NONQUALIFIED DEFERRED-COMPENSATION PLANS

Kenn B. Tacchino, JD*

 I. AN OVERVIEW OF NONQUALIFIED PLANS
Up to this point the emphasis has been on the use of a tax-sheltered qualified plan to meet the needs of the small business and the small-business owner. However, a second lucrative market is open to financial services professionals who are servicing the retirement needs of the business and the business owner. This market is the nonqualified plan market, which includes nonqualified deferred-compensation plans and executive-bonus plans. These plans help the business owner and selected employees save for retirement without being subject to the requirements that apply to qualified plans. As a trade-off for allowing the employer complete discretion in plan design and in choosing which employees will be covered by the plan, the employer loses the central advantage of a qualified plan—that is, the ability to make a before-tax contribution on the employee’s behalf that is simultaneously deductible to the business. Instead, the employer is entitled to an immediate deduction only if the employee is currently taxed, or conversely, the employee may defer tax only if the employer’s deduction is deferred.

• 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. What’s 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 client’s 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. Shombert’s 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 today’s 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 Rs—recruiting, retaining, and retiring. That’s 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.

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 employer’s objective in installing the plan can be satisfied by choosing the proper forfeiture provision. The tax implications which we’ll 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. Let’s 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 client’s 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

• should not contain any formal schedule of duties or assignments for the former executive
• should not allow the former employer to exercise the direction and control that under common-law rules establishes an employer- employee relationship (for example, the employer must not supervise the former executive in the performance of advisory services)
• should not establish a work schedule that requires the employer to give permission for the former executive to be absent from work

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 can’t 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 circumstances—particularly the type of industry involved—will 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:

• A supplemental executive-retirement plan can be set up to protect selected executives against involuntary termination if the company changes hands, by structuring the SERP to pay out or increase benefits under this contingency (a so-called takeover trigger—the executive’s alternative if a golden parachute does not exist.)
• Nonqualified plans can be designed to protect your client against involuntary termination because of declining earnings or change in control of the business by providing immediate vesting in nonqualified benefits if either of these contingencies occurs. This provision is called an insolvency trigger. If the plan with an insolvency trigger is properly structured, the executive will be taxed only when the triggering event occurs. At the time your client will willingly trade off the tax consequences of immediate taxation for the security of receiving his or her benefits. The challenge, however, is to design the nonqualified plan so that the existence of an insolvency trigger does not trigger immediate taxation. If a rabbi trust is used (see pages 2.21-2.23), this probably cannot be done. If the plan is completely unfunded, however, the insolvency trigger can be incorporated into the plan.
• Nonqualified plans can be designed to allow withdrawals prior to termination in cases of financial hardship. When this is desired the plan should spell out the exact circumstances that constitute a hardship, or it should provide for an independent third party to make the determination. By doing this your client can avoid adverse tax consequences.
• Your client should ask for a binding-arbitration clause in case of a dispute. This will help to save litigation costs.

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 designer’s 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. Here’s 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 employer’s objectives. This may mean supplementing the employer’s qualified plan or avoiding duplication in benefits by the coordination of all benefits received under the employer’s 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 executive’s 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 doesn’t 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 occurs—in 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 employer’s personnel objectives determine whether a "young" retirement age (50–62) or an "old" retirement age (65–70) 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.

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 executive’s 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 policy’s 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.

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 executive’s 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. 60–31 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. What’s 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 corporation’s 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 don’t want to risk their retirement on an unsecured promise to pay. Because executives want the best of both worlds—as much security as possible without triggering immediate taxation—many 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 equation—the employer’s 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 employee’s 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 employer’s 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 congregation’s 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 congregation’s 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 congregation’s 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 IRS’s 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 employer’s net worth falls below a certain point. (The IRS fears that accelerating benefit payments when the employer’s 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 employer’s 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 executive’s 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 employee’s 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. What’s 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 employer’s 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 employer’s part to finance promises under a nonqualified plan. Unlike a rabbi trust, however, funds held in a secular trust cannot be reached by the employer’s 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 trusts—up 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 executive’s current tax liability.

2. Secular Trusts: The Employer’s Perspective
From the employer’s 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 Executive’s 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 benefits—thus providing the executive with an indirect means of securing the employer’s 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.

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 it’s 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.

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 executive’s 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 won’t 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 employer’s tax adviser should be consulted to determine whether the alternative minimum tax will apply.

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