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NONQUALIFIED PLANS
Module 2: DEFERRED COMPENSATION PLANS
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Why Nonqualified Deferred Compensation?
In today's highly competitive business environment, one of the key elements of a company's ongoing success is its ability to retain and adequately reward key personnel. But when it comes to providing qualified fringe benefits, including profit-sharing and pension plans, there are many federal regulations that prevent an employer from discriminating in favor of a particular employee or class of employees.  Yet many employers have a small group of employees who are indispensable to the success of the business.  Nonqualified plans allow employers to target compensation to those most responsible for the company's continued viability.

In recent years, for various reasons, Congress has tightened regulations concerning qualified plans.  These changes in the law provide for tougher nondiscrimination rules and more stringent vesting provisions making qualified plans more expensive both in meeting new actuarial requirements and coping with increased administrative costs. Caps on salaries for the purposes of computing qualified plan benefits have had adverse effects on providing retirement income for highly compensated employees.  As a result , the popularity of nonqualified deferred compensation plans has grown considerably in recent years as federal regulation of qualified plans has become more complex and more restrictive.

For these reasons, employers are turning more and more to nonqualified deferred compensation plans to provide logical solutions for executive compensation concerns. Among these plans are top hat plans, SERPs and excess benefit plans.

These will be discussed later in this Module.
Upon completion of this Module, you should have a basic understanding of:

the reasons for using nonqualified deferred compensation;
the types of deferred compensation plans commonly used;
the elements of a deferred compensation plan;
federal tax rules governing deferred compensation plans; and
special issues important for majority shareholders of the firm.



Uses of Deferred Compensation Plans
Deferred compensation programs can serve a variety of purposes:   

Substitute for a Formal Pension Plan:  
The employer has complete freedom of action in the selection of the employees (including owner-employees) to participate in a deferred compensation plan. Because no government approval is required, the plan can be and almost always is discriminatory.   Further, it can be tailored to fit the funds available and may be continued or terminated at will. Also, possible adverse reaction from other employees that are not included in the plan is avoided as they never need know of its existence.


Supplement a Qualified Pension Plan

Regulations affecting pension and profit-sharing plans operate to limit benefits that can be paid to the executive class of employees.

Further, the executive may have been employed by the organization late in life and may be either ineligible for the formal plan, or because of service requirements, eligible for only a reduced pension. The deferred compensation plan overcomes this qualified plan problem by supplementing the benefits that are provided by the pension or profit-sharing plan.


Supplement a Qualified Profit-Sharing Plan

In some qualified plans, when the profit-sharing contributions are projected to retirement, it is evident that an adequate benefit will not be provided for the key employee. In many qualified plans, the key employee entered the plan late in life so that the plan will not develop benefits for the person commensurate with those projected for the firm's younger employees.  The deferred compensation plan overcomes this profit-sharing plan problem by providing additional benefits that supplement inadequate profit-sharing benefits.


Aid in Recruiting New Key Executives

In many cases, deferred compensation can give the new key employees a greater fringe benefit program than they left behind at their previous employer.  

Retain Valuable Key Personnel

An important employee can be deterred from leaving his or her present employment if leaving means the loss of substantial deferred compensation benefits. Because of this ability to retain deferred compensation participants, a deferred compensation plan is often referred to as "golden handcuffs."


Retain Key Employees to Run the Business for the Family

Deferred compensation plans may figure importantly in business succession planning. When business owners desire to see their families continue to own and operate a family business, deferred compensation can be employed to hold the key people and keep the business alive, until the owners' minor or inexperienced children can assume the management of the business.

Make Executive Compensation More Meaningful

Because of the graduated tax structure, much of a pay raise or bonus to a key executive may be taken by taxes. Deferral of such a raise or bonus to a future date-until after retirement, for example may allow the executive to keep far more after taxes because a retiree may be in a lower tax bracket.


Substitute for Stock or an Ownership Interest

Owners of closely held businesses are reluctant to grant ownership interest in the business especially if it means losing effective control of the firm.  Key employees may view minority ownership in a close corporation of having little value because of its lack of marketability. Deferred compensation for key employees is often preferred to a minority stock interest in many close corporations, especially if few or no dividends are paid.



A note about Deferred Compensation for Public Employees:  "Section 457 Plans"

State and local government employees are also permitted to establish nonqualified deferred compensation plans similar in certain ways to plans for employees in the private sector. These plans are often referred to simply as Section 457 Plans.   Many regulations similar to those for qualified retirement plans govern these governmental-sector plans and do not apply to deferred compensation plans for non-governmental organizations. For that reason, this course will not address deferred compensation plans for public employees.



Plan Benefits

It is important to understand that deferred compensation plans come in varying sizes and styles, each designed to meet the needs of both the employer and the employee.

For the employer, the deferred compensation arrangement assists in attracting and retaining key employees.  Also deferred compensation programs can be designed to allow employers to recover the cost of the benefits.

For the employee, the deferred compensation arrangement enables him or her to receive additional compensation at retirement and avoid current income taxes on the amount of compensation that is deferred. So, in the right situation, deferred compensation can be attractive to both the employer and employee.   The package of employee benefits in a deferred compensation plan might include:

retirement benefits for the plan participant;
disability benefits for the plan participant; and
survivor benefits in the event of the employee's death

There are many ways the benefit package can be structured and funded.  The primary advantage of a nonqualified plan is that it can be custom-tailored to fit the employer and key employee's unique circumstances.   Benefits can be expressed as a percentage of income or as a fixed-dollar amount.  The benefits can be secured by assets in a trust or not; the plan can be funded, unfunded or "informally funded" depending on the objectives of the employer and employee.  


Funding the Eventual Liability

Regardless of whether the deferred compensation plan contains a formula based on the executive's final salary or simply recites a fixed benefit, the judicious employer will immediately put in place the informal funding that will enable it to meet the employer liability that the plan imposes.

Any number of financial vehicles may be used by the employer to provide an asset reserve against the deferred compensation liability, including bonds, stocks and mutual funds. As we will examine in the material to follow the most effective and efficient informal funding vehicle involves insurance, both life insurance and disability income insurance on the life of the plan participant.

Life and disability insurance provide an effective means of assuring that funds will be available in the future to pay the benefits promised by these plans.  The promotion and sale of deferred compensation programs is, therefore, a natural activity for the insurance professional. Although the nonqualified deferred compensation plans discussed in this course represent sophisticated sales, the basic concepts are relatively simple.


Is Salary Deferred or Not?

Executives who leave the employment of an employer who has established a deferred compensation plan a plan under which the key employee actually defers his or her compensation generally receive their total deferrals with modest accumulated interest, such as interest at the prevailing savings account rate. This interest rate is typically much lower than would apply if the executive had remained with the employer until retirement. Thus, there is a substantial financial incentive under the plan for a participating executive to stay with the company until normal retirement.

It is customary for salary continuation plans (SERPs) which are not typically funded with employee deferrals to pay no benefit at all to the executive who leaves the firm before the specified retirement date. Any funds the executive loses are retained by the company.

Despite the "golden handcuffs" aspect of deferred compensation, a covered key executive will sometimes leave the employer's service before retirement. If the executive leaves the company before the retirement date specified in the plan document, the plan may provide either for:

no distribution whatever, or
a partial distribution according to a predetermined schedule.



Types of Plans

Which Plan Meets a Client's Needs?

There are many types of deferred compensation plans. Each is designed to meet specific needs of an employer and its key employees. The role of the financial services professional is to help the employer assess its needs and match them to the appropriate plan.

The primary deferred compensation plan types are:

Top Hat or deferred bonus plans;
Supplemental Executive Retirement Plans (SERPs); and
Excess Benefit Plans.



Top Hat Plans (Deferred Bonus Plans)

A top hat plan is maintained by an employer primarily to provide deferred compensation for a select group of management or highly compensated employees.  The term "top hat" refers to the formal hats worn by business executives in the late 19th and early 20th centuries and by inference, to the primary prospects for these plans, namely, key business executives.  

Under a top hat plan, executives forgo receipt of currently-earned compensation, such as a portion of salary, commissions, or bonuses, and direct these funds to be paid out at retirement. These plans are typically set up as defined contribution plans. That is, the amount of income that is deferred and its investment gain are credited to an account set up for the executive. The executive's benefit is an aggregate amount of all contributions and earnings.

The employer may initiate these plans as a perk or at the request of the executive during employment contract negotiations.


Supplemental Executive Retirement Plan

A supplemental executive retirement plan (SERP) is the most popular type of nonqualified deferred compensation plan. A SERP satisfies the employer's objective of enhancing executive retirement benefits and is often provided as a supplement to an existing qualified plan.

Like the top hat plan, the employer maintains a SERP primarily for the purpose of providing deferred compensation (in this case not a deferred salary but rather a deferred benefit) for a select group of management or highly compensated employees. However, unlike a top hat plan the plan participant is not required to forgo any current compensation.

At bottom, the difference between "top hats" and SERPs is whose money is funding the plan benefits. In a top hat" plan, the employee defers current compensation (a bonus or salary) into the plan to fund future benefits, in a SERP, the employer promises to fund eventual benefit payments.


Excess Benefit Plan

An excess benefit plan is used for executives who are already maxed out under their employer's qualified retirement plan. This may not occur until the employee receives payment. An excess benefit plan satisfies the employer objective of exceeding the maximum contribution and benefit limits for qualified plans-the so-called Code Section 415 limits.

The Section 415 limits for qualified plans differ depending on whether the qualified plan is a defined benefit plan, a defined contribution plan or a combination plan. The maximum benefit for a defined benefit plan in year 2007 is 100% of income up to $180,000 (this dollar amount is indexed annually for inflation).

The contribution limit for a defined contribution plan in 2007 is the lesser of 100% percent of salary, or $45,000 (this dollar amount is indexed annually for inflation). The limit for a combination plan is slightly greater than the limit available under either plan. The combined plan limit is reduced if a plan is deemed a top heavy plan (as are most small employer plans).  

Regardless of how a deferred compensation plan is structured is intended to accomplish two important functions:

To provide a benefit to the participant at some time in the future, and
To avoid income taxation on that future benefit until it is actually received



Overview of Taxation

For the participating key executive to avoid current income tax liability arising out of the deferred compensation arrangement, the promised benefits must not be secured in any way.

Understandably, this lack of security may be a cause of concern to a deferred compensation plan participant.  To overcome this concern regarding the insecurity of promised deferred compensation benefits, two important trusts have been developed: rabbi trusts and secular trusts.  These trusts and their impact on the taxability of benefits are discussed in detail later in the course.

Two income tax concepts are particularly pertinent to understanding how deferred compensation plans operate:

the constructive receipt doctrine; and
the economic benefit doctrine.


Constructive Receipt Doctrine

The constructive receipt doctrine states that income that is not actually received may be taxed as if it had been received, if the individual constructively received the income. Constructive receipt occurs when income is

set aside for the individual;
credited to the individual's account; or
made available to the individual without any substantial restrictions on the individual's control over the income.


Economic Benefit Doctrine

The economic benefit doctrine requires that an individual recognize income if property has been handled in a way that provides a cash-equivalent economic benefit to the individual.


Fortunately for deferred compensation purposes, a mere unsecured promise to pay income in the future does not constitute constructive receipt, provided the employee does not have access to the compensation that has been deferred.   As a result, when properly set up, a deferred compensation plan usually will not result in current taxable income to the employee.  





Deferred Compensation Arrangements

Each deferred compensation plan regardless of how it is structured has three important elements:

a promise to pay certain benefits;
forfeitability of promised benefits; and
a method to pay the promised benefits.



A Promise to Pay
The first deferred compensation plan element is a promise that the employer pays a stated benefit to the employee. The benefit may be expressed in a defined benefit or a defined contribution manner. The executive may be promised an amount of retirement income for a fixed period of time a defined benefit plan approach, which is often used in SERPs. Alternatively, the executive may be promised a retirement income based on what a cash fund will purchase at a given age a defined contribution plan approach, frequently used in "top hat" and excess benefit plans.

Many plans also offer a preretirement death benefit often called a survivor benefit if the participant dies while in the service of the employer. Disability benefits can also be provided under the plan. The specific package of benefits is governed by the provisions of the deferred compensation plan document.

For example:

Falcon Corporation's  deferred compensation plan provides the following for one of its key executives:

a retirement benefit equal to 60 percent of the employee's final salary for 10 years after retirement;
a disability benefit equal to 60 percent of the employee's salary at the onset of disability, payable during the employee's disability but not beyond age 65; and
a survivor benefit equal to 60 percent of the employee's salary at the time of his or her death payable for a period of 10 years.

Retirement and other benefits may be expressed as a defined benefit or based on defined contributions.  

Most "top hat" plans follow the defined contribution model the amount of income that is deferred and its investment gain are credited to an account set up for the executive. The executive's eventual "top hat" benefit is based on aggregate amount of all contributions and earnings accumulated over the life of the plan.  (In some cases, the employer will also contribute to the top hat plan, usually as a bonus for meeting some prearranged goal, e.g, reaching a sales or profit objective.  If the executive fails to live up to the terms of the plan for example, retires early he or she will typically forfeit any employer contributions to the plan.  The retirement benefits will be based solely on his or her personal deferrals.)

On the other hand, salary continuation plans (SERPs) are typically structured as defined benefit plans.  The actual level of future plan benefits is spelled out, or "defined", in the plan documents usually as a percentage of final salary or as a flat dollar amount.  


Percentage of Final Salary

In the example above, the retirement benefit is 60% of the executive's final year of salary. An executive earning $150,000 annually could expect a retirement, disability and survivor benefits equal to $90,000 per year for the designated period assuming his or her salary remained at the $150,000 level.  It is not unusual for a plan to provide retirement benefits equal to one-half of the executive's final salary for a period of 10 years but each plan is unique, benefits can be more or less than 50 percent of salary and may be for a period that is longer or shorter than 10 years, and benefits may be larger or payable longer for one key executive than for another.  

The percentage of final salary approach has the additional benefit of automatically adjusting the executive's benefits with changes in earned income during his or her working years. This is an important, considering that the benefit package may have been negotiated 10, 15 or more years before the executive's retirement.


Fixed-Dollar Amount

Couching deferred compensation benefits in percentage of final salary terms is certainly not the only method being used. Despite their inflation-induced shortcomings, deferred compensation plans whose benefits are stated in dollar, rather than percentage, terms continue to enjoy popularity.

From the employer's perspective, a deferred compensation benefit that is a specific dollar amount has two distinct benefits when compared to the percentage of final salary approach:

administrative simplicity-the funding does not require adjustment as the executive's salary changes; and
a definitely determined benefit-there is no uncertainty about the final cost of the benefits.



Forfeitability of Benefits
The second element of a deferred compensation plan is a wall or barrier that exists between the promised benefits and a cash fund. To enjoy the income tax deferral that is an integral part of the deferred compensation plan, the wall or barrier should not be breached in plan design. To maintain the important tax advantages of deferred compensation plans, there should never be any connection between the promised benefits and the accumulating fund.  

Deferred amounts under a nonqualified deferred compensation plan are merely an employer's promise to pay the employee sometime in the future they could simply "evaporate". To defer income taxes, these amounts must remain subject to the claims of the employer's creditors in the event of insolvency (i.e., they must be unsecured). This means that an employer's promise to pay may become an empty promise if the employer becomes insolvent. What happens if the employer that has promised deferred compensation benefits is bought out by another company that chooses not to honor the plan commitment or declares bankruptcy?  Quite  simply, the deferred compensation participant becomes an unsecured creditor of the employer. To overcome this concern regarding the insecurity of promised deferred compensation benefits, two important trusts have been developed: the rabbi trust and the secular trust.


Rabbi Trusts: Some Security and Deferred Taxes

The rabbi trust derived its name from a trust created in a nonqualified retirement plan under which a rabbi was a participant. The rabbi was concerned that future decision makers in his congregation might not be as kindly disposed to providing for his retirement as the current leaders. To provide additional security, the rabbi arranged for the plan assets to be placed into a trust with conditions that they could only be used for his retirement.

However, to avoid the current income taxation on those assets, the trust document left the assets available to the claims of the employer's general creditors.

Similar trust arrangements have been upheld by the Internal Revenue Service and offer a planning alternative that is appropriate in some circumstances (i.e., if the employee is comfortable about the long-term financial health of the employer but concerned about the employer's willingness to make the promised benefit payments).   


Secular Trusts:  Greater Security but No Tax Deferral

A growing trend of mergers and acquisitions, as well as bankruptcies, in recent years has spawned another trust known as a secular trust.  Secular trusts provide the protection afforded by a rabbi trust (protection against the employer's unwillingness to make promised payments) plus protection against the risk that the employer will declare bankruptcy or become insolvent and be unable to make payments.   In a secular trust, the funding assets are segregated or "earmarked" for the executive's exclusive benefit.  As a result, all contributions to a secular trust are currently income taxable to the executive.

Unlike the taxation of the trust corpus of a rabbi trust, all contributions to a secular trust are currently income taxable to the executive. This income taxation occurs because the opportunity for forfeiture of assets is sufficiently reduced by trust provisions to create current income to the executive.

The secular trust is perceived by some executives to be of value if it is expected that the income tax rate will increase dramatically in the future or if it is likely that the existing corporation will be merged or sold to unfriendly future owners.



In theory, a nonqualified plan could stop there. Benefits could be paid from the future earnings of the firm or from any of several investment options. The question the employer normally needs to answer is, "What is the least expensive way to provide the promised benefits?" And, as the discussion about rabbi and secular trust implies, there is usually something of value being held by the employer to meet the "unsecured promise" of the deferred compensation agreement.  When there is something more than a simple promise, the plan is said to be "informally funded".  (Full "funding" would occur if specific assets were set aside for the executive's eventual use but that would negate the tax deferred nature of the plan as is the case with secular trust.)


Paying the Benefit

The third element of the deferred compensation plan is its source of funding. The funds needed to pay the promised benefits can be provided on a pay-as-you-go basis a purely unfunded plan.   Obviously, it would require a great deal of trust from a key executive to accept a simple promise of future benefits.  Companies can set aside reserves, invest them in stocks, bonds or mutual funds, and pay benefits from those investments.   As long as the reserves are not specifically set aside for the employee's use, this type of informal funding would be acceptable and preserve the tax deferred nature of the plan.   If the employee is insurable, life insurance is the most financially attractive way to insure that the cash will be available when it is needed.  Permanent life insurance policies build cash values that can be accessed to help the employer pay retirement benefits, the cash value growth avoids current income taxation, and the permanent nature of the policy means that death benefits will be available to the employer to enable it to recover costs whether the executive lives for many years after retirement or dies shortly after the policy's inception.


Important Role for Insurance

Generally, insurance is the least expensive way for the employer to create a fund to pay promised preretirement and postretirement benefits. In addition, it is the only financial vehicle that enables the employer to recover its costs to provide the benefits a factor that can be attractive to many deferred compensation plan sponsors.  Life insurance is normally purchased to fund both the survivor and retirement needs, while disability income insurance can meet the obligation the deferred compensation plan's disability provision creates (These benefits are often funded through an individual disability income policy that is conditionally renewable, the condition being the executive's continued employment with the firm.)


Cash Value Policies Preferred

In the insured deferred compensation plan, the internal rate of return in a permanent life insurance policy's death benefit may be greater than can be obtained through stocks, bonds or mutual funds. In addition, the employer often use life insurance policy cash values at the time of the plan participant's retirement to fund the retirement benefit in whole or in part.

However, life insurance does not fund the plan in the usual sense; instead, it is often referred to as "informal funding." The distinction between funding in the usual sense and the informal funding that often is by life insurance provides is important. The critical factor in this distinction is that no connection exists between the amount of insurance on the participants and their contribution in a deferred compensation plan, or between the contributions made for them by the employer in a salary continuation plan.

Although employers may be able to fulfill their obligations under a deferred compensation plan without purchasing a life insurance policy, the employer who "funds the plan" with life insurance satisfies several objectives:  funds will be available to meet its pre-retirement death benefit liability,  funds will be available to help provide retirement benefits and the employer may be able to recover its costs.  A plan funded with life insurance also provides a sense of security to the executive who is more assured of his employer's ability to meet its commitments under the plan.



Key Features of a Deferred Comp Agreement

We will turn our attention now to a discussion of the main provisions of a typical deferred compensation agreement. A general knowledge of the content of these agreements will enable you to be of service to your prospects and clients. Just as importantly, it will help give you any needed confidence to effectively pursue prospects in this lucrative market.

Although there are other provisions in a deferred compensation agreement, generally the most important provisions relate to the:

income to which the agreement applies;
unfunded nature of the plan;
source of retirement and other benefits; and
conditions that must be met to receive a benefit.


Source of Income

The important point from the perspective of deferred compensation is that once income is received (actual or constructive receipt), nonqualified income deferral possibilities cease. So, for the individual to defer his or her compensation under a deferred compensation plan, the agreement must apply only to income that is unearned at the time of the signing of the agreement. Only future income, not past income, may be subject to the deferred compensation agreement.  As mentioned earlier, "top hat" plans are funded by deferrals of an executive's current income (and possibly additional contributions from the employer), while SERPs are funded exclusively by the employer.


Unvested plan

The employer's agreement with the employee is a mere promise to pay an income benefit in the future. The employee has no right to any asset of the employer nor any right to income benefits prior to the events specified in the deferred compensation agreement that trigger the payment of income.

Those triggering events are generally:

disability;
retirement; and
death.

The unvested nature of the plan applies even if the employer has purchased insurance policies or other assets to help meet its obligation to the employee.  In the insured deferred compensation plan, plan participants are insured, but they do not have any interest in the life insurance policies. Under the insured deferred compensation plan:

the corporation owns the policies;
the corporation pays the premiums; and
the corporation is the beneficiary.


Employer Retains Rights

All payments made to the employee, the employee's spouse or family must flow from the employer. If the employer owns any insurance on the employee's life, none of the incidents of ownership should be transferred to the employee not even at the employee's retirement nor should the spouse or other family member be named beneficiary of the policy.

If the employer were to name the employee's spouse as the life insurance policy beneficiary or transfer some or all of the rights to the policy to the employee so that payments would be made from the life insurance policy, there would be adverse income tax results. Specifically, the premium the employer paid for the life insurance policy the employee owned generally would be considered current income to the employee.


Payments May Be Subject to Conditions

Conditions may or may not be a part of the agreement. These are clauses that condition the payment of the benefits upon the employee either doing something or not doing one or more acts, such as:

refraining from competing with the employer after retirement;
not attempting to assign the deferred benefits; or
remaining with the employer until retirement age and acting in an advisory capacity afterwards.

In years past, deferred compensation programs had to contain some limiting conditions, in order to avoid a finding of constructive receipt of income.  Changes in the tax code have eliminated the requirement for conditions in a deferred compensation plan, but there are still good business reasons for inclusion of certain conditions.  An employer may be hesitant to enter into an agreement whereby the employee could terminate employment, receive the deferred compensation, and then immediately use the funds to finance himself or herself in competition with the employer. If the employer is concerned about possible employee actions that might be detrimental to the employer, the deferred compensation agreement should be drafted to include a provision that all benefits are lost if the employee were to violate certain agreed-upon conditions.

For example:

Sample Deferred Compensation Agreement Conditions Provision

CONDITIONS -  The provisions of paragraph 3 [providing benefits] are conditional upon the continued employment of the employee by the Company (including periods of total disability described in paragraph 1 and subject to the provisions of paragraph 5 hereof) until the 15th day of June, 2020, or his death, whichever is sooner, and upon the further condition that, during the period that retirement payments are made, the Employee shall not engage in business activities that are in competition with the Company without first obtaining written consent of the Company.





Insured Deferred Compensation Plans

While there is no requirement that a deferred compensation plan be funded with insurance, many plans do and for good reason.  A number of important tax and other benefits can be realized when life insurance is used as the funding mechanism for a deferred compensation plan. Life insurance is ideal for ensuring that the promised benefits of a deferred compensation plan will be available when necessary.

Few organizations would be willing to commit themselves to pay a preretirement survivor death benefit that might amount to hundreds of thousands of dollars and which might be payable only moments after the deferred compensation plan agreement is signed. Life insurance gives the employer the funds needed to meet its obligation to the executive's estate or heirs. For a fraction of the sum insured, the employer can receive the insurance proceeds at the executive's death free of tax to meet its obligations to the executive's family. Furthermore, life insurance enables the employer to recover some or all of the costs of the plan, regardless of whether the benefits are paid to the survivor or to the employee as additional retirement funds.

For executives who are insurable, funding the deferred compensation plan with insurance is the more effective means of fulfilling the employer's promise of benefits.


Matching Asset for Substantial Corporate Liability

As noted earlier, the life insurance policy or policies have no direct relationship to the deferred compensation agreement. In fact, a deferred compensation agreement could be carried out regardless of whether or not there is life insurance or any other employer-reserved asset involved. The purpose of the life insurance is to strengthen the corporation's overall financial picture and to facilitate its cost recovery.

Although the life insurance is designed to strengthen the employer's current and future financial picture, it impacts the employee as well. The existence of life insurance as an informal funding medium means greater peace of mind for the employee who realizes that the employer has created a matching asset for the substantial corporate liability imposed by the deferred compensation agreement.


Type of Policy

The particular type of policy used within the deferred compensation agreement depends on the general financial situation of the corporation and the ages of the prospective insureds. A cash value policy, preferably a whole life, universal life or variable life policy, is usually recommended. Using a life insurance policy that builds cash values permits the employer to make the decision at the employee's retirement as to whether to make the promised payments out of current earnings or from the policy's cash value.

Universal life insurance whether of the declared rate, equity index or variable variety can be particularly useful in a deferred compensation plan because of the policy's flexibility. The premium flexibility that is a hallmark of universal life insurance plans makes the use of permanent life insurance a more attractive funding option to employers whose cash flow may be less stable or seasonal. Knowing that a premium payment may be deferred or skipped altogether often is reassuring to these employers. In addition, the employer's ability to fully fund the benefit during the employee's working years may be important to many employers.


Policy Application and Ownership

The employer should apply for the insurance. We have noted previously that the employer should be the beneficiary, as well as the owner of all incidents of ownership in the policy. If the employee's spouse is made the policy beneficiary, or if the proceeds are made payable to a trust to be held for the benefit of the insured's family, the premiums the employer paid may be taxed in the current tax year as additional compensation to the insured.

It is equally important that when an attorney drafts the deferred compensation agreement, there are no provisions giving the employee any rights to the insurance policy, either during the employee's service with the employer or upon his or her retirement.


Employer Can Recover Its Costs

From the employer's point of view, the use of life and disability income insurance means that the business will be in a sounder financial position to:

pay benefits to a retired or disabled employee; or
make payments to a widow or widower in those cases in which survivor benefits are included under the plan.

In addition, life insurance may permit the employer to recover its costs of paying the benefits as well as its premium costs.


Accessing Policy Values

It is not the premium flexibility though it is important that makes universal life insurance so applicable to its use in deferred compensation plans, however. The more important flexibility of universal life insurance for deferred compensation plan purposes relates to the employer's ability to access policy values through cash value withdrawals and policy loans.

As we have discussed, an important feature of deferred compensation plans is the employer's ability to recover some or all of its costs. By maximizing the employer's ability to access policy values through both withdrawals and policy loans, there may be no need to surrender the life insurance to provide cash to pay the benefit. Because of that, the employer can obtain the funds needed to pay the promised deferred compensation benefit and retain much of the life insurance death benefit that the employer needs to recover its costs.



Handling the Policy at Retirement
When the employee reaches retirement age, ownership of the insurance policy should, nonetheless, remain in the employer. If the policy or any of the incidents of ownership are transferred or assigned to the insured employee, the fair market value of the policy at the time of transfer would constitute income and be taxable to the employee in the taxable year that the transfer was carried out.

There are two approaches that an employer may take with respect to the life insurance policy at the time of the employee's retirement. The employer may:

maintain the policy in force; or
surrender the policy.


Keeping the Policy in Force

In many cases, the employer will choose to continue the life insurance policy in force beyond the employee's retirement date to recover its plan costs and avoid the income tax liability on any cash value received in excess of aggregate premiums.

If the employer maintains the coverage beyond the point at which deferred compensation benefits start to become payable to the employee, the important question may become one of where the funds come from to pay those benefits. The answer is that the funds needed to pay the deferred compensation retirement benefits can come from:

cash value withdrawals and policy loans; or
current employer funds.


Using current funds, the employer keeps the policy in force with a death benefit that is undiminished by withdrawals or loans. In fact, the death benefit may continue to increase as the cash value increases even if the employer ceases policy premium payment. As a result, the employer will maximize the tax-free death benefit it receives at the employee's eventual death.

However, for the employer who wishes to avoid making deferred compensation retirement payments from current income, the policy cash value provides some welcome relief.   Before examining the use of cash values, let's consider the two factors that favor the employer's use of these values: FIFO tax treatment of policy withdrawals; and income tax deductibility of benefit payments.


FIFO    Tax-Free Withdrawals of Cost Basis

In a deferred compensation plan, the life insurance policy used to informally fund the plan has a cost basis that generally is equal to the cumulative premiums paid for the policy. So, provided the life insurance policy is not a modified endowment contract (MEC), the employer may withdraw the amount of cash needed to pay the benefit from the cash value without incurring tax liability until the total withdrawal exceeds the employer's total premiums.  In short, the current federal income tax law permits a life insurance policyowner to withdraw funds from a non-MEC life insurance policy tax free up to the policyowner's cost basis.


Modified Endowment Contract

A life insurance policy is deemed a modified endowment contract (MEC) if the accumulated premium amounts the policyowner paid under the contract during the first seven policy years exceed the sum of the net level premiums that would have been required (on or before such time) if the contract provided for paid-up future benefits after seven level annual premiums.

If the life insurance policy is an MEC, the tax treatment is LIFO (last-in, first-out), and the gain is deemed to be withdrawn first.



Benefit Payments Are Deductible

Any retirement benefit payments made by the employer under a deferred compensation agreement are income tax deductible.

For example

Assume that the employer is a corporation that has a taxable income in excess of $75,000. As a result, it is in a 34 percent federal income tax bracket.

If the employer makes a tax deductible deferred compensation payment of $2,500 each month, that payment has an after-tax cost of only $1,650. Each time the employer makes a $2,500 payment to the deferred compensation plan participant, it reduces its federal income tax liability by $850. ($2,500 × 34% = $850).  For that reason, a tax-free cash value withdrawal of $1,650 is all that is required to fund the deferred compensation payment. The balance of the retirement payment comes from the employer's tax relief.

Generally, the employer will also be subject to state income taxes, and these deferred compensation payments also will lower its state income tax liability.



Switch to Policy Loans

Withdrawals of cash value can be taken, without tax consequence, up to the policy's cost basis (the accumulated premiums paid on the policy).  At some point, however, assuming that the employee is sufficiently long lived, the employer will have taken cash value withdrawals from the life insurance policy equal to its cost basis. Any further withdrawals will result in an income-taxable distribution.

At the point that the employer's total cash withdrawals equals its cost basis, the employer may continue to enjoy the receipt of tax-free funds by switching from withdrawals to policy loans. The amount of policy loan required to make the deferred compensation payment is the same as the amount that was required as a cash value withdrawal. Specifically, it is the amount that results when the total deferred compensation payment is multiplied by 1 minus the employer's income tax bracket. [In the example above: (1.00 minus .34) × $2,500 = $1,650]

To make this policy loan arrangement even more favorable for the employer, the policy loan interest may be tax deductible if the life insurance policy is on the life of a key person.

Warning: There is a risk when taking withdrawals down to basis and then changing to policy loans.  While this commonly-used strategy will continue to provide the funds tax free to the employer; there is, however, a need to use some caution.    If the policy is subsequently surrendered or permitted to lapse, the policyowner could experience "phantom income."  Phantom income (in this context) is taxable gain as a result of lapse or surrender taxable gains without actual funds with which to pay the tax liability that arises upon termination of the contract.




Policy Surrender at Retirement

Some employers may not be concerned about recovering the costs of the deferred compensation plan. For these employers, maintaining the life insurance coverage beyond the employee's retirement date is less important. In such a case, the employer may select the cash value method of paying the benefits and may choose to surrender the policy and place the funds under an appropriate settlement option.

Depending on company practice, the employer may be permitted to elect to receive the maturity or cash surrender values under an income option for a fixed period of years. If the employer is obligated to pay an income to the employee for, say, ten years, then the employer may find it a convenient arrangement to elect a fixed-period income option for a 10-year period.

As the employer receives the periodic payments from the insurance company under the settlement option, these payments could in turn be paid to the employee to meet the terms of the deferred compensation agreement. The employee would incur income tax liability, of course, only to the extent of the amounts he or she actually received in the taxable year of receipt.

Although policy surrender and use of the cash value to pay the deferred compensation participant's retirement benefit is certainly an option available to the employer, the resulting loss of the policy's death benefit and the taxability of the employer-received cash value generally makes this choice unattractive.




Proceeds Paid at Death

At the employee's death, the employer collects the insurance proceeds income tax free. If the deferred compensation plan includes a survivor benefit, the employee's death also creates a liability for payment of the survivor benefit. The survivor benefit is generally paid from the employer's funds. Despite the tax-free nature of the death benefit proceeds the employer received, the payments made to the survivor are:

taxable income to the survivor; and
tax deductible to the employer making the payments.

The income the survivor received under the deferred compensation plan is considered income in respect of a decedent and is taxed as it would have been if paid to the employee.


Insurance Company Payment to Survivor

The plan participant may want the survivor payments to go directly from the insurance company to his or her spouse. In this case, the employer could arrange with many insurance companies to make payments directly to the surviving spouse but subject to the corporation's right to rescind the payment order.

Even though the periodic survivor payments might be made directly to the survivor, the insurance company is acting as the agent for the employer in making the payments. The employer remains the sole payee, and the arrangement has no effect on the tax treatment of the payments.



Taxation

Constructive Receipt and Economic Benefit Doctrines

Two income tax concepts are particularly pertinent to deferred compensation:

the constructive receipt doctrine; and
the economic benefit doctrine.

Because effectively deferring the tax on deferred compensation requires that income not be constructively received and that the participant not receive an equivalent economic benefit, let's look at these concepts more closely.


Constructive Receipt Doctrine
The constructive receipt doctrine states that income that is not actually received may be taxed as if it had been received, if the individual constructively received the income. Constructive receipt occurs when income is

set aside for the individual;
credited to the individual's account; or
made available to the individual without any substantial restrictions on the individual's control over the income.


Economic Benefit Doctrine

The economic benefit doctrine requires that an individual recognize income if property has been handled in a way that provides a cash-equivalent economic benefit to the individual.

Fortunately for deferred compensation purposes, a mere unsecured promise to pay income in the future does not constitute constructive receipt, provided the employee does not have access to the compensation that has been deferred.

As a result, when properly set up, a deferred compensation plan usually will not result in current taxable income to the employee.



Employer's Deduction Based on Benefit Payment
A key difference between a nonqualified plan such as deferred compensation and a qualified retirement plan is the way the plan is taxed. Qualified plans give an employer an income tax deduction at the time that contributions are made to the plan, and the employee is not subject to income tax on that contribution until he or she takes the money out many years later. Furthermore, as long as the money remains in a qualified plan, the tax on investment earnings is also deferred. None of this is true of a deferred compensation plan.

Because a deferred compensation plan is a nonqualified plan, the employer receives a tax deduction only when the benefits are actually paid to the plan participant or survivors or when they are no longer subject to a substantial risk of forfeiture. When the employer receives the income tax deduction, the plan participant or survivor is subject to income tax. The moment of taxation is the moment that the employee receives the payment or gains a right to the funds that is not subject to a substantial risk of forfeiture.


Question of Risk

Income taxation may not occur until the employee receives the deferred compensation payment. However, income tax liability may occur earlier if the money is set aside for him or her in a way that protects the funds from risk. The two most common ways to do so are through the rabbi and secular trust discussed earlier.


Taxation When Rabbi Trust Is Used
Rabbi trusts postpone the moment of taxation because, although the trust affords some protection of the employee's money, it remains at substantial risk of forfeiture. Consequently, the deduction for the employer and taxation for the employee is postponed generally until the funds are paid to the plan participant or survivor.


Taxation When a Secular Trust Is Used
Secular trusts do not postpone taxation. The increased protection of the employee's benefit has been interpreted as removing the substantial risk of forfeiture. Consequently, the deduction for the employer and taxation for the employee is not postponed but occurs when payments are made to the trust.

At first glance, this seems undesirable for the employee to be taxed without receiving the money. But, employees still might prefer this arrangement if they expect to be in a much higher tax bracket when they withdraw the funds or if they think the funds might be lost in a future merger. Understandably, however, secular trusts become somewhat less attractive to plan participants to the extent that the top individual tax rate is higher than the top corporate tax rate.


Necessary and Reasonable Tests

For compensation that an employer pays to an employee to be income tax deductible, it must be both necessary and reasonable; deferred compensation payments must meet the same test. To be deductible by the employer, deferred compensation payments an employer made for majority shareholders also must qualify as ordinary and necessary business expenses and as a reasonable allowance for services actually rendered. These are not difficult tests to meet when the employer and the employee enter into a written arm's-length agreement to pay deferred compensation.

The necessity and the reasonableness of the deferred compensation benefits may be issues when the employee is also a principal shareholder of the firm. In these cases, the corporation's deduction of a portion or all of the deferred compensation payments may be disallowed as being a distribution of dividends.


Survivor Payments
The Internal Revenue Code permits the deduction by the employer of payments made to the surviving spouse of a deceased employee under the terms of a deferred compensation contract. Income tax payments received by a survivor under a deferred compensation contract are reportable as gross income.  This rule applies even though the source of the payments is insurance proceeds the employer received, and which were excludable as income when received by the employer.


Survivor Payments Includible in Estate
The survivor receives these payments because of the deferred compensation contract, not because of the life insurance. As a result, the income the survivor received is not excludable from income taxation as amounts received under a life insurance contract. Payments to a surviving spouse under a deferred compensation contract also are considered in tax lingo to be "income in respect of a decedent".

A deferred compensation agreement, evidenced by a contract, which promises benefits beyond the death of the employee, causes those future benefits to be included in the decedent's gross estate and subject to federal estate tax. This is based on the fact that the decedent had a contractual right to have his or her employer make these payments.  The amount includible in the plan participant's gross estate attributable to the deferred compensation plan is the present value of deferred compensation payments payable after the employee's death. Federal tables are used to value the present value of these future survivor payments.

If a deferred compensation plan is noncontractual and the employer may modify or terminate it at any time before the employee's death or retirement, its death benefits may not be subject to estate tax.



Shareholder as Plan Participant

What about deferred compensation for a plan participant who is also the principal shareholder of the corporation? The answer to this question is important to the insurance professional, because a principal shareholder is often a prime prospect for deferred compensation. As a result, it is considerably easier to sell deferred compensation for the principal shareholder than for any other employee.

However, for the deferred compensation arrangement to be viable for the principal shareholder, special arrangements need to be made. Specifically, the plan should be structured so that benefits will be paid to the principal shareholder at retirement or to the shareholder's family at death, even in the event that the corporation is no longer in existence. The legal devices that may be used include the rabbi and secular trusts that we have already examined.


Other Tax Issues

There are three issues whose answers we have already alluded to in this course. However, for the sake of completeness and clarity, let's briefly examine them again. They are:

insurance premiums;
the employer's tax deduction for benefits paid; and
accumulated earnings tax.


Tax Consequences of Paying Insurance Premiums

The first issue, regarding insurance premiums, is a simple and straightforward one. Specifically, premiums paid by a corporation on an insurance policy it owns on the life of an employee even a shareholder-employee is not taxed to the employee. The payment is not deductible by the corporation either.



Deduction When Benefits Are Paid

With respect to the employer's deduction, the employer may deduct payments made to an employee or survivor, provided that:

the payment of the benefits is a necessary business expense; and
the size of the benefit is reasonable in amount.

The first requirement the necessity of the deferred compensation payment can be satisfied in most cases with a binding, written agreement at the time the deferral of income begins.  The second requirement the reasonableness of the benefit may give the employer more trouble than the first one, especially with a majority stockholder.

With respect to the majority stockholder, the questions that need to be asked and answered are:

Are the deferred compensation payments made to this employee reasonable compensation for services rendered and, therefore, deductible?
Should the deferred compensation payments be regarded as dividends flowing to this individual because of his or her stock ownership and, therefore, not deductible by the corporation?


Reasonableness of Executive Compensation to Shareholder

There are few hard and fast guidelines with respect to the reasonableness of executive compensation paid to a majority stockholder.

If the corporation has had difficulty during this shareholder-employee's working years justifying the reasonableness of the compensation paid, it is reasonable to expect that the corporation will find it even more difficult to justify significant deferred compensation levels after that individual retires. The primary problem is that justification for the deferred compensation payments is based on the total services he or she performed for the corporation during the working years.


Accumulated Earnings Tax

The issue of corporate earnings that are accumulated to pay the deferred compensation liability involving a majority stockholder is one that also presents concerns. What of the corporation that accumulates reserves-rather than purchasing life insurance-to enable it to meet its obligation to the shareholder-employee? Can it argue that these accumulations serve a legitimate business purpose and, therefore, escape the accumulated earnings tax?

When the employee is the principal shareholder, the corporation generally will find the money to pay the person a deferred benefit and, it could be argued, may not need to accumulate the funds to do so. Deferred compensation for a principal shareholder-employee continues to be an uncertain tax area that should be explored thoroughly by tax counsel before a deferred compensation plan is begun.


Life Insurance and Accumulated Earnings

In addition to all of the other reasons to use life insurance to informally fund the deferred compensation plan, from the point of view of the accumulated earnings tax, the corporation should use life insurance to fund its deferred compensation obligations. That preference applies whether the deferred compensation plan participant is the majority shareholder or not. At any time during the employee's lifetime, there would be a smaller amount accumulated as annual premiums paid than with any other method of funding.

In those cases in which the persons are minority shareholders, there appears to be no reason why they cannot be covered by a deferred compensation agreement, providing the amounts are reasonable in the best judgment of the directors and shareholders.


Prospects & Marketing


The motivation to enter into a deferred compensation agreement comes from one of two directions:

The agreement may be employer-motivated. The employer can offer deferred compensation to an employee as an inducement to stay with the company; or
The agreement may be employee-motivated. For example, an employee earning in excess of $100,000 annually may desire some tax relief. The individual may feel that he or she is not saving enough money for retirement. The employee would like to defer a portion of present income and thereby drop to a lower tax bracket. By using the salary reduction approach, highly-paid executives can gain substantial tax savings.


Employer-Motivated

A wide range of employers  can, and do, install deferred compensation plans: corporations, partnerships, sole proprietorships and non-profit organizations.   Although the reasons for establishing these plans may be the same regardless of the type of organization, certain types of organizations have very special reasons.

Public Corporations

A publicly-traded corporation (one whose stock is traded on an exchange or over-the-counter) are subject to some  restraints on the large compensation packages they award their senior executives.  In 1993,  Congress amended the Internal Revenue Code to  limit the tax-deductibility of certain executive compensation over $1 million.  This new section, Section 162(m) states, in part: "....   In the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1,000,000. "

This denial of deductibility makes compensation for highly-paid executives more expensive for the employer.  As a result, some of these organizations have looked to deferred compensation plans as an alternative way to reward their senior executives. And of course, publicly-traded corporations also employ deferred compensation plans as a way to attract and retain key executives motivations that are very common in other organizations.


Closely Held Corporations
Closely-held corporations are not subject to Section 162,  however, they have their own reasons for using deferred compensation in their executive pay packages.  For example, family-owned businesses can use deferred compensation programs as an alternative to ownership interests as a way to attract or retain key executives.     A closely-held corporation may not have the resources of a giant public corporation.  It is more likely that such closely-held companies are unable and/or unwilling to provide the general level of compensation and employee benefits available from large public corporations.  They might be able to provide competitive benefits packages, however, as long as those benefits are selective.  In other words, they may be willing and able to offer one individual a generous salary and benefits arrangement but not be able or willing to provide it to all employees.  It is in this kind of setting that nonqualified plans particularly deferred compensation plans have an important niche.


Non-corporate Organizations

It isn't only corporations, whether public or closely held, that may install and benefit from a deferred compensation plan.  Sole proprietorships, partnerships and limited liability companies may also receive benefits from such a plan, as can non-profit organizations such as charities, hospitals, private schools, country clubs, etc.  Although owners of these organizations won't enjoy the tax benefits of deferred compensation, the organizations can use these plans to attract and retain non-owner executives.



Employee-Motivated

Senior executives the people most likely to benefit from a deferred compensation plan  have an important voice in the matter.  As a result, it is not unusual for a senior executive to try to design his or her compensation arrangement to offer both current income tax relief, and supplemental retirement income

An executive in the top tax bracket could easily be taxed at a combined state and federal marginal income tax rate of 40 percent on the next dollar earned.  By delaying receipt of income to a time when his or her marginal tax rate is lower, the executive may be able to avoid a considerable amount of income tax.  Deferred compensation plans allow the executive to accomplish that.  In addition, that deferred income may substantially increase the executive's income during retirement.

Moreover, the workers covered by deferred compensation may be:

employees: such as general managers, engineers or sales managers; or
independent contractors: such as hospital- or clinic-associated physicians, manufacturers' representatives or attorneys.





Sample Preapproach Letter

The following is a sample preapproach letter that may be used in approaching prospects. It is recommended that the letter be used in conjunction with a suitable brochure.

Dear __________________:

There is no doubt about the key ingredient in most business success; it is people. The continuing success of any business enterprise is largely dependent on attracting and keeping key employees. And, one of the most effective means of attracting and retaining those key employees is through corporate fringe benefits-specifically, a special retirement program designed solely for key people.

There is a plan available to businesses like yours that can provide future benefits in return for present services. Commonly known as deferred compensation, it is a systematic retirement program for key executives and top managers. This plan offers many advantages to both employees and employers-including the employer's ability to recover all costs.

Take a few moments to review the brochure I've enclosed; I think you'll find this plan an attractive approach to attracting and retaining key employees. I would like to arrange a meeting with you to explain in more detail how a deferred compensation plan can benefit your organization. I will call you next week to arrange a brief meeting.

Sincerely,

Jane Agent