification standards. Since we are going to discuss only nonqualified deferred-compensation plans in this reading, well call them nonqualified plans for short. In the marketplace, however, it is wise to make sure everybody is on the same wavelength and isnt tripped up by the confusing nomenclature.
A. The Allure of the Nonqualified Market
Several factors prompt financial services professionals to become involved in the nonqualified market. Some get involved because nonqualified deferred-compensation and executive-bonus plans help them to provide comprehensive services to their clients. A combination of life insurance, individual annuities, qualified plans, and nonqualified plans allows the financial services professional to provide a comprehensive umbrella of retirement coverage. Others prefer the nonqualified market because it means contact with an upscale clientele, and this in turn provides networking opportunities. A third reason to be involved in the nonqualified market is to be able to sell insurance and annuity products to the nonqualified plan. As we shall see later in this reading, insurance and annuity products are a popular employer choice for funding nonqualified plans.B. Problem Solving with Nonqualified Plans
The nonqualified market is a very important part of a financial services practice in the retirement field because it allows financial services professionals to successfully deal with client situations that are otherwise unsolvable, such as these:
- Fed up with legislative changes. Frequent legislative changes to qualified plans have cost employers a small fortune in plan-amendment fees, while at the same time giving them less of what they want out of the plan. When they weigh the tax advantages offered by a qualified plan against the discretion, discrimination, and cost effectiveness possible under a nonqualified plan, some employers may feel the scales have tipped toward the nonqualified plan.
- The client needs to bring executive retirement benefits up to desired levels by adding a second tier of benefits on top of the qualified plan. Despite the tax advantages offered by a qualified plan, a client may desire to limit the income-replacement ratio under the qualified plan because of the cost of covering employees on a nondiscriminatory basis. When this is the case, a nonqualified plan should be set up to provide executives with the proper level of retirement funding.
- The client desires to circumvent the nondiscrimination requirements of a qualified plan. If your client wishes to have absolute discretion regarding which employees should be covered under the plan, a nonqualified plan should be used because it allows your client to reward selected employees on a discriminatory basis.
- The client desires to exceed the maximum benefit and contribution limitations of a qualified plan. If your client is looking to maximize retirement benefits for executives beyond the 25-percent-of-salary-or-$30,000 defined-contribution limit, or the $125,000 defined-benefit limit, a nonqualified plan should be considered.
- The client desires to reduce the reporting and disclosure workload required by a qualified plan. Companies that are tired of meeting the reporting and disclosure requirements associated with qualified plans will find substantial relief because most nonqualified plans have only nominal reporting and disclosure requirements. Whats more, fewer formalities are required to establish a nonqualified plan than a qualified plan.
- The client wants to provide a stand-alone benefit that allows highly compensated employees to defer current income as a means of supplementing retirement income. When used in this manner a nonqualified plan is usually part of a package of perks offered to key executives. This deferred-compensation arrangement differs from one utilizing a supplemental nonqualified plan, because under this arrangement the clients aim is not to provide additional retirement compensation, but rather to permit an executive to defer salary until retirement.
- The client is an owner of a closely held business who is looking to temporarily save taxes. In a closely held business corporate dollars are interchangeable with personal dollars. Therefore when the corporate tax rate is lower than the individual tax rate it behooves the business owner to shelter retirement funds in the business by setting up a deferred-compensation program for tax purposes. For example, if Dr. Shombert has the option of taking an extra $10,000 as income or leaving the money in the corporation, and if Dr. Shomberts marginal rate is 39.6 percent and the corporate rate is 15 percent, Dr. Shombert will save $2,460 in taxes by using a nonqualified plan$1,500 owed on corporate income as opposed to $3,960 in taxes owed on personal income. (Planning Note: This was a much more effective technique when the rates for corporate and individual taxes were more disparate. In todays environment the usefulness of this technique is somewhat limited.)
- The client is the owner of a closely held business that is just starting up. Closely held businesses that are just starting up often lack the cash to pay owner-employees their full salaries. A nonqualified plan allows these employees to contractually arrange for their salaries to be paid at a later date without having the IRS raise questions about the reasonableness of the compensation at that time.
- The client wants to meet the organization objectives of attracting executives, retaining executives, and providing for a graceful transition in company leadership. Although qualified plans can achieve similar objectives, nonqualified plans are more effective in managing what financial services professionals call the three Rsrecruiting, retaining, and retiring. Thats because nonqualified plans are not encumbered with qualification rules and can be designed to achieve company objectives by providing for the forfeiture of benefits unless certain requirements are met. For example, a nonqualified-plan provision stating that an employee must provide consulting services after retirement or else lose nonqualified benefits enables the organization to be weaned from its current leaders smoothly. Such a provision is not permitted in a qualified plan.
II. DETERMINING THE COMPANYS NEEDS
Once your client has indicated that one or more of the above situations is applicable,
your next step is to focus the client on the important issues involved in selecting and
designing a nonqualified plan. In addition, you need to discern the organizations
needs and objectives. The device used to accomplish these steps is a nonqualified plan
fact finder. The fact finder (figure 1) will
provide a working framework for soliciting the clients goals
FIGURE 1 Nonqualified Plan Factfinder |
NONQUALIFIED PLAN FACTFINDER Client Name: __________________________________________________ Step 1: Identify concerns. Listed below are some typical concerns that organizations have when instituting a nonqualified plan. Grade each of these concerns by scoring 1 for very valuable, 2 for valuable, 3 for moderately valuable, and 4 for least valuable. 1. Avoid the nondiscrimination requirements of a qualified plan. [1] [2] [3] [4] 2. Allow executives to defer current income for their own tax-shelter purposes. [1] [2] [3] [4] 3. Exceed the 415 maximum benefit and contribution limits of a qualified plan. [1] [2] [3] [4] 4. Supplement qualified-plan benefits that are not stretched to the maximum limits. [1] 2] [3] [4] 5. Recruit talented executives from outside the company. [1] [2] [3] [4] 6. Retain executives by inducing them to stay with the company. [1] [2] [3] [4] 7. Induce executives to take early retirement. [1] [2] [3] [4] 8. Induce executives to provide consulting services after retirement. [1] [2] [3] [4] 9. Keep executives from competing with the company. [1] [2] [3] [4] 10. Adjust executive retirement benefits to include not only the compensation considered under the qualified plan but all compensation. [1] [2] [3] [4] Step 2: List in order the primary reasons for establishing a nonqualified plan. 1. 2. 3. |
III. CHOOSING THE BEST NONQUALIFIED RETIREMENT PLAN
Once you have a full understanding of the clients objectives, you
can choose the proper nonqualified plan. There are many varieties of nonqualified plans,
but we will focus on deferred-compensation plans and executive-bonus plans because of
their importance to the financial services practice of the CLU and ChFC. There are,
however, several other popular plans:
Incentive stock options allow executives to acquire stock at a bargain
without incurring a taxable interest when the stock is acquired.
A. The Nonqualified versus the Qualified Market
When contrasted with the complexity involved in choosing a qualified plan, choosing a nonqualified plan seems relatively simple. In the qualified situation the client tends to have multiple objectives that conflict with the qualification rules. In a nonqualified situation the client tends to have fewer objectives, which can be provided for fully and effectively because the nonqualified plan can be tailored in an unfettered fashion. In fact, the most crucial decision involved with nonqualified plans is not which plan to choose, but whether to choose a nonqualified plan or some other form of executive- compensation technique, such as salary increases or executive perquisites.
B. Types of Nonqualified Plans
There are four different types of nonqualified deferred-compensation plans: top-hat plans, excess-benefit plans, supplemental executive-retirement plans, and 457 plans. Each plan type reflects a different employer objective.
1. Top-Hat Plans
If the employers objective is to provide a method for executives to defer current income (in essence, to allow a nonqualified 401(k) look-alike arrangement), a so-called top-hat plan can be used. Top-hat plans are perhaps more accurately described by their alias, nonqualified salary-reduction plans, because under a top-hat plan selected executives forgo receipt of currently earned compensation (such as a portion of salary, a bonus, or commissions) and defer this income until retirement.Top-hat plans can be set up to provide executives with additional compensation without limitations on the amount of the funds that can be contributed and without regard to which employees the plan excludes. Under ERISA a top-hat plan is defined as a plan that is typically unfunded (plan funding is discussed later) and is maintained by an employer primarily for the purpose of providing deferred compensation for "a select group of management or highly compensated employees." The exact definition of "a select group of management or highly compensated employees" is not spelled out, however; instead, a facts-and-circumstances approach determines whether a top-hat plan covering only these employees is bona fide. Two polar situations can provide some guidance. In Department of Labor advisory opinion 85-37A the DOL ruled that a certain plan was not a top-hat plan (and therefore was subject to the Title I requirements of ERISA) because the group of covered employees was too broad. This plan covered 50 of 75 employees, including a departmental foreman, factory superintendents, and officers. The average compensation of those covered was $21,000. At the other extreme is the decision in Belka v. Rowe (571 F. Supp. 1249). In this case a bona fide top-hat plan was said to exist because less than 5 percent of the work force was covered by the plan and the average salary (in 1980) was nearly $55,000. In Belka all employees covered by the plan either were salesmen or held management positions. The court ruled that the plan met the "select group of management or highly compensated employees" requirementalthough the salesmen were not managers and some managers were not highly compensatedbecause the plan had been established for either management or highly compensated employees.
A top-hat plan can either be initiated at the individual option of an executive during contract negotiations or be offered as a package of perks to selected managers or highly compensated employees. In either circumstance, however, the agreement of deferral should be entered into prior to the date that the services are actually performed to avoid unwanted tax consequences.
Candidates for a top-hat plan include
- employers who are looking to provide a low-cost benefit for highly compensated and management employees (the only employer cost is the cost of the deferral of the tax deduction)
- small closely held businesses whose owners individual tax rate is higher than the corporate tax rate
- organizations that wish to set conditions on a certain amount of executives salaries to induce desired results (discussed later)
If the employers objective is to provide a benefit (or contribution) that exceeds the 415 limits, then an excess-benefit plan should be used. ERISA defines an excess-benefit plan as a plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by Sec. 415 of the Internal Revenue Code, without regard to whether the plan is funded. In other words, an excess-benefit plan picks up where the maximum-contribution and benefit limits for a qualified plan leave off.2. Excess-Benefit Plans
Excess-benefit plans are considered a type of employer-provided salary continuation plan (as opposed to an employee-elected deferred-compensation plan). In other words, under a salary continuation plan the executive does not forgo receipt of currently earned income but instead receives an additional retirement benefit (or contribution).
Excess-benefit plans are dovetailed with an underlying qualified plan and provide the benefit or contribution that is blocked out by the Sec. 415 limits.
The Celtic Company provides a qualified defined-benefit plan with a benefit formula that provides for 50 percent of final average salary. Owners Locke and Jefferson earn $160,000 each and are effectively prevented by the $125,000 Sec. 415 limit from receiving their full 90 percent benefit ($144,000). The Celtic Company can, however, set up an excess-benefit plan that complements the qualified plan benefit and brings Locke and Jeffersons total benefits up to the desired 50 percent level.Example:
Candidates for an excess-benefit plan include
employers who have plans that are fully "maxed out" (at the maximum 415
level)
3. Supplemental Executive-Retirement Plans
A supplemental executive-retirement plan (SERP) satisfies the employer objective of
complementing an existing qualified plan that is not already stretched to the maximum
limits, by bringing executive-retirement benefits (or contributions) up to desired levels.
SERPs have some of the characteristics of both top-hat plans and excess-benefit plans.
Like a top-hat plan, a SERP is typically unfunded and is maintained by an employer
primarily for the purpose of providing deferred compensation for a select group of
management or highly compensated employees. And like the excess-benefit plan, the SERP is
a form of salary continuation plan (that is, it provides a deferred benefit, as opposed to
the deferral of a reduced salary).
SERPs operate much the same as excess-benefit plans, being dovetailed with the underlying qualified defined-contribution or defined-benefit plan. The major difference, however, is that SERPs complement qualified plan limitations that are below the 415 limits.
Regular and Offset SERPs. SERPs can complement the underlying qualified plan in one of two ways. They can be designed to provide the "missing piece" of retirement benefit (or contribution) that the employer wants the executive to have. For example, if the employer is looking to provide a replacement of 60 percent of an executives final average salary and the underlying qualified plan only provides for a 40 percent replacement, the SERP can be designed to provide a benefit equal to 20 percent of the final average salary. In cases where the exact benefit (or contribution) is unknown, however, such as when an integrated unit-benefit formula is used, SERPs can be designed a second way: to provide for the total benefit or contribution desired (for example, all 60 percent) taking into account, or offsetting, the benefits provided by the qualified plan. This type of SERP is called an offset SERP (not to be confused with a social security offset plan).
Special Uses for SERPs. When a company is less concerned with providing supplemental executive-retirement benefits than it is with accomplishing a particular objective, a SERP can be used to accommodate the companys special needs. For example, one unique use of an offset SERP is to reduce an executives benefit by the amount he or she receives under the retirement plans of other employers. This type of offset SERP is used if the employers primary objective for establishing the SERP is to attract desired executives from other companies. By providing an offset SERP that subtracts out benefits received from other employers, your client can maintain a cost-effective benefit package while at the same time allaying recruited executives fears of losing a substantial pension benefit if they transfer out of their current plan.
Candidates for SERPs. Candidates for SERPs include employers who want to
cut back benefits under their qualified plan because of increased
costs
4. 457 Plans
Sec. 457 of the Internal Revenue Code provides rules governing all nonqualified plans
of government units, governmental agencies, and non-church-controlled tax-exempt
organizations. A nonqualified plan that is sponsored by one of these organizations is
referred to as a 457 plan, and it is the only type of nonqualified plan permitted for
these organizations. A 457 plan is similar to a 401(k) plan and a top-hat plan in that
salary can either be taken as cash or deferred. Under the rules governing 457 plans the
maximum amount that can be deferred in any year cant exceed $7,500 (as indexed) or
one-third of the participants compensation, whichever is less. For employees
reaching retirement there is a "catch-up provision" that extends the amount
contributed under a complicated set of rules. In addition, the following rules apply:
Since the employer in a Sec. 457 plan does not pay federal income taxes, deductibility is not an issue.
IV. DESIGN CONSIDERATIONS
To the extent that they are subject to ERISA (discussed later), all top-hat, excess-benefit, and supplemental executive-retirement plans must conform to the applicable ERISA rules. Since these plans are usually designed to avoid being subject to ERISA, however, top-hat and excess-benefit plans and SERPs can be designed in a wide variety of ways. Plan design is an interesting and challenging assignment because the financial services professional is not inhibited by legislative and regulatory constraints. Lets look at the most common design features used in these plans.
A. Forfeiture Provisions
A forfeiture provision in a nonqualified plan
sets forth certain conditions under which an employee forfeits the benefits he or she
would normally get under the plan. For business and tax reasons, forfeiture provisions are
an essential part of an excess-benefit plan and a SERP. From a business standpoint the
employers objective in installing the plan can be satisfied by choosing the proper
forfeiture provision. The tax implications which well discuss later in this reading
are also beneficial. Top-hat plans do not typically contain forfeiture provisions because
they represent an employee election to reduce salary. The analogy can be made to the fact
that salary reductions under a 401(k) plan or 403(b) plan are always 100 percent vested
and not subject to forfeiture. But forfeiture provisions are very common in excess-benefit
plans and SERPs because they help to achieve a multitude of employer objectives.
Lets look at some client problems and see how forfeiture provisions can help solve
them.
1. Client Problem: Successful
Transition of Company Leadership
Some businesses are dependent on the special contributions of a few key executives
(executives who have specialized knowledge, unique talents, or personal contacts that are
important to the business). The retirement of these executives may prove devastating to
the profit-making ability of the organization. To prevent a drop in revenue and to ensure
a smooth transition, a nonqualified deferred-compensation plan can contain a provision
that requires the executive to provide consulting services after retirement or else
forfeit any benefit under the plan.
A consulting provision can be an effective tool for solving your clients problem. Care should be taken, however, not to create additional problems for the executive. If the consulting provision is poorly designed, the "retired" executive may be construed as still being employed by the employer. If an employer-employee relationship exists, the executive will forgo receiving social security benefits that would have been payable (this is not a factor if the rendering of consulting services amounts to performing substantial services as a self-employed individual), and the executive will lose the right to the special 5- or 10-year-averaging tax treatment on distributions from the qualified plan (a condition of which is that an employee must be separated from service). To avoid these problems the consulting provision
If these requirements are met, the business can accomplish its goals without adversely affecting the tax and social security picture of the executive.
2. Client Problem: Retention of Executives
If your client is concerned about inducing an executive to stay on board instead of
leaving prematurely, a so-called golden-handcuffs provision should be incorporated into
the plan. A golden-handcuffs provision discourages executives from leaving the employment
of your client by specifying that substantial benefits will be forfeited if service is
voluntarily terminated prior to normal retirement age. There are any number of ways to
design this provision. The employer who is not concerned about recruiting executives will
probably prefer a provision requiring the executive to forfeit all rights under the plan
if he or she terminates employment prior to normal retirement age. If executive recruiting
is a strong concern, the forfeiture of benefits can be designed to include liberal vesting
requirements. For example, the plan may provide no vesting to an employee who works less
than 5 years, 50 percent vesting to an employee who terminates between 5 and 10 years, and
100 percent vesting to an employee who terminates after 10 or more years. If executive
recruiting is a concern but not a priority, a more conservative vesting schedule can be
used (for example, 50 percent vesting after 10 years, 75 percent vesting after 15 years,
and 100 percent vesting after 20 years).
3. Client Problem: Competition from Former Employees
A major problem for employers in service industries (such as doctors and lawyers) is
an associate who leaves the business and goes to work for a competitor or uses his or her
pension money to open up a competing business. In order to deter this behavior your
clients should put a covenant-not-to-compete provision in their nonqualified plans. A
covenant-not-to-compete provision calls for the forfeiture of nonqualified benefits if the
employee enters into competition with the employer by opening a competing business. In
order to be considered valid under state law, the covenant-not-to-compete provision must
be carefully drafted or else state courts will hold the provision void because it violates
public-policy employment goals. The provision should be reasonable in terms of the
geographical area and the time period it covers. For example, a covenant that says a
former employee cant compete in the Northeast for 10 years after the employee leaves
employment is probably a violation of public policy and not valid. If the employee is
restricted from working for 2 years in the same county, however, the provision is probably
valid. The acts and circumstancesparticularly the type of industry
involvedwill be determinative. (Planning Note: The
rules for noncompetition clauses vary from state to state. To make sure that the most
restrictive schedule possible is used without risking judicial nullification, your client
should consult an attorney.)
B. Designing a Nonqualified Plan for
Executives
Up to this point the assumption has been that your client is a business entity.
However, your financial services practice may also include solving retirement problems for
executives who are negotiating a nonqualified arrangement with their employer. If this is
the case keep the following points in mind:
C. Other Features in Plan Design
Besides forfeiture provisions there are several other important design features to be
considered in nonqualified plans. In fact, if a plan is not required to meet ERISA
standards, the only real constraints on plan design are the market forces at work and the
designers imagination. In general, however, the design features of a nonqualified
plan are similar to those of a qualified plan except that they are not inhibited by IRS
restrictions. Heres an overview of some standard design features.
1. Benefit or Contribution Structure
Nonqualified plans can be designed as either defined-benefit or defined-contribution plans. Top-hat plans are usually designed as defined-contribution plans because they allow executives to contribute a deferred amount of salary each year. Salary continuation nonqualified plans (excess-benefit plans and SERPs) can also be set up as defined-contribution plans but are more frequently set up as defined-benefit plans. When excess-benefit plans or SERPs are set up as defined-benefit plans, the benefit formula should jibe with the employers objectives. This may mean supplementing the employers qualified plan or avoiding duplication in benefits by the coordination of all benefits received under the employers qualified and other benefit plans, retirement benefits earned with other employers, and social security benefits. Meeting employer objectives may also mean indexing benefits, weighing benefits for length of service (such as in a unit-benefit formula), or both.2. Eligibility
Participation in nonqualified plans is typically restricted to company executives. An excess-benefit plan can include rank-and-file employees, but the benefits of the rank-and-file employees never even approach, let alone exceed, the qualification limits. A top-hat plan or a SERP, however, must by definition be maintained "primarily" for a select group of management or highly compensated employees. In fact, care must be taken to restrict participation so that the plan is considered to be a top-hat plan or SERP for ERISA purposes.In a top-hat plan or a SERP the executives title or position typically dictates inclusion in or exclusion from the plan (for example, all executives above the level of first vice president might be included). A second way to determine eligibility is by salary. When salary determines eligibility, the chosen dollar amount should be indexed; by taking this precaution the employer doesnt risk substantial cost increases caused by the inclusion of executives who are not at the top level but whose salaries have inflated over time. A third common way to determine eligibility is to appoint a compensation committee. When this is done, the employer, who heads the committee, retains absolute control over plan membership.
3. Disability Provisions
Nonqualified plans frequently contain disability provisions. The employer can stipulate whether disability will be treated like any other termination of employment or whether special disability provisions (such as full vesting or benefits or a special benefit computation) will apply. In addition, the employer must choose whether service will continue to accrue if a disability occursin which case the plan should contain a definition of disability.Regardless of how the employer decides to treat disability under the nonqualified plan, the planner should be careful to coordinate benefits between the nonqualified plan and other employer plans. This will prevent costly duplication of benefits.
4. Retirement Age
Another key plan design to be considered is retirement age. In general, the normal retirement age of the nonqualified plan is the age at which benefits become payable without any forfeiture. The employers personnel objectives determine whether a "young" retirement age (5062) or an "old" retirement age (6570) is chosen. If the employer wants to control salary costs by keeping a young work force, then a young retirement age should be chosen (typically, this is coordinated with a young normal retirement age in the qualified plan). If the executives involved have knowledge or experience that is crucial to the company, however, a later retirement age should be selected.5. Death Benefits
Nonqualified plans can provide death benefits, which can cover the preretirement period, the postretirement period, or both. The death benefit chosen depends in part on what type of life insurance is used to fund the plan (if any) and what type of annuity is used for distribution from the plan. The choice of a death benefit should therefore be closely coordinated with the life insurance product used in the plan.
V. EXECUTIVE-BONUS LIFE INSURANCE PLANS
An alternative that can be used in combination with, or in lieu of, the previously
discussed deferred-compensation plans is an executive-bonus life insurance plan (also
known as a Sec. 162 plan). Like a deferred-compensation plan, an executive-bonus life
insurance plan can be provided on a discriminatory basis to help business owners and
select executives save for retirement. The executive-bonus life insurance plan, however,
does not provide for the deferral of income. Under an executive-bonus life insurance plan
the corporation pays a bonus to the executive for the purpose of purchasing cash-value
life insurance. The executive is the policyowner, the insured, and the person who
designates the beneficiary. The corporations only connection (albeit a major one) is
to fund premium payments and in a few cases to secure the application for insurance.
Bonuses can be paid out by the corporation in either of two ways. The corporation can pay
the premiums directly to the insurer or pay the bonus to the executive, who in turn pays
the policy premiums. In either case the corporation deducts the contribution from
corporate taxes at the time it is made (this is in direct contrast to most
deferred-compensation plans) and includes the amount of the payment in the
executives W-2 (taxable) income.
Since payments made under executive-bonus life insurance plans are W-2 income, bonuses are subject to federal, state, and local withholding requirements and to social security taxes (unless the wage base has already been exceeded).
A. Nonretirement Applications
Besides being a retirement planning tool, executive-bonus life insurance plans can be used in several other ways to serve your clients. Some planners use them in lieu of superimposed group term life insurance (life insurance over the tax-sheltered $50,000 limit). This usage has grown in popularity recently owing to COBRA changes that increase employer costs by inflicting benefit contribution requirements on group plans. Another use of Sec. 162 plans is to help the executive to purchase an insurance policy to fund a cross-purchase buy-sell agreement. Without these agreements partners may not have the assets to continue the business when one of them retires or dies. A third use of executive-bonus life insurance plans is to provide the executives estate with a source of liquid funds to pay estate taxes. Restrictions on the amount of insurance that may be used under group term life plans and qualified retirement plans make the liquidity issue an important executive concern.B. Implementation of Sec. 162 Plans
Executive-bonus plans are fairly easily implemented. First, as with all forms of nonqualified compensation, a corporate resolution authorizing the business expenditure should be obtained. Second, those in charge should select the executives to be included in the plan and the amount of benefits they will receive. Third, they should notify the Department of Labor that the plan is in effect. Fourth, either the executive or the corporation should secure the application for insurance. And finally, the executive should apply for the policy as the owner and designate the policys beneficiary.C. Double-Bonus Plans
Concern over the receipt of additional taxable income from executive- bonus life insurance plans has caused many employers to provide a second bonus to alleviate any tax that the business owner or executive may pay. (These plans are typically called double-bonus plans.) Because there will also be a tax on the second bonus the following work sheet is needed to calculate the total amount needed for both bonuses.
TABLE 1 Double-Bonus Work Sheet |
|
Step 1: State the target
premiums (the amount of the first bonus). Step 2: Specify the applicable tax rate Step 3: Subtract the step 2 amount from 1.00. Step 4: Divide the step 1 amount by the step 3 amount to find the amount of both bonuses. |
____________ ____________
____________ ____________ |
Example: JANCO wants to provide executive Kathy Beamer with a $10,000 nontaxable bonus to pay the premium under her cash-value life policy. JANCO will have to provide Kathy with $16,666.67, determined as follows:
Step 1: State the target premiums. | $10,000.00 |
Step 2: Specify the applicable tax rate. | 40 |
Step 3: Subtract the step 2 amount from 1.00. | .60 |
Step 4: Divide the step 1 amount by the step 3 amount to find the amount of both bonuses. | $16,666.67 |
Note that the 40 percent tax rate used in the example includes a 31 percent federal tax rate, a 4 percent state tax rate, and city taxes of 5 percent. In lieu of the work sheet the following formula can be used:
Amount of first bonus = Amount of both bonuses
1 - tax rate
VI. NONQUALIFIED VERSUS QUALIFIED PLANS
As we have seen, qualified pension and profit-sharing plans are retirement plans that
meet standards set out in the Employee Retirement Income Security Act (ERISA) and Internal
Revenue Code. As a payback for adhering to these burdensome rules, plan contributions are
immediately deductible by the employer, earnings on plan funds are tax deferred, and when
qualified plan funds are distributed to employees several tax-saving strategies such as
forward averaging and rollovers may be available.
In contrast a nonqualified plan cannot simultaneously give the employer the benefit of an immediate tax deduction and give the employee the benefit of a tax deferral. Most nonqualified plans are structured to defer the taxation of retirement benefits for executives. Unlike qualified plans, however, nonqualified deferred-compensation plans postpone the employers deduction until the benefit has been paid to the executive and has been included in his or her income. In addition, earnings on money put aside to fund the plan will be taxed in the year it is earned unless a tax shelter such as life insurance is used. Finally, distributions from nonqualified plans cannot be forward averaged to reduce the effective tax rate or rolled over to delay taxation (see table 2).
Despite the dismal tax comparison, nonqualified plans are favored over qualified plans
in many cases for a variety of reasons, including
design flexibility
This last reason is perhaps the chief motivation for an employer to install a nonqualified plan. Business owners claim they can save significant sums of money by excluding rank-and-file employees from the plan. In the minds of many employers the tax savings garnered under a qualified plan are overshadowed by the ability to avoid paying benefit costs for the majority of their employees. A short case study helps to illustrate this point (see also table 2).
TABLE 2 Qualified and Nonqualified Plans Compared |
||
Characteristic |
Qualified Plan |
Nonqualified Plan |
Tax
deferred to employee Tax consequences to employer Earnings accumulate tax free Special tax treatment at retirement for employee Ability to lower costs by only covering selected employees Plan administration requirements Reporting and disclosure requirements Ability to attract, retain, and motivate employees |
Yesalways Immediate deduction Yesalways Yes (rollovers and forward averaging) No (must meet nondiscrimination rules) Burdensome and expensive
|
Yes
(unless considered funded) Deduction deferred (unless considered funded) No
Minimal and inexpensive
More effective |
EFFECTIVE COMPENSATION PLANNING Clients often mistakenly believe that implementing a qualified plan will increase costs because the benefits are an additional compensationsort of a windfallfor rank-and-file employees. This commonly held opinion is correct only if benefits are an increase to the overall compensation package. If benefits are a piece of what is already being paid to an employee, however, employer costs are not increased. In other words, the employer should focus on how employees are paid, not how much he or she pays them. Effective compensation planning dictates that employers give employees (and themselves) the opportunity to save for retirement with the tax advantages that are only available through a qualified plan. Unfortunately, for many employers its the perception that counts, not the reality. One way to satisfy stubborn prospects is to gradually shift current compensation to deferred compensation. This can be accomplished by lowering future salary increases by a small percentage, which will be used to fund a deferred-compensation plan. |
A. Case Study: The Smallco Company
Smallco is a company of 10 people and is owned by two sisters. The sisters earn a salary of $100,000 each; the payroll for the additional employees is $240,000 (average salary, $30,000). If Smallco were to install a profit-sharing plan that provides a benefit of 15 percent of salary to all employees, the qualified plan would cost $66,000 plus administrative expenses ($66,000 equals 15 percent of the total payroll, $440,000). If Smallco were to provide a 15 percent nonqualified plan for the two owners and no benefits for the other employees, however, then the cost to the plan would be reduced to $30,000 plus the cost of deferring the deduction.
1. Determining the Cost of Deferring the Deduction
Smallco pays corporate taxes at the 34 percent rate. The deferral of the deduction would thus immediately cost Smallco 34 cents on every dollar put into the plan. Since $30,000 is being contributed, Smallco would thus "lose" $10,200 in tax savings (34 percent tax rate multiplied by the $30,000 contribution). In addition, Smallco loses the amount it could have gained by investing the $10,200. This of course will be offset by the amount that will be deducted when the benefits are paid. There is no way to accurately predict the employers cost for deferring the deduction because of the interest and time assumptions that must be used (not to mention potential shifts in tax rates). But even assuming that it costs Smallco $1.40 (a conservatively high figure) to provide $1 in benefits, the total plan cost in real dollars will only be $42,000. This amount is $24,000 less than the qualified plan would cost. In addition, Smallcos administrative costs will be significantly lower. To put it another way, even though it will cost Smallco more than a dollar to provide a dollars worth of benefits, the additional cost is more than offset by increased benefit costs brought about by providing benefits for rank-and-file employees.B. Tax Considerations
A client who desires a nonqualified plan must be made aware of the tax implications of having such a plan.It goes without saying that salary is taxable to an employee in the year it is paid to the employee. But what happens when the salary is deferred to a later tax year?
1. Constructive Receipt
Under IRS regulations an amount becomes currently taxable to an executive even before it is actually received if it has been "constructively received." Constructive receipt will be deemed to occur in a nonqualified plan if the deferred compensation is credited to an executives account, set apart for the executive, or made available to the executive so that he or she may draw upon it anytime or could draw on it if notice of intention to draw had been given. In other words, if the executive had the choice of taking compensation but refused to take possession, the IRS will treat that person as having taxable income. There is, however, no constructive receipt if either of the following conditions is met:
- The deferred compensation is subject to substantial limitations or restrictions.
- The election to defer compensation is a mere promise to pay, not represented by notes or secured in any way (that is, if it is an unsecured promise to pay).
Consequently, an executive in a top-hat plan, for example, will be deemed to be in constructive receipt of income because he or she is in effect postponing income in order to avoid current taxationunless the nonqualified plan meets either one of the two criteria outlined above. Since the major advantage to an executive of a nonqualified plan is the deferral of taxes, it is essential that the plan be designed to meet one of the two specified criteria.
Substantial Limitation or Restriction. Whether or not constructive receipt applies is a facts-and-circumstances decision. Substantial limitations have been held to exist if the executive must wait until the passage of a given period of time to receive the money (under a golden-handcuffs provision, for example). In addition, the employer can avoid constructive receipt by setting up the plan to require the occurrence of an event that is beyond the executives control.
Unsecured Promise to Pay. What constitutes an unsecured promise to pay will be covered in detail when unfunded plans, informally funded plans, and rabbi trusts are discussed later. The question of when the unsecured promise to pay should be made is another matter, however. The executive is better off entering into the agreement to defer compensation before services are rendered. If the executive waits to make an election later, the plan can only avoid constructive receipt if there is a "substantial risk of forfeiture." A substantial risk of forfeiture is a significant limitation or duty that will require a meaningful effort on the part of the executive to fulfill, and there must be a definite possibility that the event that will cause the forfeiture could occur. In other words, the executive will have a much higher hurdle to jump to avoid IRS claims of constructive receipt if he or she procrastinates in making the election.
When Does It End? One final point concerning constructive receipt needs to be made. The problem of constructive receipt can last beyond the asset buildup period. In other words, plan provisions also have to ensure that the executive isnt taxed on more than he or she receives in the distribution period. For example, an executive cant elect to accelerate the balance of payments due under the plan after retirement. An executive can, however, elect the time and manner of payment under the nonqualified plan without triggering constructive receipt if the election is made before the deferred amount has been earned.
2. Economic Benefit
Under the economic-benefit doctrine an economic or financial benefit conferred on an executive as compensation should be included in the persons income to the extent that the benefit has an ascertainable fair market value. In other words, if a compensation arrangement provides a current economic benefit to an executive, that person must report the value of the benefit even if he or she has no current right to receive the benefit. The economic-benefit doctrine is different from the constructive-receipt doctrine because the tax issue is not whether the taxpayer can control the timing of the actual receipt of the income (as it is in constructive receipt); the issue is whether or not there has been an irrevocable transfer of funds made on the executives behalf that provides an economic benefit to the executive. The economic-benefit doctrine is a higher hurdle for taxpayers to jump than the constructive-receipt doctrine because it requires the executive to be taxed when funds are irrevocably paid out on the executives behalf to a fund in which the executive has vested rightsregardless of whether there are substantial limitations or restrictions on the deferred income. For purposes of the economic-benefit doctrine a fund is created when property is irrevocably placed with a third party. The economic-benefit doctrine does not apply, however, when the property involved is subject to the rights of the employers creditors, because theoretically no property has been transferred and the obligation remains an unsecured promise to pay.3. Section 83
Under Sec. 83 of the Internal Revenue Code the executive is not taxed until his or her rights in the property become transferable or are no longer subject to a substantial risk of forfeiture (discussed above). A substantial risk of forfeiture is deemed to occur if the plan contains forfeiture provisions, that is, if the rights to deferred compensation are conditional on the performanceor nonperformanceof substantial services. Whether or not the forfeiture provisions accomplish this is a facts-and-circumstances determination. One final note: "property" that is transferred and is subject to the creditors of the corporation is not really property for tax purposes, because the transferred interest cannot be valued and the obligation remains an unsecured promise to pay.Lets look at some examples.
Example 1: Employer Able sets up a separate account that will be used to pay off nonqualified benefits. Able retains ownership over the assets in the fund and can direct the funds assets to business use if necessary. Under this scenario the executives avoid taxation because they cannot control the timing of the actual receipt of the income, and the employer has not made an irrevocable transfer of funds on the executives behalf. The executives in this example, however, may not feel secure that they will receive their benefit because they have only an unsecured promise to receive benefits.
Example 2: To provide the executives with more security employer Able transfers the funds to a trust. The assets placed in the trust cannot revert back to the employer and are not subject to attack by the employers creditors if the company files for bankruptcy. Under this scenario the executives are certain that they will receive their nonqualified benefitbut they are also subject to immediate tax on the transferred assets. Reason: the transferred assets are no longer an unsecured promise to pay and are not subject to a substantial risk of forfeiture; therefore the executives have constructively received and derived an economic benefit from the assetseven though they have not actually received the assets.
VII. PLAN FUNDING
Nonqualified plans can be funded, unfunded, or informally funded. As you have probably
concluded by now, plan funding for tax purposes and "storing assets" to pay
future nonqualified promises are two different things from a tax standpoint. Lets
take a closer look.
A. Funded Plans
A nonqualified deferred-compensation plan is considered funded for tax purposes when, in order to meet its promise of providing benefits under the plan, the company contributes specific assets to an escrow or trustee account in which the executive has a current beneficial interest. In other words, to pay benefits the company sets aside funds that are beyond the reach of the general creditors of the corporation. In addition, a nonqualified plan will be considered funded if the executives obligation is backed by a letter of credit from the employer or by a surety bond obtained by the employer. If a nonqualified deferred-compensation plan is considered funded, the executive will be subject to immediate taxation under the rules of constructive receipt (unless substantial limitations apply), economic benefit and Sec. 83; and ERISA rules concerning participation, funding, vesting, fiduciary enforcement, and reporting and disclosure will apply (discussed later). Since this defeats the purpose of the plan, most plans are designed to be unfunded for tax purposes.B. Unfunded Plans
A nonqualified deferred-compensation plan is considered unfunded for tax purposes if there is no reserve set aside to pay the promised benefit under the plan. Rev. Rul. 6031 states that a mere promise to pay that is not represented by notes or secured in any way is not regarded as a receipt of income. Therefore an unfunded, unsecured promise by an employer to pay compensation at some future date will not constitute current taxable income to an executive.C. Informally Funded Plans
Unfunded plans that do not make contingencies for storing funds to pay nonqualified promises pose a major problem for the executive because benefit payments hinge on the fiscal health of the employer at the time benefits become payable. Whats more, many executives wonder if their own status will be different by the time they collect. Management change, business buyouts (through hostile takeover or otherwise), or a demotion due to performance problems or "office politics" may put the employee in an untenable position when he or she approaches the time to collect benefits. The executive is relying mainly on the corporations unsecured (albeit contractual) promise to pay. Thus executives are caught in the horns of a dilemma. On one hand if the plan is funded executives will be taxed immediately. On the other hand executives dont want to risk their retirement on an unsecured promise to pay. Because executives want the best of both worldsas much security as possible without triggering immediate taxationmany plans are informally funded. A plan is informally funded when a reserve is set up to pay the nonqualified benefit, but the assets of the reserve are retained as assets of the corporation, subject to attack by creditors of the corporation. In other words, as long as the executive does not have a current beneficial interest, the plan is considered unfunded for tax purposes. When a plan is informally funded, it is important to consider the other side of the equationthe employers deduction.D. Income Tax Effects on the Employer
Under the cash method of accounting a taxpayer is not entitled to a deduction until benefits have been paid to executives. Some employers are subject to the accrual method of accounting, however. Under the accrual method of accounting a taxpayer is entitled to a deduction in the year during which all events have occurred that gave rise to the liability and the amount of such liability can be determined with reasonable accuracy. However, the timing of deductions for the payment of nonqualified deferred compensation comes under special IRS regulations. Unlike the usual tax accounting rules applicable to other deductions, Reg. 1.404(b)-1T allows a deduction for nonqualified deferred compensation only in the year in which the payment is includible in the employees gross income. Although unfunded deferred-compensation arrangements would often qualify as deductible expenses under the usual accrual requirements, Reg. 1.404(b)-1T will take precedence and delay the deduction for the employer until the income is taxable to the employee.E. Rabbi Trusts
The tax and funding implications of nonqualified plans boil down to one simple question: How can executives secure their interests in a nonqualified plan without triggering plan funding for tax purposes? The answer is a rabbi trust.The so-called rabbi trust is a trust established and funded by the employer that is subject to the claims of the employers creditors (thus escaping current taxation for the executive), but the funds in the trust cannot be used by or revert back to the employer. It was invented in 1981 by a rabbi who came up with a better idea for funding his deferred-compensation plan. Under the plan his congregation set aside deferred-compensation funds in an irrevocable trust to be paid out to the rabbi at retirement. The major difference between this trust and other trusts set up at that time was that the funds remained subject to the congregations general creditors and could be paid to them if the congregation defaulted on any of its obligations. The rabbi obtained a private-letter ruling in which the IRS agreed with him that since the money remained subject to the congregations creditors, even though he was vested he had not really received it and should only be taxed when the benefits were actually paid to him. The IRS reasoned that since the payments were subject to the congregations general creditors, they were subject to a substantial risk of forfeiture and therefore did not fall under the rules of Sec. 83. In addition, the IRS ruled that they were an unsecured promise to pay and thus did not constitute constructive receipt or economic benefit. The new planning tool was quickly dubbed a rabbi trust.
Since the time that the rabbi trust was first implemented, its limits have been more clearly defined. For many years a sponsor wanting the IRS to rule on the validity of the rabbi trust agreement had to request a private letter ruling. In Rev. Proc. 92-64 the IRS made the use of the rabbi trust more secure by providing a model trust agreement. In order to have IRS approval of a deferred-compensation agreement today, the sponsor in almost all cases must use the IRSs model rabbi trust form.
The model trust generally conforms with IRS guidelines already well known from prior IRS private letter rulings. Optional paragraphs are provided to allow some degree of customization. The model contains some relatively favorable provisions. For example, it allows the use of "springing" irrevocability. That is a provision under which, if there is a change of ownership of the employer, the trust becomes irrevocable. Similarly, at the change in control the employer can be required to make an irrevocable contribution of all remaining deferred compensation. Also, the model permits the rabbi trust to own employer stock. However, the model does not allow "insolvency triggers" that hasten payments to executives when the employers net worth falls below a certain point. (The IRS fears that accelerating benefit payments when the employers financial position deteriorates may result in all benefits being paid before any creditors have a chance to attach the assets of the trust.) Other requirements either contained in the model trust or in prior rulings include the following:
- The assets in a rabbi trust must be available to all general creditors of the company if the company files for bankruptcy or becomes insolvent.
- The participants must not have greater rights than unsecured creditors.
- The plan must provide clear rules describing when benefits will be paid.
- The company must notify the trustee of any bankruptcy or financial hardship that the company is undergoing. When a bankruptcy or financial hardship occurs, the trustee should suspend payment to the trust beneficiary and hold assets for the employers general creditors.
1. Unique Uses for Rabbi Trusts
The rabbi trust has evolved into a planning tool that has many uses. As stated above, a rabbi trust can have a springing irrevocability provision, protecting an executives rights in the case of a management takeover. This permits the executives to be secure while at the same time allowing the company to have the current use of assets that might be transferred to the trust. Another way to protect the participants in the event of a hostile takeover is to give the trustee control over the investment of plan assets upon the change in control. This prevents the "bad guys" from making investments in illiquid employer-leased real estate or an employer-related venture. The ability to require employer contributions to the trust upon a change in control can provide another layer of protection for the covered executives. Such a provision opens the door for the use of a new generation of "as-needed" rabbi trusts.The IRS has also confirmed that a single rabbi trust can be used to fund the assets of multiple deferred-compensation plans sponsored either by a single employer or by an employer and its subsidiaries.
Participants can elect the form of distribution from the rabbi trust when contributions to the trust are made without triggering constructive receipt. In addition, a change in the form of business organization by the employees company (from a partnership to an S corporation, for example) will not adversely affect the rabbi trust.
Finally, executives can take a hardship withdrawal from a rabbi trust without triggering constructive receipt. The withdrawal is limited to an amount reasonably needed to meet the emergency. Whats more, the emergency must be unforeseeable, that is, pose a severe financial hardship to the participant or result from a loss of property due to casualty or other similar extraordinary and unforeseeable circumstances beyond the control of the participant.
2. A Final Word on Rabbi Trusts
Although rabbi trusts accomplish the dual objective of deferring taxation and providing a measure of retirement security to executives, they have one important disadvantage: rabbi trusts provide no benefit security for executives should the employer go bankrupt. In other words, the executive must stand in line with other creditors if the employer files for bankruptcy. Rabbi trusts, therefore, are very effective in providing retirement security if the employer is unwilling to pay promised benefits, but they do not provide security if the employer is unable to pay benefits.F. Secular Trusts
In situations where the employers ability to pay promised benefits comes into question some professionals have been recommending a so-called secular trust in lieu of a rabbi trust. Like a rabbi trust, a secular trust calls for an irrevocable contribution on the employers part to finance promises under a nonqualified plan. Unlike a rabbi trust, however, funds held in a secular trust cannot be reached by the employers creditors. This means that executives can expect to receive promised benefits even if the employer goes bankrupt. It also means, however, that employer contributions to a secular trust are taxable.Unfortunately, several recent IRS private-letter rulings have questioned the continued viability of secular trusts. In these rulings the IRS indicated that in some circumstances trust earnings would be subject to double taxation, once when earned at the trust level and again when actually paid out to the employee. This change would certainly discourage the use of the secular trust; however, these rulings are unclear and presently the fate of secular trusts is in doubt. If you decide that a secular trust is appropriate, you should seek professional guidance.
1. How Secular Trusts Work
Secular trusts work like rabbi trustsup to a point. That is, the trust agreement is adopted and funded by the employer, and payments are made to an independent trustee. They are unlike rabbi trusts, however, because to compensate for the additional tax burden on the executive, the trust typically makes annual distributions to the executive, equals the amount of the executives current tax liability.2. Secular Trusts: The Employers Perspective
From the employers standpoint the secular trust has several advantages over a rabbi trust. The greatest advantage to the employer is that funds placed in a secular trust are deductible in the year transferred. This makes it less expensive to provide the nonqualified benefit because the deduction is not deferred. In addition, earnings on plan funds are taxable to the executive, not the employer. In a small closely held business whose corporate rates are higher than individual rates, accelerating the deduction to the employer and shifting earnings to the individual can be worth more in tax savings than postponing the income of the business owner.3. Secular Trusts: The Executives Perspective
The big advantage of secular trusts for executives is the security they derive from such an arrangement. If executives are so inclined, then forgoing deferral to secure nonqualified promises is a good idea. From the executives standpoint, however, the question needs to be asked: Why not take the payments as current compensation? Aside from the fact that the employer may not be willing to give the employees ready access to their retirement funds, there is no good reason for them to abrogate control over the money while being taxed currently on it. Since executives typically have a significant amount of say over their nonqualified benefit, secular trusts are not widely used. In other words, executives who are concerned about security typically demand their "deferred compensation" currently.G. Surety Bonds
For the executive who feels uncomfortable with the possibility of benefits going unpaid from a rabbi trust because of an employer bankruptcy but wants to avoid the use of a secular trust because of the tax consequences, an alternative may be available. For these executives you should look into the use of a surety bond. A surety bond provides for a bonding company to pay promised benefits if the employer defaults on the promise to pay nonqualified benefitsthus providing the executive with an indirect means of securing the employers unsecured promise.In order to prevent the purchase of a surety bond from triggering a constructive-receipt, economic-benefit, or Sec. 83 problem, certain precautions must be taken. The executive must bear the cost of the surety bond, and the employer should not have an involvement with the bonding company. If these precautions are taken, the executive can have the security of continued protection for nonqualified retirement payments.
TABLE 3 Comparison of Funding Approaches |
||||
Type of Plan |
Funds Set Aside Prior to Retirement |
Secured against Unwillingness to Pay |
Secured against Employer Insolvency |
Delayed Taxation for Executives |
Unfunded pay-as-you-go plan Rabbi trust Secular trust |
No Yes Yes |
No Yes Yes |
No No Yes |
Yes Yes No |
The downside is that surety bonds for nonqualified plans can be expensive and difficult to obtain. Premiums are typically 1 to 3 percent of the annual amount deferred, plus earnings. In addition, very few companies provide this coverage. Finally, renewal of the bond can be difficult if the employer experiences an economic downturn. Surety bonds are issued for from 3 to 5 years and may not be renewed if bankruptcy is on the horizon. Ironically, this is when they are most needed!
H. ERISA Considerations
In addition to understanding the tax implications for funding nonqualified plans, your clients need to understand the ERISA implications as well.Nonqualified plans may be subject to certain ERISA provisions that your clients generally wish to avoid. These provisions deal with reporting and disclosure, participation, vesting, funding, fiduciary, and ERISA enforcement (employee access to federal courts to claim ERISA rights). In general an excess-benefit plan that is unfunded will not be subject to any of these requirements. If its funded, the excess-benefit plan will be subject to limited reporting and disclosure requirements and ERISA enforcement provisions only but not the participation, vesting, funding, and fiduciary standards. Unfunded top-hat plans and SERPs are treated the same for ERISA purposes. If these plans are unfunded, only the reporting and disclosure, fiduciary, and ERISA enforcement provisions will be applicable but not the ERISA participation, vesting, and funding requirements. If these plans are funded, however, all the above-mentioned ERISA requirements apply.
I. "Funding" Nonqualified Plans With Life Insurance
Corporate-owned life insurance (COLI) is a popular way for most publicly held and almost all closely held businesses to set up a reserve against future obligations under a nonqualified plan. No single type of contract is best. Most employers, however, prefer policies with premium and investment flexibility and low mortality and expense costs. In addition, since the policy values are generally used to finance retirement benefits, permanent rather than term coverage is indicated.
TABLE 4 Summary of ERISA Application to Nonqualified Plans |
||||||
ERISA Requirement |
Unfunded Plans |
Funded Plans |
||||
Excess- Benefit | Top-Hat |
SERPa |
Excess- Benefit | Top-Hat |
SERP |
|
Reporting and disclosure Participation Vesting Funding Fiduciary ERISA enforcement |
NA NA NA NA NA NA |
App* NA NA NA App App |
App NA NA NA App App |
Limitedb NA NA NA NA App |
App App App App App App |
App App App App App App |
a This refers
only to a SERP that constitutes an unfunded plan maintained by an employer primarily to
provide deferred compensation for a select group of management or highly compensated
employees. b Limited reporting and disclosure requirements include only furnishing participants with summary plan descriptions or annual reports and termination reports about individual benefits, as well as furnishing the Department of Labor with the name and address of the employer, the employers identification number, and a declaration that the employer maintains the plan primarily to provide deferred compensation to a select group of management or highly paid employees, plus a statement identifying the number of such plans and the employees in each.* Abbreviation for applicable |
1. Advantages of COLI
The use of COLI is attractive for many reasons:
- The tax-free inside buildup that occurs in a life insurance policy is important to a nonqualified plan because, unlike those of a qualified plan, earnings on nonqualified-plan assets are not tax deferred.
- Life insurance proceeds received by the company can protect the company against the premature death of an executive. This works two ways. If the executive is not fully vested in his or her promised benefit at death, or if no death benefit is provided at all, the excess death benefit received by the company can be used to cushion the company against anticipated losses owing to the executives death. If the executive is fully vested in a substantial death benefit and dies shortly after entering the plan, the life insurance policy will be able to pay the promised benefit in full, whereas the other reserves would have been inadequate.
- Life insurance proceeds received by the company upon the death of the executive are tax free.
- Policies can be borrowed against to help pay the cost of future premiums. Knowing that if cash flow is a problem the funding of his or her benefit wont suffer should give the executive an added sense of security. An added benefit of a leveraged insurance contract is that the employer is allowed to deduct any interest paid on policy loans that total $50,000 or less. (Planning Note: The $50,000 ceiling on policy loans was added by TRA 86. Prior to that time leveraged life insurance products had been a highly desirable way to fund nonqualified plans, but the trend now seems to be away from leveraged policies and toward variable life insurance.)
- Life insurance funding provides the employer with flexibility. The employer may either use the cash values of the policy to pay nonqualified benefits or use other assets and keep the policy in force until death. If the latter course is taken, the employer can often receive more from the insurance company as death proceeds than it pays out under the plan.
- Life insurance policies can be used to provide a supplemental disability benefit. The waiver-of-premium clause in a life policy will enable the executive to get the full nonqualified benefit even if he or she becomes disabled.
- If life insurance purchased on the life of the executive is owned by the company, premiums are paid by the company, and the company is the sole beneficiary, then constructive-receipt, economic-benefit, and Sec. 83 problems are avoided.
- If the nonqualified plan requires the plan to pay a life income to the executive, by electing a life-income option the employer can pass on to the insurance company the risk that the executive will live beyond his or her normal life expectancy.
2. Disadvantages of COLI
Two major disadvantages of using life insurance to fund a nonqualified plan concern the limitation on a corporate deduction for interest paid on policy loans (previously discussed) and the alternative minimum tax on corporate assets. The alternative minimum tax offers some impediment to the use of life insurance to fund a nonqualified plan because the life insurance that is payable to the corporation, although not subject to regular taxes, may be subject to the alternative minimum tax (AMT). If so, employer costs are increased. Employers should be advised that they may need to purchase additional insurance so that they can pay any AMT as well as their obligations under the plan. Although the AMT will usually be about 15 percent of the death benefit (and in many cases far less), some experts suggest that the employer obtain slightly over 15 percent more life insurance than the amount needed to fund the plan. In any case the employers tax adviser should be consulted to determine whether the alternative minimum tax will apply.
VIII. THE INSTALLATION AND ADMINISTRATION OF NONQUALIFIED PLANS
The final issue we will consider in this reading is the installation and
administration of your clients nonqualified plan. In order to install a nonqualified
plan the employer should adopt a corporate resolution authorizing the purchase of life
insurance to indemnify the business for the expenses it is likely to incur. A second
restriction should authorize the production of either a contract or plan document that
will spell out both the corporations and executives benefits and obligations.
In addition, a rabbi trust document or a secular trust document should be created.
Finally, a one-page ERISA notice should be completed and sent to the Department of Labor.
This notice is a letter informing the DOL that a nonqualified plan exists and that certain
named employees are covered by the plan.
APPENDIX A
NONQUALIFIED DEFERRED COMPENSATION
Design Work Sheet
(from Leimberg and McFadden, Tools and Techniques of Employee Benefit and Retirement
Planning, The National Underwriter Co., Cincinnati, Ohio.)
A. EMPLOYER AND EMPLOYEE DATA
Employer_______________________________________________________________
Employers address__________________________________________________
__________________________________________________________________
Telephone No. ( )________________________________Zip________________
Employer I.D. No.___________________________________________________
S corporation election? Yes_________________No_______________
Date of S election__________________________________________
Accounting year and method__________________________________
Company contact (name and title)________________________________________
Telephone No. ( )_________________________________________
Employee__________________________________________________________
Title_______________________________________________________________
Employee address___________________________________________________
___________________________________Zip___________________
Telephone No. ( )_____________________________
Social Security No._______________________________
Percent ownership of employer________________________________
Effective date of deferred-compensation arrangement_________________________
B. PLAN FORMULA
Formula type (check)
___________ Salary reduction
___________ Salary continuation
___________ Other_________________________________________________
_________________________________________________________________
Nonqualified Deferred Compensation, cont'd.
Salary reduction formula (if applicable)
Reduction amount__________________________________________
Per (month, year, other)_____________________________________
Date of initial election_______________________________________
Annual election date thereafter________________________________
Other election date (specify)_________________________________
Company contribution, if any_________________________________
Conditions on company contributions___________________________
Company guarantee of interest on account balance (check one)
___fixed rate of_______________percent
___rate based on
____________________________adjusted (how often)____________Salary continuation formula (if applicable)
Benefit payable at (check)
___________age 65
___________other specified age___________Benefit formula
____________percent of compensation monthly
(times years of service) (up to___________years)Compensation means
___Annual compensation over highest___________years
___Other (specify)_________________________________________
________________________________________________________Offset for other benefits
______percent of social security benefits actually received
______percent of qualified retirement plan benefitsOther (describee.g., workers compensation, disability)
_________________________________________________________________
_________________________________________________________________Benefit payable at termination of employment prior to retirement
___No benefit
___Account balance (not applicable to salary continuation plan)
___Vested accrued benefit determined as follows__________________
_________________________________________________________________
Nonqualified Deferred Compensation, cont'd.
C. VESTING
Vesting Schedule
____Immediate 100 percent vesting
____Graduated schedule (specify)_______________________________________Forfeiture provisions
____None
____Forfeiture for___________________________________________________
_________________________________________________________________
D. DISABILITY BENEFIT
____disability treated like other termination of employment
or
____Special disability provisions____Full vesting
____Special benefit computation (specify)________________________
_________________________________________________________
____Service continues to accrue for purposes of this plan
Definition of disability_______________________________________
____________________________________________________________
E. BENEFIT PAYMENT
Options
___Lump sum (actuarially equivalent to)___________________________________
___Periodic payment options (specify)____________________________________
__________________________________________________________________Optional forms must be elected before____________________________________
__________________________________________________________________After benefits commence, payment option (cannot be changed) (can be changed or modified) (annually) (other__________) by election prior to ____________________________________________________________________
After benefits commence, future benefits are forfeited if ____________________________________________________________________
____________________________________________________________________
Nonqualified Deferred Compensation, cont'd.
F. DEATH BENEFITS
____Benefits forfeited at death
____Death benefit payable to named beneficiary or estate if no named beneficiary
____Other__________________________________________________________
_______________________________________________________________Amount of Benefit
____Amount that would have been paid to employee at termination of employment
____Face amount of insurance contracts (describe contracts)___________________
____Other__________________________________________________________
G. FINANCING
___Formal funding (specify)____________________________________________
____________________________________________________________________
___Informal financing
___Insurance contracts (specify)_________________________________
_____________________________________________________________________
___Rabbi trust (describe)_______________________________________
______________________________________________________________Third-party guarantees, surety bonds, etc. (describe)
_____________________________________________________________
___________________________________________________________
______________________________________________________________No financing arrangement
APPENDIX B
ALTERNATIVE REPORTING AND DISCLOSURE STATEMENT FOR UNFUNDED NONQUALIFIED DEFERRED-COMPENSATION PLANS FOR CERTAIN SELECTED EMPLOYEES
To: Top Hat Exemption
Pension and Welfare Benefits Administration
Room N-5644
U. S. Department of Labor
200 Constitution Avenue, N.W.
Washington, D.C. 20210
In compliance with the requirements of the alternative method of reporting and disclosure under Part 1 of Title I of the Employee Retirement Income Security Act of 1974 for unfunded or insured pension plans for a select group of management or highly compensated employees, specified in Department of Labor Regulations, 29 C.F.R. Sec. 2520.104-23, the following information is provided by the undersigned employer.
Name and Address of Employer: ____________________________
___________________________________________________
___________________________________________________
Employer Identification Number: _____________________________
(Name of employer) maintains a plan (or plans) primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.
Number of Plans and Participants in Each Plan:
___________Plan covering___________employees (or)
___________Plans covering___________,___________, and
___________employees; (respectively)
Dated_____________________, 19___
(Name of Employer)
By______________________________________________________
Plan Administrator
APPENDIX C
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TABLE 1
Years until Break Even for Deferred Compensation Assuming Tax Rates Will Increase and
Current Rate is 33 Percent (Combined State and Federal)
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Current Tax Rate | 33% | 33% | 33% | 33% | 33% | |
Projected Tax Rate | 35% | 40% | 45% | 50% | 55% | |
Number of Years to Break Even *number of years = natural log of (new tax rate/current tax rate) natural log of (1 + interest rate) |
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Before-tax Return on Plan Investments |
3% | 1.99 | 6.51 | 10.49 | 14.06 | 17.28 |
4% | 1.50 | 4.90 | 7.91 | 10.59 | 13.02 | |
5% | 1.21 | 3.94 | 6.36 | 8.52 | 10.47 | |
6% | 1.01 | 3.30 | 5.32 | 7.13 | 8.77 | |
7% | 0.87 | 2.84 | 4.58 | 6.14 | 7.55 | |
8% | 0.76 | 2.50 | 4.03 | 5.40 | 6.64 | |
9% | 0.68 | 2.23 | 3.60 | 4.82 | 5.93 | |
10% | 0.62 | 2.02 | 3.25 | 4.36 | 5.36 | |
11% | 0.56 | 1.84 | 2.97 | 3.98 | 4.89 | |
12% | 0.52 | 1.70 | 2.74 | 3.67 | 4.51 | |
13% | 0.48 | 1.57 | 2.54 | 3.40 | 4.18 |
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TABLE 2
Years until Break Even for Deferred Compensation Assuming Tax Rates Will Increase and
Current Rate is 28 Percent
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Current Tax Rate | 28% | 28% | 28% | 28% | 28% | |
Projected Tax Rate | 35% | 40% | 45% | 50% | 55% | |
Number of Years to Break Even | ||||||
Before-tax Return on Plan Investments |
3% | 7.55 | 12.07 | 16.05 | 19.62 | 22.84 |
4% | 5.69 | 9.09 | 12.10 | 14.78 | 17.21 | |
5% | 4.57 | 7.31 | 9.72 | 11.88 | 13.84 | |
6% | 3.83 | 6.12 | 8.14 | 9.95 | 11.59 | |
7% | 3.30 | 5.27 | 7.01 | 8.57 | 9.98 | |
8% | 2.90 | 4.63 | 6.16 | 7.53 | 8.77 | |
9% | 2.59 | 4.14 | 5.51 | 6.73 | 7.83 | |
10% | 2.34 | 3.74 | 4.98 | 6.08 | 7.08 | |
11% | 2.14 | 3.42 | 4.55 | 5.56 | 6.47 | |
12% | 1.97 | 3.15 | 4.19 | 5.12 | 5.96 | |
13% | 1.83 | 2.92 | 3.88 | 4.74 | 5.52 |
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