PRINT -- Chapter 2
Deferred Compensation Plans
The important points addressed in this lesson are:
Business profits are more often determined by the imagination and drive of executives than by any other factor
The ability of companies to attract, retain and reward their key executives is often essential to their success
Nonqualified deferred compensation plans include true deferred compensation plans under which an executive actually delays receipt of income, and salary continuation plans under which no income is deferred
Nonqualified deferred compensation plans generally provide retirement, survivor and disability benefits
Deferred compensation plan benefits may be designed as defined contribution plans or as defined benefit plans
Defined benefit deferred compensation plans are normally used in salary continuation plan design, while defined contribution plans are usually associated with true deferral plans
Generally all benefits payable under a deferred compensation plan are taxable when received and tax-deductible to the employer that pays them
Nonqualified deferred compensation plans may be installed by public corporations, closely held corporations and unincorporated businesses
In addition to the desire to attract and retain key executives, closely held businesses often install nonqualified deferred compensation plans as a qualified plan substitute or as an alternative to an ownership stake in the business
Nonqualified deferred compensation plans are normally discriminatory and usually provide benefits for only a handful of top executives
Nonqualified deferred compensation plans may be funded or unfunded
Funded deferred compensation plans have specific assets allocated to the plan, and these assets are shielded from the employer's creditors; they do not provide the executive with tax deferral
Unfunded deferred compensation plans provide the executive with tax deferral and include plans that are informally funded
Using life insurance to informally fund a deferred compensation plan provides tax benefits to the employer and the opportunity to recover plan costs
Universal life insurance policies as informal funding vehicles offer the employer flexible premium payments and the ability to access cash values through withdrawals
A rabbi trust can be used to ensure that successor management doesn't withhold promised benefits
A secular trust protects plan benefits from the decisions of successor management and the employer's general creditors
Deferred compensation benefits at retirement may be funded from the employer's current income or by accessing policy values
Businesses may live or die principally due to the quality and imagination of their management. Under the leadership of intelligent, imaginative and motivated executives, shoestring businesses often thrive while their better-funded competitors languish.
The stories of small, thriving businesses that fail to survive after being purchased by cash-rich companies are so numerous as to be almost trite. In the overwhelming majority of cases, the difference isn't in the business' products, employees or customers; the difference that makes all the difference is its management.
The ability of a business to attract superior management talent and, once that talent has been hired, to ensure that is retained is important in any business. In smaller, closely-held businesses, it may be the sine qua non of its continued existence. Nonqualified plans in general provide a method for these business organizations to attract high-impact executives and retain them once they become employees. For many organizations, however, only a deferred compensation plan will meet all of the firm's needs.
To Defer or Not to Defer
To many people, the idea of deferred compensation is simple and obvious: in a deferred compensation plan an employee agrees to delay receiving compensation until some date in the future. However, not unlike many other "obvious" things, this understanding is so oversimplified as to be simplistic.
The term "nonqualified deferred compensation" encompasses two fundamental plan designs, known as:
"True" deferred compensation plans, and
Salary continuation plans
At bottom, the difference between the two types of deferred compensation is whose money is funding the plan benefits.
A true deferred compensation plan is one that is consistent with the common understanding of the term: the participating executive agrees to delay the receipt of a portion of the compensation to which he or she is entitled. Typically compensation is delayed until the executive retires.
In contrast, a salary continuation plan -- the other deferred compensation design -- does not require that the executive defer any compensation at all. Instead, the employer agrees to fund the benefit entirely. Although true deferred compensation plans continue to be used, it should come as no surprise that they are far less popular among executives than salary continuation plans. These plans are often known as SERPs -- Selective Executive Retirement Plans.
Typical Deferred Compensation Plan Benefits
There is always the danger in discussing "typical" benefits that they will come to be seen as the "only," or as the "preferred," plan design. Despite that, we can identify three typical benefits that are included in a deferred compensation plan:
Disability benefits, and
The actual plan design of a deferred compensation plan and the benefits included in it will depend on the needs of the employer and the executive.
Retirement Benefits Benefits at retirement are equal to 50 percent of the executive's final salary for 10 years.
We briefly examined defined contribution plans and defined benefit plans in Chapter One in the discussion of qualified plans. Nonqualified deferred compensation plans may also be couched in terms of the contribution to be made or the benefit to be received. Although there are some exceptions to this general rule, true deferred compensation plans are usually of the defined contribution variety, and salary continuation plans are usually designed as a defined benefit plan.
It is not unusual for a salary continuation plan to provide retirement benefits equal to one-half of the executive's final salary for a period of 10 years. The annual benefits promised, of course, may be more or less than 50 percent of salary and may be for a period that is longer or shorter than 10 years. Furthermore, the deferred compensation plan benefit may be larger or payable longer for one key executive than for another.
An important byproduct of the defined benefit plan design in which benefits are a percentage of final salary is that, since the plan benefit is determined by the executive's final salary which, presumably, keeps up with and far exceeds the inflation rate, the actual benefit (at the commencement of retirement benefit payments) tends to retain its purchasing power. This is an important consideration since deferred compensation plans are often entered into many years before the executive's retirement.
A deferred compensation plan often provides for the commencement of benefits in the event of the executive's total disability. These benefits are often funded through an individual disability income policy that is usually conditionally renewable, the condition being the executive's continued employment with the firm. In addition, such disability policy should contain a non-transferability provision so that its issuance will not affect the executive's ability to be properly insured under a disability income policy protecting his or her earned income.
Disability Benefits Benefits in the event of the executive's total disability are equal to 50 percent of the executive's salary for the duration of such total disability but not for more than 10 years.
The benefits that may be provided to the totally disabled executive are generally stated in terms that are very similar to the terms used to describe his or her retirement benefits. As a result, it is not unusual for the total disability benefits provided under the deferred compensation plan to give the disabled executive 50 percent of his or her current salary for the duration of disability but not for more than 10 years. Alternatively, the disability benefit may continue until the executive's age 65 or other age recited in the plan document, at which time the normal deferred compensation retirement benefits would commence. Additionally, partial disability benefits may also be provided under the plan's disability provision.
Just as an executive may become disabled, he or she may also die while in the service of the employer. For that reason, survivor benefits are usually a part of a deferred compensation plan.
Survivor Benefits Benefits in the event of the executive's death while employed before retirement are equal to 50 percent of the executive's salary for 10 years.
Survivor benefits under a deferred compensation plan are often, but not necessarily, provided at the same level as they would be at retirement. So, it is not unusual to find pre-retirement survivor benefits couched in terms of 50 percent of the executive's salary. The salary, of course, to which the 50 percent applies, is the executive's current salary at the time of his or her death.
As we will see when we consider the taxability of deferred compensation plan benefits, the survivor benefits are fully taxable as income to the survivors when received despite their being payable under an insurance policy owned by the employer. In some plans, the employer and executive may choose to combine an employer-owned policy under a split dollar plan with a deferred compensation plan. By combining these two approaches, the pre-retirement survivor benefit is received by the survivors entirely free of income tax.
Regardless of the actual benefits provided under the deferred compensation plan, it is important to understand that the plan can be tailored to meet the employer's needs and those of the key executive. These deferred compensation plans are almost infinitely variable.
Deferred Compensation Plan Eligibility
The type of organizations that can, and do, install deferred compensation plans is broad. In fact, it is difficult to review the balance sheet of any substantial corporation and fail to find a note referencing an existing deferred compensation plan. 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.
A public corporation is a corporation whose shares of stock are readily available to the general public and are bought and sold in the open market. Although the names of certain giants come to mind when we think of public corporations -- names such as IBM, AT&T and General Motors, for example -- this category includes firms that are far less visible and that may also be less responsive to stockholders.
In order to put some restraints on the large compensation packages that certain public corporations were awarding their senior executives, Congress amended the Internal Revenue Code in 1993 to add §162(m) that generally limits the tax-deductibility of certain executive compensation to no more than $1 million.
Excessive Employee Compensation Non-deductible
Sec. 162. Trade or business expenses TITLE 26, Subtitle A, CHAPTER 1, Subchapter B, PART VI, Sec. 162 STATUTE (m) Certain excessive employee remuneration (1) In general 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 IRC change generally makes the compensation that exceeds $1 million for these individuals more expensive. Not surprisingly, some of these organizations have looked to deferred compensation plans as a means of appropriately rewarding their senior executives. (IRC §162(m) is included in its entirety in Appendix A.)
Public 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 generally avoid some of the restraints that normally apply to public corporations, such as the non-deductibility of certain executive compensation under IRC §162(m). These organizations, however, have their own reasons for using deferred compensation in their executive pay packages. Chief among the reasons for establishing a deferred compensation plan is the desire to attract key executives and, once hired, to provide incentive for them to remain with the organization.
Although a closely held corporation may have resources that rival those of a giant public corporation, that is not usually the case. It is more likely that such organizations are unable and unwilling to provide the level of compensation and employee benefits normally associated with large public corporations. They may be able to afford significant benefits packages, however, as long as those benefits are selective. In simpler terms, 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.
It isn't only the organization's needs, however, that may provide the motivation for installing a deferred compensation plan. Senior executives also 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.
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. 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.
Motivations for Deferred Compensation Plan Establishment
We noted at the outset that the reasons for establishing a deferred compensation or other nonqualified plan may be the employer's reasons or the executive's reasons. In many cases, these plans are developed to meet the needs of both parties. While enabling the employer to attract and retain the executive, the deferred compensation plan allows the executive to achieve some tax relief and add to his or her retirement income. However, there are reasons other than these traditional motivations that may be in the mind of the business owner considering a deferred compensation plan. Let's consider some of them.
In the closely held organization -- an organization to which the majority of agents are likely to gain entrée -- there are many reasons for installing a deferred compensation plan. Some of these reasons arise out of the nature of a closely held company. In these organizations, a deferred compensation plan may be established for any or all of the following reasons:
As a substitute for a qualified plan
To help ensure that successor family owners have an experienced management team, or
As a substitute for an ownership stake in the organization
Let's consider these reasons.
Qualified Plan Substitute
Qualified plans enable the business to meet a range of objectives. However, they tend to be prohibitively expensive for some organizations and somewhat inflexible, because of ERISA safeguards. Furthermore, some employers may feel little or no obligation to help provide for the retirement security of their employees. Despite those issues, these business organizations may want to provide retirement benefits for some of their employees -- particularly for their senior executives.
Nonqualified deferred compensation plans permit the employer to give selected employees -- including its owners in some cases -- extremely generous retirement benefits. Since no government approval is necessary (DOL notice may be required, however), these plans are almost always discriminatory and usually provide benefits for no more than a handful of senior executives. The possible adverse reaction from other, not-included employees is usually avoided since there is no requirement of notice to these employees, and they frequently are unaware of the existence of these plans.
Ensuring Successor Owners of an Experienced Management Team
Greater longevity, advances in reproductive medicine and the increasing prevalence of multiple marriages have all resulted in the commonness of childbirth into the parents' 40s and 50s. Healthy children have even been born to parents in their 60s. While these late-in-life births have consequences that extend well beyond the issue of business succession that, too, may be seriously affected.
Family businesses often remain in the family provided there is sufficient capital along with a family member interested in managing the business when the current owner steps down. But, what happens when there are minor children who may eventually have an interest in working in the family business but who have years of education ahead of them before that can occur?
The answer may lie in ensuring the continuation of an experienced management team to run the business during that interim period. The question, of course, is how to ensure the team's continuation. Picture the situation from the non-family member's perspective.
Jim Walters and Marcy Witt joined Family Electronics, Inc. several years ago largely because of its owner, Dudley Peters. Dudley was one of those business owners that most employees only hear about and never experience firsthand. He eagerly shared business information and responsibility with his staff. He promoted them as far as their talents allowed and always treated them with respect, even when they made mistakes. And, when the business became profitable, he made sure that his employees enjoyed some of that success by ensuring they had larger paychecks. As vice presidents of the firm and Dudley's friends, Jim and Marcy were among the first to learn that he was ill and would have to step down.
Dudley's oldest child, Sean, is currently seventeen years old and has expressed a desire to take over firm ownership. To Jim and Marcy, Sean has all of the characteristics of an employee's nightmare: he is uneducated, untested and may soon be their boss. Fortunately for Jim and Marcy, they are both highly thought of in the industry and will soon be offered the opportunity to head up business operations for other companies. For Dudley, Sean and Family Electronics, Inc., the loss of these two seasoned executives may very well mean that the company will no longer be a family business. Instead of family retention, the business may have to be sold or liquidated.
Another answer may result from the use of a salary continuation deferred compensation plan designed to ensure that Jim and Marcy remain with Family Electronics while Sean obtains the necessary education and training to assume active management and ownership. A salary continuation plan often envisions the payment of retirement benefits upon the executive's reaching normal retirement age -- age 65, for example. However, age 65 isn't a "magic" age.
Suppose that Jim and Marcy are deemed critical to the business' ability to continue into the future and that they are both age 40. Further assume that it is reasonable to assume that Sean would be ready to assume active ownership of the business after 10 years -- four years of college and 6 years of business training at the company. A salary continuation plan could be designed that would give Jim and Marcy a salary continuation benefit of 50 percent of their final salary for a period of 15 years, provided they remained at Family Electronics for 10 years. During this time, Sean could be groomed to take his father's place at the head of the company.
Substitute for an Ownership Stake
For many executives, the opportunity to gain an equity position -- to own some or all of the business -- is much sought after. Conversely, owners of closely held corporations often choose to limit ownership to a very few individuals and, if stock shares are granted, to limit those shares to a small minority ownership. This tends to keep control of the entity in the hands of current owners.
Key executives, mindful of the decided lack of control granted by minority ownership often see a minority interest in a close corporation as having little value. Normally stock shares in close corporations have restrictions on their sale. Furthermore, even without these typical restrictions, the market for minority interests in close corporations is virtually non-existent.
For this reason, businesses are turning more frequently to nonqualified deferred compensation as an alternative to granting a key executive an ownership interest in the company. The plan is completely selective and may meet both the financial and psychological needs of the executive.
Deferred Compensation Plan Fundamentals
The design of a deferred compensation plan -- whether true deferred compensation or salary continuation -- 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
The Promise to Pay a Benefit
The basis of the payment of a benefit under a deferred compensation plan is the agreement between the employer and the key executive under which the employer agrees to pay a benefit upon the fulfillment of certain conditions. Those conditions normally include the executive's agreement to remain in the service of the employer and may or may not involve an agreement not to compete with the employer for some specified period.
The deferred compensation agreement may promise to pay a specific benefit -- sometimes referred to as a defined benefit model -- couched in terms of dollars or as a certain percentage of final salary (or average of the final three years' salary or any other mutually-agreeable arrangement). Such a provision might be stated as follows:
From and after the Employee's retirement from the Corporation's service at age 65, or such younger age as may be approved by the Corporation, the Corporation shall thereafter pay the Employee the sum of $50,000 yearly for a period of 10 years, payable in equal monthly installments, commencing with the first day of the first month following his retirement.
This defined benefit model of the deferred compensation agreement's promise to pay is characteristic of salary continuation plans and may also be used, although far less frequently, in true deferred compensation plans under which the executive actually delays receipt of income.
In the majority of true deferred compensation plan agreements, the promise to pay is stated in terms of the defined contribution model. Specifically, the employer agrees to pay a benefit that is determined based on the amount deferred plus any additions. The provision used in a true deferred compensation plan agreement might read as shown below:
The Corporation agrees that, from and after the Employee's retirement from the service of the Corporation upon reaching age 65 or upon reaching his Early Retirement Date, the Corporation shall pay thereafter as a retirement benefit to the Employee the Employee's entire Accrued Benefit, payable in equal monthly installments for a period of 120 months, commencing with the first day of the first month following his retirement.
Typically in these true deferred compensation plan agreements, the employer agrees to make contributions of additional amounts. These additional amounts are payable only if the executive remains in the service of the employer until age 65 or a previously agreed -- upon early retirement date. If the executive terminates his or her services prior to the dates stated in the agreement, only the amounts deferred by the executive are payable to him or her; the employer's additions are forfeited. In a true deferred compensation plan agreement, the language providing these additions may state the following:
Additions to Amounts Deferred
The Corporation hereby agrees that it will credit deferred amounts in the Employee's Retirement Account with additions thereon from and after the dates deferred amounts are credited to the Retirement Account. Additions to deferred amounts shall accrue beginning on the date the Retirement Account first has a positive balance and shall continue until the date that benefits commence. Additions will be calculated at the rate of 8 percent per annum, compounded annually.
In a true deferred compensation plan agreement, the additions may be calculated in any way that is agreeable to the executive and the corporation. One method that will tie the executive's eventual benefit to the performance of the employer is to credit additional amounts based on the company's earnings.
Separating the Promised Benefits from the Employer's Assets
Normally, one of the important elements of deferred compensation is the delay in taxation of the deferred funds. To understand the requirements that must be met to ensure that the executive is not taxed currently on compensation that he or she will not receive until some time in the future, we need to consider the difference between a funded plan and an unfunded plan.
A funded plan is a deferred compensation plan to which specific assets are allocated to ensure that the promised benefit will be paid. We will examine rabbi trusts and secular trusts later in this section, and as we will see, the secular trust's exempting the asset supporting the benefit from the general assets of the company attachable by creditors is sufficient to cause the benefit to be immediately taxable to the executive. Although there are certainly cases in which the assurance of the benefit is of greater moment than its tax deferral, avoidance of current income taxation is usually central to the plan.
An unfunded plan is a deferred compensation plan whose benefits are supported by the general assets of the employer, rather than by a specific asset that has been segregated from those general assets. As such, these assets are attachable by the employer's creditors. In the bulk of cases, unfunded deferred compensation plans employ an informal funding approach under which a specific asset is acquired by the employer to support the benefits provided by the plan. Although this informal funding may use virtually any type of investment to support the benefit -- mutual funds, life insurance, etc. -- many organizations opt for life insurance as the informal funding vehicle because of its tax treatment and the opportunity it provides for the employer to recover some or all of the costs of providing the promised deferred compensation benefits.
Informal Funding Through Life Insurance
We noted just above that informal funding simply means that an asset has been purchased by the employer to help it to meet its obligation to provide the promised benefits. That informal funding may be provided through the purchase of mutual funds, the creation of a sinking fund, the purchase of life insurance or by acquiring any other asset that will help enable the employer to provide the benefits that were promised. Regardless of the informal funding vehicle, for tax purposes, an informally funded plan is considered unfunded because the identified asset is attachable by the employer's creditors.
Life insurance generally provides the most cost-effective method of informally funding a deferred compensation plan, as long as the executive participant is insurable. The life insurance policy used in the informal funding of a deferred compensation plan is a permanent life insurance policy that is owned by the employer who is also its premium payer and beneficiary. The executive participant in the plan has no rights at all in the policy.
We noted that the typical deferred compensation plan generally provides benefits:
At the participant's retirement from the employer's service
During the participant's disability prior to retirement, and
To survivors upon the participant's death before retirement
During the period before the key executive's retirement, the employer normally makes regular premium payments for the life insurance policy that has been purchased to support the promised benefits. The policy's cash values grow on a tax-deferred basis, and the death benefits are immediately available to provide any pre-retirement survivor benefits. The survivor benefits could, of course, become payable almost immediately after the deferred compensation agreement is entered into.
The pre-retirement survivor benefits normally provided by deferred compensation plans may constitute a substantial financial obligation for the employer and one that it might be reluctant to assume without the protection of life insurance coverage. When the participant retires, the cash values -- which may be based on interest crediting or the performance of a separate account -- can be accessed by the employer to provide the retirement payments. At the executive's eventual death, the life insurance policy's death benefits -- possibly diminished by withdrawals and policy loans -- are payable to the employer on a tax-free basis to enable it to recover the costs for both the benefits and the life insurance.
The life insurance policy selected by the employer as the informal funding vehicle should be a permanent policy for several reasons:
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 even if the executive lives for many years after retirement
Although whole life insurance policies may enable the employer to meet its obligations under the deferred compensation plan, many employers prefer to use universal life insurance policies. These policies permit the policyowner to withdraw funds from the policy's cash value as well as take loans from it. In contrast, access to cash values in whole life insurance policies is generally limited to policy loans, unless the policyowner is willing to substantially reduce the policy's face amount through a partial surrender. (Dividends, of course, may be another source of cash in a whole life policy.)
The universal life insurance policy chosen as the informal funding vehicle in a deferred compensation plan may be one whose cash value growth is affected by:
The insurer's declared crediting interest rate
The change in an equity index, such as the S&P 500,or
The performance of a separate account funded by securities
The choice of policy type should generally reflect the policyowner's risk tolerance level and desire for policy guarantees.
Regardless of the type of universal life insurance policy chosen, universal life insurance gives the policyowner not only access to cash values but also important premium flexibility. It is the unusual business whose cash flow doesn't vary from time to time. Because of that cash flow variability, the ability to make large premium payments when cash flow is high, smaller premium payments when it is low and no premium payments when cash flow is interrupted can be the critical component in making the sale.
Although an employer may be able to fulfill its obligations under a deferred compensation plan without purchasing any particular asset, such as a life insurance policy, the employer that buys a life insurance policy to support its obligations actually satisfies several objectives. It guarantees that funds will be available to meet its pre-retirement death benefit liability, that funds will be available to help provide retirement benefits and that it can recover its costs. The purchase of a life insurance policy on the participant's life also tends to provide a sense of security to the executive who is more assured of his employer's ability to meet its commitments under the plan.
Providing Additional Guarantees through Trusts
As executive compensation has grown while the level of benefits that can be provided these participants under qualified plans has generally decreased, executives and their employers have frequently turned to nonqualified deferred compensation plans to provide increasing amounts of retirement income. By some estimates, many executives can expect to receive as much as 50 percent of their retirement income from nonqualified deferred compensation plans. At the same time that this has been occurring, the business environment has become increasingly unstable and marked by leveraged buyouts and hostile takeovers.
We don't need to look very far to see the effects of this vicissitude in the economic and business environment. In 2003 Bethlehem Steel Company, once the backbone of the American economy, effectively ceased all operations and left the economic stage. A company that had employed several hundred thousand workers had been relegated to economic history.
It is the uncertainty of business that renders many nonqualified plans -- particularly deferred compensation plans -- somewhat risky. 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? The simple fact is that the deferred compensation participant becomes an unsecured creditor of the employer. However, ensuring that the funds intended to support plan benefits remain available to the employer's creditors has been key to the plan's ability to defer income taxation.
Because of the unenviable position in which the executive is thrust in such a case coupled with the increasing importance of these plans, interest in securing the benefits promised by a deferred compensation plan is also increasing. A trust can help provide some of that security.
Trusts that have been used to help secure the deferred compensation plan benefit are the following:
Rabbi trusts, and
Let's briefly examine how they work.
A rabbi trust is designed to overcome the concern that a change in company management could place the promised deferred compensation plan benefits in jeopardy. A rabbi trust, however, contains a provision that the trust assets would always be available to the employer's general creditors in the event of bankruptcy. As a result of that provision, the IRS has held that, in the case of a deferred compensation plan whose benefits are secured by a rabbi trust, the participant would have no current taxable income.
The use of a rabbi trust effectively eliminates the risk that the benefit will not be paid except in the case of the employer's bankruptcy or insolvency. So, the trust resolves the security issue in the event of a change in management and the refusal of the new management to pay the promised benefit. It represents an advance in protecting the promised benefits of a deferred compensation plan without the loss of its tax advantages. In the next trust that we will consider -- the secular trust -- the results are different.
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. As a result of the protection of the secular trust's assets from the claims of the employer's creditors, the executive is currently taxed on the deferred compensation benefits; that is to say that, while the compensation may be deferred under the plan, its taxation is not-generally, a poor combination. In some cases, however, the secular trust and its disadvantageous tax treatment are preferable to exposing the deferred compensation benefits to the risk that the employer will not survive.
Certain companies and industries -- because of their exploitation of new technology, or for some other reason -- are characterized by significant risk that can't easily be transferred through insurance. The dot.com companies that were the fuel behind the high-tech market run-up of the 1990s are a good example. Many of these companies produced a lot of "paper" millionaires. However, when the dot.com bubble burst early in the 21st century, the majority of those companies were gone. If a key executive had a deferred compensation plan with one of them and did not use a secular trust, the benefits were probably lost when the company folded. In such a case, the secular trust would have been a far more desirable approach despite the income tax issue.
Delivering Deferred Compensation Plan Benefits
There are typically three situations in which benefits under a deferred compensation plan may be payable at:
death before retirement. or
The methods normally used to provide the promised benefits are different, depending on which situation requires their payment.
Benefits at the Executive's Retirement
Paying the benefits at the key executive's retirement may be done using the employer's current income alone, or funds may be made available to the employer by accessing the asset used to informally fund the plan. Regardless of whether funding comes entirely from the employer's current income or by accessing a life insurance policy used as an informal funding asset, the employer has two options with respect to the policy:
The employer may surrender the policy, or
The employer may keep the policy in force.
The employer that surrenders the policy that informally funds a deferred compensation plan experiences two important consequences, both of them bad:
The employer will be required to recognize current income to the extent that the policy's cash value exceeds the employer's cost basis; the employer's cost basis is generally equal to its aggregate premium payments.
The employer forgoes its ability to recover its plan costs since the death benefits will no longer be payable.
Of course, the employer receives the policy's cash value on surrender and may use those funds in any way it chooses, including using them to pay the deferred compensation plan benefits. As a result of these two adverse consequences, however, employers using life insurance to informally fund the plan benefits will usually keep the policy in force.
If the employer elects to keep the life insurance policy in force, it may pay the retirement benefit out of its current earnings or may choose to take funds from the policy's cash value. To the extent that the employer accesses cash value, it will diminish the eventual death benefit. If the benefits are to be paid by using policy values and the life insurance policy used to informally fund the plan benefits is a whole life insurance policy (preferably a life paid-up at 65), the employer has probably used any dividends to purchase paid-up additional insurance. Upon commencement of retirement benefits, the employer can surrender sufficient dividend additions to pay the deferred compensation plan benefit. When dividends have been exhausted, the employer may begin making cash value loans.
The flow of funds in a universal life insurance policy is even more advantageous because of the availability of cash value withdrawals and their favorable tax treatment. The tax treatment enjoyed by withdrawals from a life insurance policy that has not been deemed a modified endowment contract (MEC) is known as first in, first out (FIFO). Under FIFO tax treatment, withdrawals are tax free until the policyowner has withdrawn an amount equal to its cost basis. Only then will withdrawals be taxable as ordinary income.
As a result of that tax treatment, employers generally choose to take withdrawals from the life insurance policy used to informally fund the deferred compensation plan benefit until they have recovered their cost basis. When their cost basis has been recovered, the employer then changes the cash value access to policy loans.
Since the payments made by the employer are tax-deductible and withdrawals are tax-free to basis, the employer enjoys a certain amount of tax leverage. For example, if the employer is a corporation in a 34 percent tax bracket, a $100,000 annual deferred compensation payment actually costs the employer $66,000; the other $34,000 comes from reduced income tax liability resulting from the tax-deductible payment. So, the employer would normally take a withdrawal equal to its net after-tax cost of $66,000.
Policy loans are also received tax free, provided the policy is not subsequently surrendered. (If surrendered, the outstanding loan balance is deemed to be a part of the surrender proceeds.) To make this arrangement even more favorable for the employer, the policy loan interest paid by the employer on policy loans under policies insuring a key person is deductible to the extent that the indebtedness does not exceed $50,000.
Note of caution: The strategy of taking withdrawals to basis and then changing to policy loans to continue to receive the funds tax free is one that is used frequently; there is, however, a need to approach the strategy with some caution. If the policy is subsequently surrendered or permitted to lapse, the policyowner could experience a condition frequently referred to as "phantom income." Phantom income (in this context) means that the policyowner will experience taxable income as a result of lapse or surrender without having cash value funds with which to pay the tax liability that arises because of the termination of the contract.
The retired executive receives the deferred compensation payments as taxable income in the year in which they are received.
Benefits at the Executive's Disability
Benefits that are payable under a deferred compensation plan at the executive's disability generally come from disability income policies paid for by the employer. These policies should be of the conditionally renewable variety, and continued renewability should be conditional on the executive's continuing to be employed by the employer. Conditionally renewable policies owned by the employer are not generally taken into consideration in determining the amount of disability income coverage available to the executive.
Disability income policies used to provide pre-retirement disability benefits pursuant to a deferred compensation agreement are normally owned by and payable to the employer. Since the policy is owned by, and benefits are payable to, the employer, premiums are not deductible. The disability benefit received by the employer is tax free; the benefit when paid to the executive is income taxable to the executive and tax-deductible to the employer.
Alternatively, an employer may elect to pay premiums on a disability income policy owned by the executive. In such a case, the premium paid by the employer is tax-deductible but is not taxable to the executive. The disability benefits, however, are taxable to the executive under this arrangement. If the executive and employer opt for this approach, i.e. payment of premiums on an executive-owned disability income policy, the deferred compensation plan agreement should clearly indicate that the employer's obligation is limited to the payment of disability income insurance premiums. If the disability income policy is owned by the executive, it will affect the executive's ability to obtain other disability income coverage.
Pre-retirement Survivor Benefits
If the executive covered under the deferred compensation plan dies while in the service of the employer, benefits will normally be paid to his or her survivors -- often at the level that would have been paid to the executive at retirement. Since the life insurance policy used by the employer to informally fund the deferred compensation plan benefits is owned by the employer who is also the beneficiary, the entire tax-free death benefit is paid to the employer when the executive dies.
Benefits are payable to the executive's survivors in accordance with the terms of the deferred compensation plan agreement. The benefits are considered taxable income when received by the survivors and tax-deductible when paid by the employer.
In some cases, employers and their executives choose to combine an employer-owned, endorsement-method split dollar plan with a deferred compensation plan. The advantages of that combination include:
Death benefits received by survivors are income tax-free, and
The employer's cost may be reduced slightly by the executive's payment of a portion of premiums equal to the economic benefit of the split dollar death benefit
Although the adequacy of capitalization and the desirability of products or services are important factors in the success of any business, it is the drive and imagination of the firm's management that account for the bulk of its profits. In short, it is the business' ability to attract and retain key executives that is often essential to its success. Nonqualified plans -- particularly deferred compensation plans -- may be instrumental in enabling a business to attract and retain those high-impact executives.
While nonqualified deferred compensation plans are often discussed as though they were all of a single type, "deferred compensation plan" is a more generic term that includes true deferred compensation plans as well as salary continuation plans; the principal difference in these plan types derives from whose money -- the employer's or the employee's -- funds the benefits. These plans generally provide an array of highly selective executive benefits including retirement benefits, pre-retirement survivor benefits and disability benefits.
Nonqualified deferred compensation plans may be designed according to a defined benefit or a defined contribution model, somewhat similar in that respect to qualified plans. Salary continuation plans are generally defined benefit in design, while true deferral plans tend to be of the defined contribution type.
Plan benefits are normally provided in nonqualified deferred compensation plans to a small group of highly compensated key employees; as such, these plans are discriminatory in nature. They may be funded or unfunded, depending upon whether or not specific assets are allocated to provided the promised benefits. Funded plan benefits are shielded from the claims of the employer's creditors and provide no tax-deferral benefits for the executive participant. Plans that are considered unfunded plans, however, may be supported by the purchase of a particular asset, i.e. they may be informally funded and still provide tax-deferral as long as the assets supporting the benefits may be attached by the employer's creditors.
Life insurance is often seen as the most desirable informal funding vehicle for nonqualified deferred compensation plans. Its use provides tax benefits to the employer and the opportunity to recover plan costs. Although any type of permanent life insurance may usually be used to informally fund the plan benefits, universal life insurance is often desired because of its premium flexibility and easy access to the policy's cash value.
Nonqualified deferred compensation plan benefits may be secured against a successor management's decision to withhold them through the use of a rabbi trust. This trust provides a level of protection for plan benefits, but, since the trust assets are attachable by creditors, the approach still gives the executive participant the benefit of tax deferral. A secular trust, in contrast, offers more significant protection for plan benefits by shielding them from both a decision by management to withhold them and the employer's general creditors in the case of insolvency or bankruptcy. This protection, however, comes at a price: that price is the loss of tax deferral by the executive.