Many businesses today provide their employees with qualified benefits of various types. "Qualified" refers to plans established to provide employee benefits that qualify forspecial tax treatment according to the tax code. While this text does not address the specific requirements of qualified plans, we have briefly mentioned that employers must deal with issues ofnondiscrimination, funding limits and the requirements of the Employee Retirement income Security Act (ERISA). While there are significant benefits for both employers and employees in providing and receiving qualified benefits, employers have a great deal more flexibility in the use of nonqualified benefits.
Nonqualified benefits are simply those that do not meet the legal requirements for receiving special tax advantages. Key person insurance and split-dollar life insurance, for example, are nonqualified benefits. Besides avoiding the possibility of tax law violations and significant reporting requirements, the use of nonqualified arrangements allows employers to legally discriminate among employees in order to provide special "rewards" to those who are most valuable to the business.
Even when an employer has some type of qualified plan in place for all employees on a nondiscriminatory basis, the employer might want to provide additional benefits to key people. Nonqualified plans allow the employer to do so, as you've already seen in the key person and split dollar discussions.
In this chapter, we'll explore still another such benefit, commonly known as nonqualified deferred compensation. Like the other benefits we've discussed, deferred compensation plans can assist the employer in recruiting, hiring and retaining valuable employees. Although not "qualified," these plans do have some attractive tax features for both employers and employees if the plans follow certain rules. Furthermore, the limits on compensation that may be considered for qualified pension plan contribution purposes as imposed by OBRA '93 have made nonqualified deferred compensation arrangements even more attractive for key employees.
The term-deferred compensation is descriptive: Some part of the compensation that an employee would otherwise be entitled to receive is deferred until a future date. There are two basic reasons an employee would defer compensation:
1. To allow an individual with current high income to defer part of taxable income to the future, hoping the income tax effects will be less severe.
2. To allow an individual to amass a greater amount of retirement income by having part of current compensation deferred until retirement.
The financial situation of any given individual determines which reason is primary and which is secondary. However, for the very highly compensated, reducing current income taxation is generally the impetus. Individuals with more modest current incomes are more likely, on the other hand, to find the increased retirement income possibilities a greater incentive for deferring income.
Whatever the primary goal, the actual mechanics of deferring compensation can take different forms.
Some practitioners believe all parties involved should very carefully weigh the value of deferred compensation arrangements in light of many economic uncertainties. First of all, Congress constantly tinkers with tax laws in order to close loopholes and find methods to raise additional taxes. Secondly, no one can predict positively what will occur in the distant future with economic factors such as inflation and interest rates. However, there are significant differences of opinion since others in the benefits field believe OBRA '93 has improved the market for nonqualified deferred compensation plans. You'll see that there are some risks associated with deferring compensation, regardless of the tax and economic climates. However, deferred compensation arrangements currently provide benefits that are attractive to employers and employees alike. Most importantly from your viewpoint, you can offer a way to reduce the financial risks inherent in deferred compensation arrangements through life insurance funding.
Other terms associated with deferred compensation (and sometimes used as synonyms) are salary reduction and salary continuation plans. Both are methods for deferring compensation into the future.
A salary reduction form of deferral is sometimes called "pure" deferred compensation, presumably because it most accurately reflects the deferral of current compensation. Under such a plan, the employee typically agrees to have his or her salary reduced currently in order to defer part of compensation until a future date. Instead of actually taking a reduction in current salary, the employee could alternatively agree to a "reduction" by means of giving up bonuses or pay raises the employee would otherwise receive.
Let's look at an example of how salary reduction works in its most straightforward form the employee allows the employer to reduce the amount of current salary actually paid. Employee Chastain has just been hired by ABC Corporation at an annual salary of $250,000. ABC has offered and Chastain has accepted an arrangement under which Chastain will defer receiving 20% of his annual salary until he retires. For Chastain's first year of employment, he will defer 20% of $250,000 or $50,000. His taxable income from ABC, then, will be $200,000 instead of $250,000.
Even if the salary reduction doesn't result in a lower tax bracket, at these rates the dollar tax savings can still be significant.
Of course, no one knows what individual federal income tax rates will be in the future, but one goal of deferred compensation plans is to pay out the deferred compensation in such a way that the tax bite is smaller. Typically, the compensation that was deferred will be paid in installments to the employee, rather than in a lump sum, since one large payment could trigger the highest tax rate.
A second type of deferred compensation plan is salary continuation. Unlike salary reduction methods, the employee's salary is not reduced currently. Instead, the employer agrees to continue paying the employee a salary in the future, generally after retirement from the business (Deferred Compensation Agreement, "DCA"). Normally, the salary continued will not be equal to the full current salary or the salary just before retirement, but will be some agreed-upon percentage-perhaps up to 50%. The amount is not a legal issue, but one that must satisfy the employer, the employee and, in the case of a corporation, the board of directors. Furthermore, you'll learn that the IRS has some strong opinions about what represents "reasonable compensation” for an executive. Whether or not compensation is considered reasonable can affect the tax outcomes of deferred compensation plans.
For either of the deferral methods the basic principles are essentially the same from the employer's viewpoint. The employer wants to provide a special reward for an important employee and eventually gain a tax advantage for the business by doing so. Additionally, employers sometimes like these plans because the business is expected to be in a better financial position to pay the additional compensation in the future, rather than currently.
Employees, too, may benefit in essentially the same way regardless of which type of deferral is used. Current taxable income is reduced and extra retirement income will be available in the future. Furthermore, many employers provide not only for retirement income, but also write the agreement to allow benefits to pay benefits to the employee's survivors if the employee dies before receiving any or all of the deferred compensation.
The “top-hat” plan is the most common approach for an ERISA exemption. A DCA that is “un-funded and is maintained by an employer primarily … for a select group of management or highly compensated employees” is exempted from most Title I requirements. The Department of Labor takes the position (that the word “primarily” modifies the type of benefit being provided under the plan and not the participants, meaning that a top-hat plan may not cover any employees other than management or highly compensated employees.
A top-hat plan is, however, subject to reporting and disclosure provisions. Labor Regulations allows for an abbreviated compliance procedure. Failure to take advantage of this procedure will require an employer to file an Annual Return/Report of Employee Benefit Plan, with requisite penalties for noncompliance.
An unfunded top-hat plan for ERISA purposes generally conforms to an unfunded plan for tax purposes, as discussed below. Determining what constitutes a “select group of management or highly compensated employees” is more problematic. The Department of Labor (DOL) has formulated no definitive standard, but has indicated that the requisite top-hat group should be limited to individuals who, by virtue of their position or compensation level, have the ability to affect or substantially influence the design and operation of the DCA. Some tax advisors and courts have equated highly compensated employees for ERISA purposes with highly compensated employees under the IRC (section 414(q)) definition, even though the preamble to the section 414(q) regulation states that the definition should not be extrapolated for ERISA purposes.
Even though the SEC has not formally clarified when DCAs are subject to security registration requirements, as long as the plan is a true top-hat plan, concerns about registration of the plan as a security should be mitigated under the private sale exemption. The SEC has issued a number of “no-action” letters with regard to DCAs.
A variation on deferred compensation plans is the excess benefit plan, which is not exactly the same as a traditional deferred compensation plan, even though their purposes are similar-to provide additional retirement income.
Excess benefit plan. ERISA section 3(36) defines an excess benefit plan as a DCA maintained by an employer to provide benefits for certain employees in excess of the IRC section 415 limitations for qualified plans. Irrespective of whether the plan is funded or nonfunded, ERISA’s participation and vesting standards are not applicable. If the plan is funded, however, many other Title I requirements are applicable. A supplemental DCA that is structured (as is commonly the case) to make up for a limitation on qualified plan benefits due to the constraints of both section 415 and 401(a)(17) may not qualify as an ERISA excess benefit plan.
The primary difference is those excess benefit plans, if properly developed, need not meet any of the ERISA requirements that cause so many compliance problems for employers. While nonqualified deferred compensation plans are generally exempt from ERISA requirements, employers must be very careful to ensure the plans do not fail in some way that requires the employer to meet ERISA rules.
Excess benefit plans are designed specifically to provide additional benefits for certain employees beyond the dollar limits imposed on qualified pension and profit-sharing plans. For example, under one type of qualified plan, the employee's annual benefit after retirement may be no more than $118,800 (in 1994, but adjusted annually for inflation). Thus, an employer who wants to pay, in 1994, a retirement benefit of $150,000 annually to a valued executive is simply not permitted to do so legally under a qualified plan. An excess benefit plan, on the other hand, can be used to provide the difference of $31,200 to equal the desired benefit.
Though excess benefit plans are generally subject to the same taxation rules as deferred compensation plans, excess benefit plans differfrom deferred compensation plans in:
1. Their stated purpose, which is to provide benefits over and above qualified plan limits (rather than to defer income for tax purposes) and
2. Their exemption from all ERISA considerations providedthe plan is put together correctly.
The parties to a deferred compensation agreement have an option about whether the plan will be funded or unfunded. A funded plan is one for which the employer has established, specifically for the employee involved, an account to receive funds that will pay the deferred compensation in the future. This account could be in the form of an irrevocable trust, an escrow account or some other means that removes the funds from availability to the employer or the employer's creditors. When a deferred compensation plan is funded, the employee can be fairly secure in the knowledge that money backs up the employer's promise to pay in the future. Unfortunately, there's a price topay for this security-taxation.
When a deferred compensation plan is formally funded, the tax code requires the employee to be taxed on the employer's contributions when the employee's right to receive the funds becomesnonforfeitable or substantially vested. To be substantially vested, the employee must have a right to transfer thefunds without concern about a substantial risk of or forfeiture. In other words, if the employee has an absolute right to the funds, they become immediately taxable whether or not the employee actually receives them. Numerous tax rulings and court cases have addressed the issue of what represents a substantial risk of forfeiture, but this is generally determined on a case-by-case basis since whether such a risk exists is, apparently, not easy to decide.
The rule that controls taxation based on the employee's right to receive funds is called the doctrine of constructive receipt, which holds that taxation will occur currently if an individual could have received a monetary benefit, whether or not the individual actually did receive it. Generally, amounts are considered constructively received if they are credited to the individual's account or set aside in some way specifically for that individual. In other words, if the money is available to the individual on demand, the money is constructively received and, therefore, taxable currently.
The constructive receipt doctrine requires a taxpayer to currently include in gross income compensation that the taxpayer does not actually possess but that was under his dominion and control and that could have been readily obtained without incurring any substantial penalty or restriction.
The IRS had often but unsuccessfully attempted to invoke the constructive receipt doctrine in the context of a DCA. In Revenue Ruling 60-31, the IRS finally conceded that “a mere promise to pay [a DCA benefit], not represented by notes or secured in any way, is not regarded as a receipt of income within the intendment of the cash receipts and disbursement method.” A DCA payable only out of the employer’s general assets will not result in a taxable event to the employee until payment is received.
The key to avoiding application of the constructive receipt doctrine is to contractually enter into the DCA before the deferred income is earned. As noted above, this requirement has been codified in the new IRC section 409A.
The IRS will not issue advance rulings on the tax consequences of a controlling shareholder/employee participating in a DCA. When the controlling shareholder’s participation is as an employee (rather than a shareholder), the courts, with acknowledgement from the IRS, have respected the DCA arrangement.
A simple example is the interest paid on a bank savings account. The bank credits the interest to the account and the interest is taxed in the same year. The account holder might not take or use the interest, but because he or she has an unreserved right to do so, the interest is taxed.
Also, to avoid constructive receipt, there must be substantial limitations imposed on the individual's right to access the funds. For another easy example, consider a bank certificate of deposit (CD). A taxpayer has a two-year CD on which the bank pays interest periodically during the two years. While the individual may take the money, including the interest, out of the CD before the two-year period ends, there is a substantial penalty for doing so. Because this is considered a substantial limitation on access to the funds, taxation of the interest does not occur currently as long as the funds are left on deposit. In this case, the funds are not constructively received. At the end of the two-year period, the interest becomes available without restrictions to the taxpayer, who at that time must pay taxes on it.
These same general rules apply to deferred compensation arrangements; substantial limitations must be in place to restrict the employee's access to the funds. Otherwise, the funds will be considered constructively received and immediately taxable. The IRS describes methods that can be used to avoid constructive receipt under deferred compensation plans. The deferral agreement between the employer and the employee should include provisions that:
1. The deferral being made by the employee is irrevocable. Once the employee agrees to a salary reduction or the employee agrees to pay salary continuation, the decision may not be revoked.
2. The choice to defer income is being made before the employee actually earns the compensation to be deferred. If, however, the compensation has already been earned when the agreement is entered into, the deferred compensation plan must include nonforfeiture provisions that place the employee at substantial risk of losing the benefits.
3. The agreement must include a specific period during which the compensation will be deferred before the employee is eligible to receive it. The period could be expressed, for example, as 15 years or until retirement or termination of employment.
Whether or not the employee receives a taxable economic benefit is also a concern with a funded deferred compensation plan. As stated earlier, an economic benefit does not necessarily mean the employee receives cash only that the individual receives something that has an economic value. If the employer's contributions are (1) dedicated solely for the employee's benefits, (2) are irrevocable and (3) are available to the employee without limitations, the IRS says the employee has received an economic benefit. Again, then, the funds become immediately taxable as being constructively received.
The economic benefit doctrine would currently tax the value of property transferred by an employer to fund a DCA to the extent that the property transferred was legally set aside from the claims of creditors of the employer (e.g., under a secular trust or escrow arrangement) for the benefit of the employee under the DCA. This would be true even though the benefited employee has no current actual or constructive access to the money or property funding the trust.
A number of “informal funding” techniques have developed that do not invoke the economic benefit doctrine. The employer’s obligation may be financed through life insurance or annuity contracts. The policy must be the sole property of the employer and constitute a general asset subject to creditor claims.
Several trust formats may be used for the informal funding and accepted by the IRS, but the primary trust that explicitly seems to have the approval of the IRS is called the Rabbi Trust, and this is discussed later in the "Trusts" section.
Another problem with funded plans is that they often protect the deferred compensation from the employer's general creditors since the funds are deposited strictly for the use of the employee in a trust or escrow account. In other words, the employee is not at risk of losing the funds in the event the employer experiences financial problems that cause creditors to demand immediate repayment. This protection for the employee has caused problems with the substantial risk of forfeiture requirement necessary to avoid immediate taxation.
An employee may designate a nonbinding preference regarding the investment of employer assets used to finance a DCA, but the employee remains an unsecured creditor of the employer. The unsecured contractual guarantee of a third party has been found not to result in a currently taxable economic benefit. Examples of this, (found in PLRs 9040050 and 8741078, Berry v. United States, 760 F. 2d 85 (4th Cir. 1985)), would be a guarantee by a parent of a subsidiary’s deferred compensation promise, or by the team owner of the employer-team’s promise to pay a ballplayer’s deferred compensation.
In addition to the possibility that the employee will have to pay taxes on the funds before they are actually received, there is yet another disadvantage to a funded deferred comp plan. Funding causes the plan to fall under the regulation of the Employee Retirement Income Security Act (ERISA), which requires special fiduciary and vesting considerations and considerably more detailed reporting to the government. These requirements cause the nonqualified plan to be treated much like a qualified plan but without the tax advantages. Generally, this is one of the problems employers are attempting to avoid when they offer nonqualified benefits.
A DCA (other than a true excess benefit plan) formally funded by a trust or other funding vehicle must comply with minimum coverage, participation, and other burdensome Title I ERISA requirements.
On the other hand, the tax code allows deferred compensation plans to be generally exempt from ERISA requirements provided the plans are both:
1. Unfunded and
2. The major purpose is to provide deferred compensation for a selected group of management personnel and/or highly compensated employees.
When the plan meets these conditions, the only ERISA requirements with which the employer must comply are notifying the Department of Labor that the plan exists and providing some basic information about the plan.
For the reasons described above, most deferred compensation plans are unfunded, which means no formal method is used to set aside the money specifically to pay deferred benefits. Under an unfunded plan, one of two situations exists: (1) literally no fund exists to receive the deferred compensation or (2) a fund exists, but remains completely available to the employer's creditors, rather than being earmarked specifically for the employee.
Under either of these circumstances, with no funding guaranteed, it seems the employee has no security whatsoever about whether the deferred benefits will be available in the future. Indeed, with an unfunded deferred compensation plan there is a risk that the employer will either be unable or unwilling to pay the promised benefits when the time comes. Of course, the employee has a contractual agreement with the employer, but, like any other contract, it is only as secure as whatever backs it up. Therefore, employees are not likely to agree to an unfunded deferred compensation agreement with employers whose businesses do not have a solid financial base.
Assuming, however, that the employer is financially solvent, there is a way to provide a measure of security for the employee without the formal funding that causes tax havoc. The tax laws permit a deferred compensation plan to be considered unfunded even when the plan is informally funded, thereby avoiding current taxation. Informal funding may occur in various ways, the most important of which—from your perspective—is through life insurance. Informal funding is the entree for the life insurance agent. The rest of this section, therefore, concentrates on unfunded plans that are informally funded through life insurance.
A recent publication started a brief but succinct informational on informal funding as:
" A number of 'informal funding' techniques have developed that do not invoke the economic benefit doctrine. The employer’s obligation may be financed through life insurance or annuity contracts. The policy must be the sole property of the employer and constitute a general asset subject to creditor claims."
Life insurance is the single most optimum solution to securing deferred compensation for the employee on an unfunded basis. When other methods are used, such as interest on investments, and the employee dies before the funds have grown adequately, the employer maybe unable to fulfill its obligation. The result is that the employee's survivors receive little or nothing of the deferred compensation that the employee “earned”. On the other hand, with life insurance on the employee's life payable to the employer, the employee's death results in an immediate payment of death proceeds to the employer, who may then use the proceeds to fulfill the deferred compensation agreement by paying benefits to the insured's estate or survivors.
It is generally accepted by the IRS that a deferred compensation plan informally funded by life insurance does not cause a plan to be considered funded for purposes of taxation, provided all of these conditions exist:
1. The employee has no interest or rights in the policy under which the employee is the insured person.
2. The policy is the sole property of the employer, who is both owner and beneficiary.
3. The policy's values remain, like any other business asset, subject to claims of the employer's general creditors.
Therefore, the life insurance policy may not be payable to the personal beneficiaries ofthe insured, the employer must be the beneficiary in order to avoid current taxation. This status also ensures that the insured employee is not taxable on any economic benefit received as the result of premium payments the employer makes.
For the employer, a life insurance policy purchased to informally fund the deferred compensation can provide additional benefits. During the period the policy is in force, the cash values grow without current taxation, just as any cash value life insurance policy does. The employer, as policy owner, may borrow from the cash values.
Furthermore, employers are relieved of the burden of finding other means to eventually pay the deferred compensation. Employers have the assurance that as long as they pay the policy premiums, the insurance will be available to pay the benefits promised in the future. The cash values and the death benefit are guaranteed to be paid, unlike some investment vehicles, which are riskier.
A number of other benefits are available to the employer when the deferred compensation is finally paid, as discussed later.
A trust is a legal instrument that in order to be effective, must follow certain legal requirements. Obviously, when an individual or business uses a trust to accomplish its purpose(s), an attorney must be involved. A trust is an arrangement under which one person or institution holds legal title to real or personal property for the benefit of another person or persons. This arrangement nearly always takes the form of a written document which sets out the rights and responsibilities of all parties. A trust is a valuable instrument used to hold property for the benefits of other persons, now or in the future, and often avoid some taxes that otherwise would have to be paid.
An irrevocable trust may not be changed or revoked after it is created, and its usual purpose is to remove property and its future income and appreciation from the estate of the creator of the trust. An irrevocable trust can also be used to protect assets given to the beneficiary's creditors.
Property placed in an irrevocable trust will not be removed from the estate if the owner retains certain interests or powers in the trust, such as a provision that the person will receive the income from the trust for the rest of their life. Further, gift taxes will apply when the owner relinquishes ownership of the property to the extent that control over the property has been relinquished.
A revocable trust (or living trust) is created during the individual's lifetime and it may be amended or revoked at any time. The trust document provides instructions as to how the assets under the trust are to be managed at anytime. However, since the trust is set up so that the ownership of the property can be altered or changed, at any time and for any reason, the person has not committed himself to anything, and any income and deductions attributable to the property in the trust will be taxed as individual income. However, the person will not be liable for any gift tax when the assets are contributed to the trust.
Congress enacted special rules that allow a method of making gifts to minors that qualify for the annual exclusion. A gift to such qualifying trust established for an individual under the age of 21 will be considered as a gift of a present interest and qualifies for the $12,000 annual gift tax exclusion. The trust must stipulate that the gift property and its income may be expended for the benefit of the beneficiary before reaching age 21 and to the extent not being expended, will pass to the beneficiary upon reaching age 21. If the child dies prior to reaching age 21, the funds must be payable under a general power of appointment.
Crummey Trust and the Totten Trust have been discussed early in the section on gift taxes.
One of the most popular means used in recent years to informally provide an unfunded deferred compensation plan is a so-called Rabbi Trust. The terminology comes from the first such IRS-approved trust, which happened to be established for a rabbi. Revenue Procedure 92-64 further clarified the acceptable rules for Rabbi Trusts along with a model trust document and the required features to avoid constructive receipt of income to the employee.
An example of the use of a Rabbi Trust is where an employee receives compensation, the taxation of which is deferrable as a non-qualified deferred compensation plan.
The Rabbi trust may also be used when one business purchases another business but wants to set aside part of the purchase price and defer its payment as well as the taxability to the payee upon the satisfaction of conditions to which both parties agree.
A non-qualified deferred compensation plan is where current income of an employee is deferred but not taxable to the employee. The employer, however, sets aside the assets in a separate trust for the employee's future. Ordinarily, this would cause current inclusion into gross income even though the employer has yet to reduce the money to income because of the economic benefit theory doctrine. So the IRS allowed by private letter ruling that the trust would not result in income according to Section 83(a) of the Code if the assets of the trust were to the reach of the employer's general creditors. This is because until the employee is vested, he is under a substantial risk of forfeiture and under the Code and accompanying regulations, as such is not subject to current inclusion into gross income.
All non-qualified deferred-compensation plans must involve substantial risk of forfeiture or other methods of avoiding constructive receipt, such as conditioning payment upon performance of future conditions or service. The unique feature of the Rabbi trust is that the money placed in it is protected from changes of heart of the employer. Once placed in the trust, the money cannot be revoked by decisions of the employer. As long as the financial position of the employer is sound, the money is relatively protected.
When one business purchases another business, the purchasing business may want to set aside part of the purchase price and defer its payment to the payee upon the satisfaction of conditions to which both parties agree. A Rabbi trust may be used in this situation to defer the taxability to the payee of the deferred payments of the purchase price.
For the Rabbi trust to be successfully applied, there must be real risk of forfeiture upon the failure by the payee to fulfill the agreed upon conditions. If the condition is not impossible to fail, then constructive receipt may overcome the successful applications of the Rabbi trust.
The Rabbi trust allows the deferment of compensation whether employment income or the purchase price of a business acquisition and the absence of this would result in the taxability to the payee of the compensation not yet received by the payee. This would serve as a disincentive for deferring such payments.
By establishing such a trust, the employer provides some security for the employee because the trust generally is irrevocable the employer cannot dismantle it at will. Furthermore, the trust must be completely inaccessible to the employer's owners or management, now and forever, to qualify for this purpose. The trustee, who may not be the employer, is responsible for eventually paying the deferred compensation to the employee from the trust.
However, the trust secures the tax deferral on contributions for deferred compensation because the funds remain subject to claims of the employer's general creditors if the employer becomes insolvent or bankrupt. This means the trust could be depleted if it is raided by creditors of which the employee is now considered one, by the way. Nevertheless, the fact that such an informal funding method is available is much more attractive to employees. The trust eliminates the possibility that the employer might refuse to pay the deferred income, although the risk remains that the employer will be unable to use the trust for that purpose if the funds have been depleted by other creditors.
Because Rabbi Trusts have become so widely used, in 1992 the IRS developed a "model" Rabbi Trust document for use as a guide in drawing up the trust to informally fund nonqualified deferred compensation plans. If the trust is developed based on the model, the problems associated with funded plans should be eliminated.
The model includes all provisions required to establish an approved trust except one: that investment possibilities the trustee may pursue. Investment powers must be spelled out by the individuals involved in the trust agreement and the agreement must provide some discretionary powers to the trustee.
Somewhat contradictorily, the IRS requires the language of the model to be used verbatim, while at the same time allowing deviation as long as the different language is "not inconsistent" with the model language. In addition, the model suggests several alternatives for certain provisions, allowing the parties to select the one that meets their needs.
Life insurance policies may be used to provide the funds in a Rabbi Trust. The model provided by the IRS places three conditions on the trustee's powers when life insurance is used. The trustee may not:
1. Name any person other than the trust as beneficiary of the life insurance proceeds. (Remember that a "person" could be an unnatural person, such as a corporation, as opposed to a natural person, which is a human being—generally speaking...)
2. Assign the life insurance policy to any other person except a successor trustee (in the event the trustee resigns or is removed).
3. Lend to any person any amounts the trustee borrowed from the policy. However, one of the optional provisions in the model trust document permits the trustee to lend these amounts to the employer, so this arrangement could be included if desired.
The topic of a Rabbi Trust raises questions about other types of trusts to informally fund deferred compensation agreements. One type is called a secular trust, but it does not accomplish the same tax deferral as a Rabbi Trust. We mention it here essentially to warn you and your clients away from a secular trust when the employee's tax benefits are important factor in a deferred compensation arrangement, as they usually are.
Some employers have sought to allay employee fears about default in the event of bankruptcy by funding the non-qualified deferred compensation plan with a secular trust. A secular trust is an irrevocable trust created to fund non-qualified deferred compensation liabilities. Unlike a Rabbi Trust, a secular trust places funds outside the reach of creditors. Therefore, unless provisions are inserted creating a substantial risk of forfeiture, the employee is currently taxable as a result of contributions to the trust. Correspondingly, the employer is able to deduct contributions to the trust as they are made. Because the employee is taxed immediately on deferred amounts, future payouts of the principal amounts will be tax-free.
Since the employee has an interest in the trust, the secular trust is considered "funded" for ERISA purposes. In addition, because the employee has a vested interest in the trust, it will not become property of the company's creditors during a bankruptcy situation. This protects employees from an employer's bankruptcy because the secular trust represents an irrevocable transfer of assets that cannot be reached by an employer's creditors. Unfortunately, because of that stipulation, amounts set aside in a secular trust are taxable to the employees in the year the amounts are placed in the trust. Thus, employees must pay current taxes on amounts set aside in a secular trust, even though they do not receive this money until retirement.
A secular trust can be beneficial to the employee who objects to risking forfeiture of deferred amounts. These amounts are, after all, part of the employee's current compensation. It may make little sense to defer that compensation if its ultimate receipt is subject to new risks. To take care of the tax cost, the plan may provide for immediate distribution from the trust of sufficient funds to cover the employee's tax costs. Some companies gross up the deferred amounts to cover all or part of the tax costs.
Secular trusts are interesting and agents working in the business area should be at least familiar with the term, however rarely have such trusts been implemented. While the benefit security aspects of a secular trust are attractive, the cost is substantial. To offset to the effects of adverse taxation, many companies make "gross up" payments to their executives. These costs are often material, and may need to be disclosed in the company's proxy report. For that reason, they tend not to be popular with shareholders. The trust's earnings are potentially subject to double taxation: once at the trust level, and again when distributed to the employee.
Another method to protect employee interests is a springing trust. A springing trust is the consequence of an unfunded non-qualified deferred compensation plan containing a provision that, if some event such as a change in ownership or effective control of the company occurs, the company is required to establish a Rabbi Trust to hold the deferred amounts. A variation of the springing trust is the "rabbicular trust".
More sophisticated planners seeking the best of both worlds have developed a hybrid, the "rabbicular trust," under which a Rabbi Trust converts to a secular trust (and becomes taxable) upon the occurrence of an event signaling financial difficulty for the employer (short of bankruptcy), such as a stipulated decline in debt-equity ratios, net worth, gross sales, earnings per share, etc., and when the event occurs, the trust becomes a Secular trust and the executive is given the right to withdraw benefits.
The rabbicular trust can protect against:
In addition to these changes, a "call" is another tool that executives might wish to consider in order to help protect their investments. A call allows the employee to receive their investments at any time. For example, if you, as the investor, feel that your non-qualified deferred compensation is at risk, you may than collect your compensation immediately. However, there is a downside to a call. Typically, the executive will incur a penalty upon exercising a call of a benefit. The penalty may be a percentage of the total compensation withdrawn.
The objective is to (1) protect the assets from the claims of the employer's creditors if events occur which make insolvency likely, and (2) to take advantage of the tax deferral and ERISA exemptions until that time. However, federal bankruptcy laws permit the bankruptcy Trustee to reclaim any transfer made within ninety (90) days of the employer's bankruptcy (or within one (1) year for transfers to insiders). A rabbicular trust must be designed very carefully to ensure that it accomplishes the desired tax deferral without compromising the security of the benefit.
Another mechanism for avoiding loss of deferred amounts on bankruptcy is called a "haircut provision." Here the executive is given the right to an immediate payout of the deferred amounts, subject to forfeiture of part of the deferrals. It is generally recommended that the "haircut" involve a forfeiture of at least ten percent of the executive's deferred account. (The Internal Revenue Service has not issued any rulings on the effect of "haircut provisions".) Frequently, non-qualified deferred compensation plans that include "haircuts" also provide that the executive cannot participate in the non-qualified deferred compensation plan in the future, once a "haircut" withdrawal has occurred.
"Haircuts" have a built-in public relations disadvantage. If key executives start to exercise withdrawal privileges at a time when the company is under siege, other employees as well as shareholders and suppliers may assume that the prospects for its survival are slim.
While these trusts may have "cute" names, the Secular trusts are the ones that are the most used, so the discussion that follows will address the Rabbi and Security trusts primarily. As one financial planner has noted recently, there is a lot of talk about these trusts, but that is all it is, just talk.
Briefly, a secular trust provides formal funding in an irrevocable trust. The trust funds are protected from the employer's general creditors. The trust is established for the benefit of the employee. The employee is taxable on contributions to the trust in which the employee is substantially vested. According to the IRS, substantial vesting occurs if the employee's interest is either transferable or not subject to a substantial risk of forfeiture. You can see that it is likely the employee will pay current taxes on employer contributions to a secular trust.
The IRS has published some opinions about secular trusts-opinions that have been challenged or criticized by tax practitioners as inconsistent and even incorrect. The uncertainty about the IRS's position on taxation of secular trusts, coupled with the general current taxability of contributions to the employee, has resulted in less interest in using secular trusts than in using Rabbi Trusts for deferred compensation plans.
A deferred compensation plan involves a contractual agreement between the employer and the employee. This contract is based on a formal plan the employer has designed in conjunction with attorneys, tax authorities, the employee and the insurance agent (if life insurance policies provide the informal funding). We will look at the components that are included in a typical plan design, as well as the provisions generally included in the contract between the employer and the employee.
Many elements of a deferred compensation plan that appear in the plan design document will also appear in the contract between the employer and the employee, while others will not. For example, whatever the formal plan stipulates as the event that triggers payment of the deferred compensation will show up in the contract as well. On the other hand, eligibility information included in the plan design, such as salary minimums or job descriptions, will probably not appear in the contract with the employee.
The primary eligibility requirement is based on the tax code provision that the plan must have been developed for a specific group of management personnel or highly compensated employees. Beyond that, there are no legal guidelines for eligibility. However, the employer must be careful not to include an extremely broad group of employees. If the group is not selective enough, the IRS can decide the deferred compensation plan is just another employee retirement plan that is subject to the dollar limits and complex regulations that govern such plans.
For this reason, eligibility should be greatly restricted or not specifically defined in the plan at all. For example, a restrictive provision could define the positions that make an individual eligible, such as all employees at the executive vice president level and above. Sometimes, minimum salaries are used, but the employer must be careful to tie salaries to an inflation index. Otherwise, employees at lower salary levels when the plan is introduced could eventually be included inadvertently.
Some employers prefer not to define eligibility at all, instead using a provision that permits the employer to select participants on a case-by-case basis. If the employer is a corporation, for example, the plan could indicate that a committee will nominate potential participants who must then be approved by the board of directors.
The plan design might include service requirements related to the future payment of deferred compensation. For instance, the employer could require that an executive be employed with the company for 10 or 15 years before retirement in order to receive the deferred compensation benefits. To retain flexibility, however, the employer might also include provisions for valuable employees who have shorter tenures with the business.
For example, the company's situation in the future-unknowable at the time the plan is designed could call for hiring a high-powered executive to turn around a faltering division in the business. This could be a highly experienced person who wants to retire in five years, but who is willing to join the company for that period. In order to gain the person's services, the employer could use this alternate provision to offer deferred compensation even though the executive will not be with the company long enough to fulfill the 10- or 15-year service period that otherwise applies. Flexibility such as this can be important in order not to constrain the employer's ability to respond to unpredictable economic needs.
A provision that is sometimes tied to or coordinated with service requirements is the retirement age at which deferred compensation benefits are payable. Some employers want to encourage or at least allow employees to retire at a younger age than the employees might otherwise choose. The plan can provide that the employee will receive the full-deferred compensation benefit even if he or she retires at, perhaps, age 62, as long as the service requirements have been met.
Another provision could indicate that, if the employee retires even earlier, say age 59, the benefit will be reduced slightly until another age is reached. For example, an employee's benefit will be reduced by 3% per year until the employee reaches age 62, at which time the employer begins paying the full-deferred compensation amount. Employers often tie provisions such as these to the normal retirement age of basic pension plans that are provided for all employees.
The income replacement goals of the employer and the employee can be stipulated in the plan. A typical amount that would be paid to a retired executive under a deferred compensation plan is about 50% of current earnings. Remember that the deferred compensation is generally considered a supplement to other retirement income. Fifty percent is an amount that is likely to be approved by a corporation's board of directors or others involved in the decision. In addition, the employer must be aware of the IRS position about "unreasonable compensation," which essentially is that the company may take a tax deduction only to the extent that compensation is "reasonable." The tax code defines reasonable compensation as:
"Such amount as would ordinarily be paid for like services by like enterprises under like circumstances."
If the IRS decides compensation is not reasonable, a portion of the payment will not be tax deductible. Furthermore, in the case of a corporation, unreasonable compensation paid to an employee who is also a stockholder will be taxed as a dividend and, therefore, not only not deductible, but doubly taxed to both the corporation and the stockholder.
Because future benefits to be paid under a deferred compensation plan are generally tied to the employee's compensation base, the plan should provide a means to establish that link. A commonly used method is to determine the average compensation over a stipulated period that includes the highest earning years-which are usually the last years before retirement.
For example, the plan could specify that the base compensation is determined by averaging gross pay for the five years of highest compensation during the last 10 years the individual is employed before retiring.
It's beneficial for the employee to be allowed consideration for the highest earning years since compensation includes bonuses and other incentives the employee has received. If bonuses are smaller in some years, those years can be ignored for purposes of determining the compensation base in orderto boost the average.
To average the five years of highest earnings, the income for those years is totaled and divided by five:
Then, if the plan provides for a benefit equal to 50% of usual compensation, the employee will receive 50% of the average compensation:
$455,600 x .50 = $227,800
This, then, is the annual deferred compensation benefit the employee will receive upon retiring.
The approach to paying the deferred compensation can be based on either a defined benefit method or a defined contribution method. (These, by the way, are the same choices available under qualified plans.) The terminology is fairly descriptive in that under a defined benefit plan, the plan identifies or defines the benefit that will ultimately be paid. A defined contribution plan identifies or defines the contribution that will be made during the deferral period.
When a defined benefit plan is selected, the benefit might be specified as either of the following:
1. A flat dollar amount (which may or may not be indexed for inflation) or
2. A formula (which is generally similar to the averaging method described previously, that is, the average of the five years of highest earnings during the last 10 years of employment).
The defined benefit might also take into consideration the number of years of service the particular employee gives. For example, a certain additional amount could be added for each year of service, thus rewarding further an employee who not only met a 15-year service requirement, but actually was with the employer for 20 years.
Another feature of a defined benefit plan is that the benefit to be paid can be offset by other retirement benefits the individual is entitled to, such as Social Security and/or benefits from a company sponsored retirement plan for which all employees are eligible. As an example, the plan could stipulate that the employee will receive from all sources no more than 70% of average earnings. For simplicity, let’s say the employee’s average earnings are $100,000, which restricts retirement income to $70,000 per year. The employee receives:
From Social Security: $18,000
From all other retirement income sources 27,000
Total before deferred comp is paid: $45,000
Maximum permitted: $ 70,000
Less other benefits: 45,000
Defined benefit to be paid from deferred comp: $35,000
Another advantage of a defined benefit plan is that it can more directly reward the individual’s performance. Obviously, the higher the earnings on which the benefit will be based, the higher the benefit will be.
Salary continuation (versus reduction) plans often use the defined benefit approach since the two complement each other, while salary reductions and defined contribution methods are also complementary as you’ll see.
As the name implies, a defined contribution plan indicates the amount of the contribution that will be made annually. Defined contribution plans are also called money purchase plans. Because the amount contributed can be the same as the amount of the employee’s salary reduction, theses arrangements work well together.
The contribution that is stipulated in the plan document is the amount of the employee has agreed to have deferred. This probably will be indicated as a percentage of each year’s salary, allowing the amount to increase as the employee’s compensation increases. The amount might be actually placed in an account for the employee (within the rules for funded versus unfunded plans) or the contribution might simply be an accounting entry to designate the employee is entitled to this amount. If the money is actually set aside, remember that for nonqualified deferred compensation to work properly, the funding must be informal, such as through life insurance or a Rabbi Trust (which might or might not include life insurance).
Where there is no actual funding under a defined contribution plan, the employee does not have the advantage of earning income on the deferred funds. To offset this disadvantage, the employer sometimes stipulates a certain rate of interest that will be paid as if it had actually accrued. With a life insurance policy, of course, the employee can indirectly earn income through the cash values that build during the deferral period if the employer chooses to use the earnings for that purpose.
To protect the employer and provide another reason for the employee to stay with the company, the plan probably includes forfeiture provisions. These provisions require the employee to give up all or part of the deferred compensation if certain events occur before the employee retires. The most common events used to trigger forfeitures are:
1. The employee is terminated by the company with cause," which generally means for a serious work or legal violation of some type (frequent absences from work, sexual harassment and embezzlement are examples).
2. The employee leaves voluntarily and goes to work for a competitor of the company providing the deferred compensation arrangement or competes personally as a self-employed person.
The plan could include somewhat more lenient provisions when termination occurs under other circumstances. For example, it is possible that the employee, the employer or both could decide in the future that the employment relationship is no longer satisfactory. The plan might provide for gradual vesting of the deferred compensation for the employee so he or she will still receive a percentage of the benefits if employment terminates after a certainnumber of years.
Unlike qualified retirement plans, under which specific vesting schedules apply, nonqualified deferred compensation plans require no vesting at all. Therefore, an employer who decides to include such a provision may design any vesting schedule desired-or none.
The primary purpose for benefits paid under a deferred compensation plan is to provide retirement income. Therefore, the usual trigger is the employee's retirement according to the plan provisions. In addition, the plan may be written to pay benefits from the deferred compensation plan in the event of death as well.
There is always the possibility the employee will die, either before receiving any ofthe deferred compensation or after receiving only a portion of it. Many plans allow the payment of death benefits to the employee's survivors or estate, before and/or after the employee retires. Remember that, if the plan is informally funded by life insurance, the employer owns and is the beneficiary ofthe policy, so no direct death benefits would be paid to the employee's survivors from the policy. However, the employer might choose to use a portion of the death proceeds from the policy to pay a death benefit to the survivors. This is another advantage of using life insurance; the proceeds are available exactly when they are needed.
One disadvantage of such a death benefit is that it is taxed to the person who receives it as ordinary income, rather than being received income tax free as benefits paid directly from life insurance policies generally are. However, the tax code does allow the first $5,000 of any death benefits paid by an employer to the employee's survivors to be excluded from income taxation under most circumstances. We'll talk more about the details of the $5,000 death benefit exclusion later. We'll also discuss the payment of periodic death benefits to survivors in the section of this chapter that covers the payout of deferred compensation.
The most commonly used deferred compensation payment method is monthly installments. Alternately, the employer could make annual payments or pay the entire amount in one lump sum. Lump-sum payments, however, are rare. First, they require the employer to provide a very large sum at once, which can be difficult under unfunded plans. Second, the employee must pay taxes on that very large amount in a single tax year. Furthermore, if the employee has a great deal of control about the form in which payments may be received-such as an option to take either a lump sum or installments, constructive receipt becomes an issue.
It is very important for all parties and their tax consultants to consider carefully how the payments will be made in order to arrive at the optimum tax benefits for all involved.
In addition to the above, various other provisions may be included, depending on the particular plan.
Naturally, all parties to the agreement are identified by name and respective positions, the employee, the employer or company, and the trustee, if any.
It's also typical to include an acknowledgment that the parties to the agreement have no right to assign, transfer, exchange or sell any benefits provided under the plan.
Some plans allow the employee to take a so-called hardship withdrawal in the event of an "unforeseeable emergency" as the IRS defines it. The definition that must be included in the plan to satisfy the IRS is essentially the following:
An unanticipated emergency caused by an event beyond the individual's control and which would cause severe financial hardship if the individual were not permitted to make the withdrawal.
The employee must be limited to withdrawing the amount needed to take care of the emergency. Except for these special restrictions, an employee taking a hardship withdrawal could have constructive receipt problems and be taxed on the entire amount of deferred compensation. Under this provision, the only taxable amount would be the withdrawn amount.
Another provision stipulates that successors to the parties to the agreement are bound by the agreement. This includes successor companies in the event the employer is sold or reorganizes under a different form of ownership or name. Successors of the employee, who are also bound, include beneficiaries, heirs and the executor of the employee's estate.
The agreement should also acknowledge compliance with the laws of the state in which the employer is doing business and in which the employee resides.
When the employer is incorporated, the agreement may include a resolution by the board of directors, agreeing to honor the deferred compensation arrangement.
If funding is provided, there should be a provision describing the form in which it will occur. Even for an unfunded plan, if life insurance policies and/or a Rabbi Trust are established, the agreement should cite and identify those documents as well.
The trust itself, where used, is established with a separate trust document that cross-references the deferred compensation agreement. The trust document and all others, of course, require the services of attorneys and tax accounts as well as the insurance agent when insurance is included.
Finally, the agreement will include any other conditions, provisions and benefits that may be negotiated between the parties. The deferred compensation plan and the agreement between the employer and employee are complex legal documents that require careful consideration and preparation by competent legal and tax experts.
There are additional tax factors that come into play when the deferred compensation benefits are paid to the employee or, if the employee dies, to his or her heirs. There are also certain tax complications that can occur with a deferred compensation plan.
When life insurance has been used for informal funding, the employer has a number of options when the employee retires and becomes eligible to receive the benefits. If funds to provide the compensation to the employee are available from a source other than the life insurance policy, the employer needs not use the policy's cash values unless desired. For example, the employer might have made certain investments that have resulted in sufficient funds to pay the promised benefits. Remember that there is no requirement for the life insurance policy to be used to make the payments, especially if the plan is legally considered unfunded. Instead, the employer may choose to keep the policy in force. If the retired employee dies, the policy will still pay the death benefit to the employer.
Let's assume, however, that the employer does want to make use of the life insurance to pay the employee's deferred compensation. There are two basic options:
The employer surrenders the policy for its cash value, which the employer uses to pay the employee's benefits. The policy no longer exists in this case. The disadvantage is that the employer also gives up the opportunity to receive the death benefit, which would be paid income tax free to the employer when the retired employee dies. Thus, the employer does not recoup funds to offset the premium payments made during the years the employee was working.
Alternately, the employer could take a policy loan from the cash values and uses the loaned amount to pay the deferred benefits. The employer must pay interest on the loan, of course, but the rate of interest for insurance policy cash values is often considerably less than interest rates in the marketplace. So, if the employer would otherwise be required to borrow funds to pay the benefits, this could be an economic option. Furthermore, interest is typically deductible as a business expense when a life insurance policy is owned by a business.
There is one potential drawback to the policy loan option. The tax code limits the amount of deductible interest when the policy covers the life of an officer, employee or any other person who has a financial interest in the employer's trade or business. If the aggregate indebtedness for any one of these persons is greater than $50,000, only the interest on the first $50,000 of debt is deductible. Notice, if the employer has loans from policies on the lives of two employees retired at the same time, the limit is on $50,000 of indebtedness for each individual. However, especially if the employer has sources of funding for the deferred compensation in addition to the insurance, this interest limitation may not be a significant factor. The employer could borrow up to $50,000 on the policy and use other sources to make up the funding difference.
Generally, employers borrowing from cash values borrow only as much as necessary in any one-year to meet current needs. This keeps the interest amount lower than, for example, borrowing all cash values when the full amount is not needed to pay the deferred benefits. The employer continues to pay interest until (1) the loan is repaid, (2) the policy is surrendered or (3) the employee dies and the death benefit is paid. Any outstanding loan amounts, of course, are deducted from the death benefit.
The original goal of any deferred compensation plan is, of course, that the employee will live to receive retirement benefits. At this point, Uncle Sam demands his due from the employee, while finally providing a tax benefit to the employer.
Payments from deferred compensation arrangements are taxable to the employee as current income in the year received—included with all other income, deferred compensation benefits aretaxed atthe individual’s regular individual tax rate. The employee may or may not be in a lower marginal tax bracket when the benefits are paid. While the possibility of a lower bracket after retirement is one of the potential tax benefits of deferred compensation arrangements, this is not necessarily what actually happens, so the employee should be mentally prepared to pay taxes at the same rate (or even a higher rate) as before retirement.
Taxes are one of the primary reasons deferred compensation benefits are usually paid in installments, rather than in one lump sum. Payment of a large amount in a single tax year could significantly increase the tax burden. It is a rare situation where the employer even offers the employee an option to receive the funds in this manner. Furthermore, if the employee does have an option to receive the entire amount at once, constructive receipt again becomes an issue. Remember that if someone has an unrestricted right to receive the funds, they become immediately taxable, whether or not the individual actually receives them.
Because the IRS defines deferred compensation payments as wages, the payments are subject to withholding taxes just as if the employee had received the money before retiring. Taxes that will be withheld from each payment, therefore, include:
1. Regular income tax withholding
2. Social Security withholding or FICA (Federal Insurance Contributions Act).
3. FUTA (Federal Unemployment Tax Act).
Deferred compensation benefits paid in 1994 and later years are subject to withholding for at least the HI portion of the tax.
Deferred compensation payments might be subject to withholding on the old age, survivors and disability insurance (OASDI) portion, depending on other taxable income. If income for the year equals or exceeds the OASDI taxable wage base, some or all of the payment may be subject to withholding. FUTA withholding is similar to FICA withholding, but with a lesser amount.
Now that the employee has begun receiving the deferred compensation, the employer is finally entitled to a tax deduction for its payments to the employee. The tax code allows the deduction only when the deferred compensation is included in the employee’s taxable income. Therefore, the amount deductible is not the full deferred amount at once (assuming no lump-sum payment to the employee), but only the amount the employer actually pays in each of the employee's taxable years.
Furthermore, the deduction is limited to what the IRS considers "reasonable compensation," an issue we've already discussed. The IRS has demonstrated over the years that it is inclined to scrutinize, for issues of reasonableness, deferred compensation payments made to a controlling stockholder of a corporation more carefully than any other such payment. The reason behind this scrutiny is to determine whether excessive compensation actually represents a dividend that has not been paid-and therefore has not been doubly taxed as dividends normally are. Because of this concern, deferred compensation plans for controlling stockholders should be very carefully monitored by the company's tax and legal experts beginning with the preparation of the plan and contract and continuing with reviews during the deferral period. Minority stockholders and non-owner employees, on the other hand, are not as likely to be subjected to IRS challenges on the issue of reasonable compensation in the absence of any blatantly excessive compensation.
Deferred compensation agreements commonly provide for the payment of death benefits to the employee's survivors whether death occurs before or after the employee retires. If the agreement is funded by an employer-owned life insurance policy, the employee's death triggers payment of the proceeds to the employer. The employer receives the death proceeds income tax free and may then use the funds to pay the agreed-upon benefit to the employee's heirs if desired. However, there is no requirement that the employer actually use the proceeds for this purpose. That is, any death benefit payable could come from any source of funds available to the employer.
Remember, though, even if the employer actually uses the life insurance funds, the heirs do not receive life insurance proceeds as defined by law. They are simply receiving "compensation" provided for under the deferred compensation agreement. Therefore, the heirs must pay income taxes on any death benefit the employer pays.
Although the survivors must pay income taxes, a portion of the death benefit may be excluded, using the $5,000 death benefit exclusion. As indicated earlier, an employee's estate or beneficiary may receive up to $5,000 as a death benefit from the employer income tax free. Amounts over $5,000 are taxed when received as ordinary income.
This $5,000 exclusion is the maximum exclusion allowed for anyone employee. Thus, for example if the employer pays more than one death benefit on an employee's life, the $5,000 limit still applies. Let's suppose the employer pays a death benefit of $25,000 to the deceased employee's spouse and another $25,000 to the employee's adult child. In this case, the spouse and the child must share the $5,000 exclusion proportionately to their shares of the death benefit. Since each receives one-half of the death benefit in this scenario, each may take one-half of the exclusion or $2,500. Both the spouse and the child will then pay current income taxes on the balance of the death benefits they received-$22,500 each in this case, as shown here:
Spouse Child
Death benefit from employer $25,000 $25,000
Shared exclusion 2,500 2,500
Taxable income $22,500 $22,500
If there were three beneficiaries, each could take one-third of the exclusion. If there were four, each would be entitled to one-fourth of the exclusion, and so forth, depending on the number of people receiving death benefits from that single employee's death.
Other restrictions apply to using this death benefit exclusion. The exclusion may not be used when any of the following situations exist.
Finally, the $5,000 death benefit exclusion may be used by the survivors of employees of corporations, partnerships and sole proprietorships. However, proprietors and partners themselves are not eligible for the exclusion. These restrictions apply to nonqualified deferred compensation plans and other nonqualified arrangements, but not to qualified retirement plans.
When payment of death benefits results from a contractual agreement, such as the deferred compensation agreement, the benefits are considered income in respect of a decedent— a consideration that affects federal estate taxation. Income in respect of a decedent must be included in the income of one of the following:
Under the tax code, income in respect of a decedent refers to compensation the deceased person earned but did not receive before death. This type of income must be included in the deceased's estate even though it was actually paid to someone else, such as a spouse or other survivor. To the extent that any estate taxes paid are attributable to income in respect of a decedent, the person who received the death benefits may take a personal income tax deduction.
The deferred compensation agreement may stipulate that death benefits, if any, will be paid in any one of several ways. Although a lump-sum death benefit is permitted, most employers prefer not to use it, opting instead for installment payments that more closely resemble the payout method used when the employee lives. Often, the employer agrees to pay a stipulated percentage less than 100% of the amount the employee was receiving or would have received while living.
Here are some examples of how the agreement could stipulate that death benefit installments will be paid by the employer:
Other methods could be negotiated between the employer and the employee when the agreement is developed. In all cases, except where the $5,000 exclusion applies, the benefits are taxable as current income to the recipients.
One variation of the deferred compensation arrangement, a death benefit only (DBO) plan, is used primarily to avoid including any funds in the employee's estate, subject to estate taxation. A DBO is designed to provide no income to the employee; instead, payments are not made from the deferred compensation plan until the employee dies, and then the payment is a death benefit paid to survivors.
A DBO works to avoid estate inclusion only if the employee has no right to receive any of the funds at any time. For example, if the plan attempts to qualify as a DBO plan, but provides that the employee may receive the funds, let's say after reaching age 75, the IRS will disqualify the plan as a DBO. Likewise, any other provisions that guarantee the employee any right to the funds if the employee does not die will result in the funds being included in the estate whether or not the employee ever actually receives them.
When a DBO is properly developed and the funds are paid to the beneficiaries, the death benefits are treated as described previously. That is, the benefits are current taxable income to the beneficiaries and may be eligible for the $5,000 exclusion. The employer may take a tax deduction for the DBO amounts as they are paid to the beneficiaries.
In addition to the tax issues discussed in various contexts in this chapter, other tax effects will occur or may arise, depending on the circumstances of the particular situation.
When the employer uses a life insurance to informally fund a deferred compensation plan, the premiums are not deductible as a business expense. On the other hand, the employer receives the death proceeds free of income taxation. This treatment is the same as life insurance where the business is both the owner and beneficiary of a policy covering an employee's life.
The one income taxation concern is that payment of the life insurance proceeds to the business will trigger or increase the possibility of triggering the alternative minimum tax (AMT).
For corporations, the buildup of life insurance cash values and or the amassing of premiums technically could trigger the accumulated earnings tax discussed earlier in the course. Even if the employer uses some means other than life insurance to accumulate funds to meet a deferred compensation agreement, the accumulations may come into question. However, several tax rulings appear to support the contention that these accumulations represent a reasonable need of the business, which is the standard required to avoid the tax.
In addition to other potential problems involving controlling shareholders, there is the additional problem of whether or not such an individual can avoid the nonforfeitable rights requirements. Even when a deferred compensation agreement with a controlling stockholder specifically limits these rights, the IRS must be further convinced. At issue is whether or not, because the individual has control over the corporation, he or she also has control over whether the restrictions remain in place or are removed. If the controlling stockholder can remove the restrictions the deferred funds would be deemed constructively received and taxable currently. While this issue can't be ignored-since the IRS pointedly watches for it-past court rulings have so far not considered a controlling interest alone as evidence of a nonforfeitable right to the funds. When a controlling stockholder is involved, therefore, legal advice and monitoring become even more important in order to retain the tax benefits of deferral.
In relation to a deferred compensation plan, third-party guarantees refer to arrangements whereby an employee acquires from a third party (not the employer) some type of assurance that the benefits will be paid. The potential problem with third-party guarantees is whether or not the IRS will decide the plan is funded, the employee has nonforfeitable rights, and therefore, the deferred compensation has been constructively received.
In one actual case, a parent company was the third-party guarantor for a deferred compensation agreement between one of its subsidiaries and the subsidiary's employee. The tax ruling on this case left the tax deferral intact.
Another form of third-party guarantee available is insurance that indemnifies the employee if the employer fails to provide the deferred benefit, discussed in more detail elsewhere in this text. Again, the IRS has not required the deferred income to be taxed currently simply because an individual purchased this type of insurance. This is true even if the employer reimburses the employee for the premium payments, as long as the employer did not purchase and does not own the policy. However, the employer-reimbursed premium is includable in the employee's personal income for tax purposes.
The only way to completely avoid estate taxation of deferred compensation is through a carefully prepared death benefit only (DBO) plan as described previously, with only the survivors (not the employee) receiving any part of the deferred income. Remember that the plan must be written to deny the employee any right to the funds at any time. As long as the employee holds no interest in the death benefits, the benefits cannot be included in the estate.
Deferred compensation payments are included in the employee's estate under other circumstances. If the employee has begun receiving the income before dying and the deferral agreement requires the employer to continue payments to survivors, a certain amount is included in the estate. The amount, determined as of the date of death, is the present value of the payments that remain to be paid under the contract. For example, suppose 10 annual payments remain under an agreement to pay benefits for 15 years. Only the value of the remaining 10 payments is included in the estate.
Now let's assume the employee died during deferral before receiving any benefits. The present value of all future payments would be included in the estate, provided the employee had the right to receive those payments in the future after he or she was no longer employed. On the other hand, if the employee had no enforceable right to receive future payments, nothing is included in the estate.
While many of the major tax concerns associated with nonqualified deferred compensation plans have been discussed, any individual situation can trigger additional tax issues.
Everything discussed so far has been about plans between private businesses and employees. The tax code regulates somewhat differently nonqualified deferred compensation plans for state and local government employees and employees of certain tax-exempt entities. These plans are generally referred to as Section 457 plans for the applicable section of the tax code.
If an employee is covered by certain amount of retirement plans, he may choose to have part of his compensation contributed by the employer to a retirement fund, rather than being paid directly to the employee. This amount that is set aside—elective deferral—is treated as an employer contribution to a qualified plan. An elective deferral, other than a designated Roth contribution, is not included in wages subject to income tax at the time contributed, but it is included in wages that are subject to Social Security and Medicare taxes. Elective deferrals include elective contributions to the following retirement plans: (Note: These plans are, for the most part, retirement plans and are not within the scope of this text.)
For 2007, one should not have deferred more than a total of $15,500 of contributions to (1), (2) and (4) above. The limit for SIMPLE plans is $10,500. The limit for (5) is the lesser of $7,000 or 25% of your compensation. The limit for Section 457 plans is the lesser of your includible compensation or $15,500.
Note: "Qualified plans" has been defined earlier in this text, refers to whether participating employees may defer taxation on their employer's contributions.
While this text does not thoroughly cover retirement plans, Roth 401(k) plan contributions should be addressed as there have been recent changes. Employers with section 401(k) and section 403(b) plans can create qualified Roth contribution programs so that the employee may elect to have part of all of his elective deferrals to the plan designated as after tax Roth contributions. IF the employer's plans allow it, the employee may designate part of all of his 401(k) contributions as "Roth 401(k)" contributions, wherein his contributions are nondeductible. However, all of the income to the plan will be tax-free to the employee when it is distributed if the employee has 5 years of participation and distribution after age 59 ½, death, disability6, or for up to $10,000 for a first home purchase.
Taken together, deferrals to all of these plans, including the Section 457 plan, must total a deferral of no more than the limits described. If the employer contributes to any of these plans on behalf of the employee, the employer's contributions are also included in meeting the limits.
Under Section 457, employees elect to defer compensation monthly, and they must elect to do so before the beginning of the month. The plans may be available to all employees or only to selected individuals at the employer's option.
Section 457 plans must be unfunded, remaining the property of the employer and subject to the employer's general creditors.
These plans must meet specific rules for distribution of the funds. Specifically, no funds may be distributed to the employee until:
1. The employee's separation from service or
2. The calendar year in which the employee reaches age 7 or
3. An unforeseeable emergency occurs (one that is beyond the employee's control and will cause a financial hardship if the employee is not allowed to receive a distribution).
Life insurance may be used under Section 457 plans. As long as the employer both owns and is the beneficiary of the policy, the employee is not taxed on the economic benefit of premiums paid.
Like other deferred compensation plans, the employee has taxable income only when the benefits are paid. Likewise, distributions are subject to withholding taxes for Social Security and FUTA, with one exception. Section 457 payments for employees of a state or a political subdivision of a state are not subject to FUTA taxes.
If any of the Section 457 requirements are violated, the plan becomes "ineligible" and the plan participants are taxed immediately.
As with any retirement plan, there are many other features that will need to be addressed if one is to work in this particular market.
1. The form of deferred compensation that does NOT require the employee to directly give up a portion of current compensation is called:
A. salary reduction.
B. salary continuation.
C. pure deferred compensation.
D. hybrid deferred compensation.
2. When there is no substantial risk of forfeiture, an employee will be taxed currently on contributions to a deferred compensation plan-even if the employee does not actually receive the fund because of the doctrine of:
A. constructive receipt.
B. secular vesting.
C. top-hat plans.
D. fraud.
3. Protection from an employer's general creditors is provided under a deferred compensation plan that is:
A. funded.
B. unfunded.
C. secured .
D. unsecured.
4. ______ is the single most optimum solution to securing deferred compensation for the employee on an unfunded basis.
A. common stock.
B. real estate.
C. life insurance.
D. a certificate of deposit.
5. What trust has the IRS approved for tax-deferred informal funding of deferred compensation plans and has even developed a model for use by employers?
A. revocable trust.
B. irrevocable trust.
C. secular trust.
D. Rabbi Trust.
6. The type of plan that specifies the amount the employer will pay into the deferred compensation plan is:
A. defined benefit plan.
B. defined contribution plan.
C. secular trust plan.
D. compensation accumulation plan.
7. The primary purpose of a deferred compensation plan is to:
A. secure a tax deduction for the employer.
B. provide taxable income to the employee upon employment termination.
C. provide retirement income.
D. maintain employee loyalty.
8. If a deferred compensation plan is informally funded by life insurance the _______ owns the policy and the _______ is the beneficiary of the policy.
A. employer, employer.
B. employer, employee.
C. employee, employee.
D. employee, employer.
9. Payments from a deferred compensation arrangement are taxable to the _____ as current income in the year ________.
A. employer, paid.
B. employer, received.
C. employee, paid.
D. employee, received.
10. Upon the death of an employee for whom compensation has been deferred, if an employer pays the employee’s survivors a death benefit, the death benefit is:
A. fully taxable.
B. not taxable.
C. taxable to the extent it exceeds the published IRS requirements.
D. taxable to the extent it exceeds $50,000 per beneficiary.
Answers
1B 2A 3A 4C 5D 6B 7C 8A 9D 10C