Arrowsmlft.gif (338 bytes)Previous Table of Contents NextArrowsmrt.gif (337 bytes)

LIFE INSURANCE IN NONQUALIFIED
DEFERRED-COMPENSATION PLANS

Advantages of Nonqualified Plans

A nonqualified deferred-compensation plan is an employer-provided retirement plan that does not meet the qualified plan rules. The nonqualified approach may be advantageous for a closely held corporation if it has the following objectives:

 

Types of Nonqualified Deferred-Compensation Plans
and Salary Reduction Arrangements

A salary reduction plan, also called an in lieu of plan, is an agreement between the employer and the participating employee either to reduce the employee�s salary or to defer an anticipated bonus and provide that such amounts be received in future tax years. These plans defer compensation that the employee would otherwise receive in cash, and they generally provide an investment return on the amounts deferred. One type of salary reduction plan, the top-hat plan, is a deferred-compensation plan for a select group of management or highly compensated employees in which the participant elects to defer current salary amounts to provide benefits at his or her retirement.

As discussed later, the taxation for such compensation will be deferred only if specific requirements are met. Salary reduction arrangements have decreased in popularity with the reduction of individual income tax rates.

Salary Continuation Plans

Most nonqualified plans fit into the broad category of salary continuation plans. Salary continuation plans can be designed to provide deferred-compensation benefits at the participant�s death, disability, and/or retirement. These arrangements have no current cash option available to the employee. The death or disability benefits are a percentage of the employee�s compensation and are provided to the employee or his or her designated beneficiary. (Disability salary continuation plans are covered in more detail in chapter 7.)

Salary continuation plans designed to provide retirement benefits can be categorized as excess-benefit plans or supplemental executive retirement plans (SERPs). An excess-benefit plan is a retirement plan in which selected participants, generally shareholder-employees and key executives, will receive retirement benefits in excess of those possible under the qualified plan limitations. That is, these plans provide (1) benefits in excess of the 100-percent-of-salary or $130,000 (for 1998) limitation in defined-benefit plans or (2) contributions in excess of the 25-percent-of-salary or $30,000 limitation in defined-contribution plans.

A SERP generally complements the qualified plan benefits for a selected group of participants. SERPs provide benefits for a corporation�s key executives and, unlike excess-benefit plans, supplement the retirement benefits at levels both above and below the qualified plan limitations. These plans will meet the goal of providing discriminatory benefits to shareholder-employees and other key executives. A closely held business can use a salary continuation plan to provide a substantial retirement, disability, and death benefit to the owners without necessitating the costly inclusion of rank-and-file employees.

Death-Benefit-Only (DBO) Plans

DBO plans are nonqualified plans designed to provide death benefits to a participant�s heirs. While DBO plans can provide a lump sum to the participant�s survivors, they generally pay installment benefits at the participant�s death. Since a DBO is a nonqualified plan, participation can be based on discriminatory factors. Survivor benefits are taxable as ordinary income to the recipient-survivor and are deductible by the corporation when paid to the survivors. The DBO plan benefits will be included in the participant�s estate unless (1) the decedent participated in no other nonqualified deferred-compensation plan with the employer that provided living benefits and (2) the participant did not reserve the right to change the beneficiary initially designated. If estate inclusion is a problem, the employer and employee should consider a Sec. 162 bonus plan or a split-dollar agreement (both discussed earlier) with the use of an irrevocable life insurance trust (ILIT).

Requirements for Income Tax Deferral in Nonqualified
Deferred-Compensation Plans

The taxation of nonqualified deferred-compensation benefits links the timing of the corporation�s deduction to the participant�s receipt of benefits. The key to success is deferring the income tax liability until the receipt of the benefit. To avoid current taxation on the deferred benefit, the employee cannot (1) be in constructive receipt of the income or (2) receive a current economic benefit from the deferred amounts.

To avoid constructive receipt the employee�s receipt of the income must be

 

 

Any economic benefit currently received from the nonqualified plan is immediately taxable to the participant even if the benefit is not constructively received. The participant receives an economic benefit if funds are vested or set aside for the employee outside the claims of general corporate creditors. Under such circumstances the economic benefit exists because the employee has a cash equivalency in the form of a secured and funded promise.

An economic benefit also exists if the funds are placed in an irrevocable trust on behalf of the participant. The corpus of the trust will be a cash equivalent because the employer has given up control of the assets in the plan. To avoid an economic benefit, the plan assets must be subject to substantial risk of forfeiture. The assets can be set aside in (1) a reserve account held by the employer, (2) a revocable trust, or (3) a rabbi trust. Under a reserve account or revocable trust there is no economic benefit because all plan funds are subject to the employer�s control. In a rabbi trust, because the assets are available to the general creditors of the corporation by the terms of the trust, no economic benefit exists.

Financing the Employer�s Obligation in Nonqualified
Deferred-Compensation Plan with Life Insurance

The employer can finance its obligation in a nonqualified plan through corporate-owned life insurance. This type of financing is attractive since life insurance as a corporate asset is a good match for the type of liabilities created by the various nonqualified arrangements. The accumulation in an ordinary life insurance policy or the benefits of an annuity policy can be useful in the participant�s retirement years to provide for any salary continuation benefits offered by the plan. Of course, the primary benefit of the life insurance financing is its ability to meet the employer�s death benefit obligation should the participant die prematurely. The life insurance financing is particularly appropriate to provide benefits in a DBO plan.

Nonqualified plan policies are owned by and payable to the employer. As such, they avoid the constructive-receipt or economic-benefit problems because the general creditors have access to the funding policies. The premiums are, of course, nondeductible; however, the cash surrender value builds up tax free, and the proceeds will be nontaxable when received (the corporate alternative minimum tax [AMT], discussed later in this chapter, may create an alternative tax liability under these circumstances). The corporation receives a deduction when the benefits are actually paid to the participant.

For quick reference, table 12-4 shows the applications of the various types of executive life insurance plans discussed in this chapter.

Arrowsmlft.gif (338 bytes)Previous TopArrowsm.gif (337 bytes) NextArrowsmrt.gif (337 bytes)