Deferred Compensation In a Nutshell October • 2002 Why Non-Qualified Deferred
Transcription
Deferred Compensation In a Nutshell October • 2002 Why Non-Qualified Deferred
October • 2002 Allen Gralitzer, Corporate Vice President, J.D., LL.B., LL.M., CLU, ChFC, FMLI Deferred Compensation In a Nutshell File: MDRT I/R Code: 1700 The following provides a basic explanation of non-qualified deferred compensation plans. Future bulletins will expand on this area and cover such topics as Top Hat Plans, Excess Benefit Plans and Deferred Compensation Arrangements for employees of tax-exempt organizations. (Note: Advanced Underwriting Bulletins 806 and 7/24/86 have been superseded by the enclosed bulletin.) Table of Contents Why Non-Qualified Deferred Compensation? ...... 1 Background ............................................................ 1 Non-Qualified Deferred Compensation Plans Defining The Term................................................. 1 Salary Reduction vs. Salary Continuation - Some Further Refinements............................................... 2 Tax Considerations - Employee ............................. 2 Constructive Receipt Doctrine ............................... 2 Economic Benefit Doctrine / Informal Funding .... 3 Taxation to Participant at Retirement .................... 4 Taxation of Death Benefits .................................... 4 Social Security (FICA) and Federal Unemployment Taxes (FUTA) ........................................................ 4 Federal Income Tax Withholding .......................... 4 Income Tax - Employer.......................................... 4 Life Insurance vs. Other Sources of Informal Funding................................................................... 5 How To “Feel” A Bit More Secured...................... 5 Impact of ERISA .................................................... 6 Accounting Aspects of Deferred Compensation.... 6 Where’s The Market?............................................. 7 “S” Corporation...................................................... 7 Deferred Compensation and Split Dollar Life Insurance Agreement.............................................. 8 Documentation ....................................................... 8 Why Non-Qualified Deferred Compensation? In today’s economic climate, the competition is intense to attract, retain and reward talented executives. Moreover, the success of any business is largely dependent on the company’s ability to motivate their key people to perform at a high level. Accordingly, employers are continually looking for new ways to provide incentive benefits to select employees. From the employer’s perspective, the one area of executive benefits -- perhaps more than any other -- that offers needed flexibility coupled with the relative absence of government supervision is non-qualified deferred compensation. For key employees the ability to defer the receipt and taxation of income while supplementing their retirement savings may be just the enhanced benefit package that will satisfy their long-term financial strategies. A review of the basic fundamentals of nonqualified deferred compensation is essential to a further understanding of other deferred arrangements providing supplemental executive benefits. Unless indicated to the contrary, the words “employer” or “company” refer to a “C” corporation. For more detailed information on the deferred compensation marketplace see page 7. Background At the outset it is important to distinguish between deferred compensation as a qualified plan (e.g., pension, profit sharing, and Section 401(k) plans) vs. non-qualified plans. Both types of arrangements are bound by the common thread that defers the reporting of income earned by employees until sometime in the future. However, when it comes to the employer deduction there is a parting of the ways as only the qualified plan allows the employer to obtain a current income tax deduction for contributions made on the employees’ behalf. Unfortunately, there is a price to be paid for qualifying a deferred compensation arrangement -- compliance with a number of highly technical and burdensome requirements mandated by the IRS and the DOL (Department of Labor) as a result of ERISA (Employee Retirement Income Security Act of 1974) -- including plan participation, funding requirements, vesting, reporting and disclosure. These rules have been promulgated to insure that discrimination does not arise in favor of key and highly compensated employees. The result of the government’s concern in recent years over this discrimination issue has been to limit the maximum benefit that can be offered. In response to these restrictions, more and more employers are seeking alternative programs that will provide them with greater flexibility in providing a satisfactory benefit package for their key executives. More often than not, the search begins in the non-qualified deferred compensation area. Non-Qualified Deferred Compensation Plans - Defining The Term In general a non-qualified deferred compensation plan is a contractual unsecured promise by an employer to pay benefits to one or more of its key executives sometime in the future (e.g., at death, disability or retirement). Design flexibility such as the ability to 1 Deferred Compensation in a Nutshell discriminate in favor of select employees must be weighed against the fact that the amounts set aside are part of the general assets of the employer with the employee’s status being a general unsecured creditor of the employer. Usually, a non-qualified deferred compensation plan is classified as a salary reduction or salary continuation plan. Some consider salary reduction plans the only true or pure deferred compensation arrangements since the employee agrees to forego a portion of current compensation for the promise of deferred benefits. Of course, there is nothing to prevent the employer from deferring compensation in the form of a bonus. In reality, the employee is foregoing a salary increase. On the other hand, salary continuation plans are more in the nature of supplemental benefits paid with employer dollars. The name distinctions between the two plans can be traced to a late 1970’s contention by the IRS that since the employee, under a salary reduction plan, had the option to defer or take cash, current taxation resulted. This is not the case in salary continuation plans where the dollars to pay the supplemental benefits come from the employer and are therefore not currently taxable. Thankfully, Congress did not agree and today private non-qualified deferred compensation plans encompass both salary reduction and salary continuation plans. (Non-qualified deferred compensation plans for employees of state and local governments as well as other tax-exempt organizations are governed by the more restrictive provisions of IRC Section 457. This area will be discussed in a separate bulletin at a later date.) Salary Reduction vs. Salary Continuation - Some Further Refinements In a typical non-qualified deferred compensation agreement, certain provisions highlight the difference October 2002 between the two arrangements. For example, a salary continuation plan frequently uses a defined benefit qualified plan approach with plan benefits based on a percentage of average compensation measured over a period of years representing the employee’s highest earnings. Another alternative for gauging employee plan benefits would be years of service. The benefits may also be in the form of a fixed amount, (e.g., $8,000 per month for life or a certain period). Contrary to the inflexibility of qualified plan formulas, non-qualified benefit formulas are negotiable between the parties. On the other side of the ledger, a salary reduction plan more closely resembles a defined contribution approach with, for example, a specified amount of salary periodically set aside in an informal account for the participant employee. The informal account (i.e., the amounts are unsecured) can be actually set aside to accumulate or merely represent a bookkeeping entry in the participant’s name. Additionally, the agreement may provide that the participant’s account will earn interest based on some formula or index. In any event, whether salary reduction or salary continuation, benefit payments, when paid out, may take the form of a lump sum amount, a series of periodic payments, or may be converted into a single life annuity or joint and survivor annuities for employee - participant and spouse. with the company. In order to achieve tax deferral, the non-qualified plan must be structured so as to avoid two rules of tax law: the constructive receipt doctrine, and the economic benefit doctrine. Constructive Receipt Doctrine IRC Section 451 and accompanying regulations define the constructive receipt doctrine. Under this doctrine, even if income is not actually received, it will be taxable if it is credited to, set apart for, or otherwise made available to the employee. However, income is not constructively received if the employee’s control of its receipt is subject to substantial limitations or restrictions1. For example in a deferred compensation arrangement, if the agreement requires the executive to work until “normal retirement” (as defined in the agreement) or lose all benefits, this provision will constitute a substantial risk of forfeiture sufficient to prevent the application of the constructive receipt doctrine. The IRS has issued guidelines concerning the application of the constructive receipt doctrine to “unfunded” deferred compensation arrangements. The major requirements are as follows: 1. Employee’s initial election to defer compensation usually must be made before the beginning of the period of service for which the compensation is payable. The IRS generally regards the period of service as the calendar year. Translation…. the election to defer must be made before the compensation is earned. 2. Exception to above -- In the year the plan is first implemented, an election to defer may be made during the implementation year for services to be performed subsequent to the election. Caveat: such election must be made within 30 days after the date the plan is effective or within 30 days after the date the executive becomes eligible to participate. Tax Considerations Employee From the employee’s standpoint, tax deferral (of both the principal amount and any growth) may be a compelling reason for entering into a deferred compensation agreement. For a key executive presently receiving compensation at or near his or her top income tax bracket, the ability to defer income tax on current compensation supported by the employer’s contractual promise to pay amounts sometime in the future, may be an attractive executive benefit and a primary determinant for remaining 2 Deferred Compensation in a Nutshell 3. 4. 5. The plan must specify the time and method for paying deferred compensation for each event (such as termination of employment, regular retirement, disability retirement or death) that entitles the participant to benefits. The plan must provide that participants have the status of general unsecured creditors of the employer and that the plan constitutes a mere promise by the employer to make benefit payments in the future. If a trust is part of the deferred compensation plan, the IRS has issued model rabbi trust provisions.2 The model trust is intended to serve as a safe harbor for employers that adopt grantor trusts in connection with unfunded deferred compensation plans. If the model trust is used, an employee will not be in constructive receipt of income solely on account of the adoption of the trust, provided that the deferred compensation plan effectively defers compensation. (More about Rabbi Trusts beginning at page 5.) 6. The plan must also state it is the parties’ intention that the arrangement be unfunded for tax and ERISA purposes. (Note: “unfunded” is a necessary ingredient to avoid the undesired result that may occur if the plan is considered “funded” - i.e., loss of deferral and / or imposition of burdensome ERISA requirements.) 7. If the plan contains a payout provision in the event of an “unforeseeable emergency”, such emergency must be defined as an unanticipated emergency beyond the control of the participant or beneficiary that would cause severe financial hardship if early withdrawals were not permitted. Any such premature distribution must be employer approved and limited to the October 2002 amount necessary emergency. 8. to meet the Finally, it is essential that the plan indicate that a participant’s rights to benefits under the plan are not subject to anticipation, alienation, sale, transfer, assignment, pledge, encumbrance, attachment, or garnishment by creditors of the participant or participant’s beneficiary. Thus an employee can have nonforfeitable rights to deferred payments and not be in constructive receipt so long as: (1) the deferred compensation arrangement is entered into before the compensation is earned; and (2) the employer’s promise to pay deferred compensation is unsecured.3 The doctrine of constructive receipt also plays a significant role where a deferred compensation plan is instituted for a controlling stockholder/employee. The IRS has successfully contended that a nonqualified deferred compensation arrangement for a controlling stockholder (i.e. more than 50% ownership), funded with a deferred annuity, resulted in the stockholder-participant being in constructive receipt of compensation and therefore taxable currently on the premium paid to maintain the annuity contract. The IRS reasoned that a controlling stockholder is in a position to direct the corporation to do his bidding. In effect, the deferred amounts were available to him at any time so that he could have access whenever he so desired. (Please note that this ruling (TAM 8828004) was issued prior to the enactment of the socalled “nonnatural person” rule that would annually tax the owner of the deferred annuity contract, generally on the value in excess of premiums paid. In general, the “nonnatural person” rule refers to a situation where contributions are made after February 28, 1986 to a nonqualified deferred annuity contract held by a corporation or other entity not a natural person. Since the contract is not treated for tax purposes as an annuity contract, deferral of taxation is lost and current taxation results.) On the other hand, a number of court cases and a revenue ruling recognize that the corporation and the stockholders are separate entities and uphold the validity of deferred compensation arrangements entered into by the parties.4 The IRS may continue to scrutinize deferred compensation arrangements for controlling stockholders but will not issue an advance private letter ruling on the tax consequences of such a plan.5 Economic Benefit Doctrine / Informal Funding Under the economic benefit doctrine immediate taxation occurs if funds are irrevocably set aside beyond the reach of the payor and its creditors. For example, if an employee is given an interest in any fund, account, or asset, which secures the employer’s promise to pay under a non-qualified deferred compensation agreement, the employee will incur current income tax liability. In the context of deferred compensation and the economic benefit doctrine, a leading case is Goldsmith vs. U.S.6 In Goldsmith, the deferred compensation arrangement was funded with life insurance. The Court of Claims differentiated between the employer’s unsecured promise to pay retirement and severance benefits and the life insurance policy purchased to fund the plan. The Court ruled that the purchase of life insurance amounted to a receipt of a current taxable economic benefit to the employee. It would appear that the Court’s rationale was based on the secured nature of the arrangement as evidenced by the policy itself which constituted a measurable economic benefit. 1. The Lesson of Goldsmith - informal funding with life insurance Although the Goldsmith case is inconsistent with the IRS’ position in numerous later rulings, care should be taken that the deferred compensation plan does not specifically refer to life insurance as the formal funding mechanism for the plan. However this “better safe than sorry” approach should not be construed as 3 Deferred Compensation in a Nutshell 2. October 2002 eliminating life insurance as an informal funding vehicle. A key to successfully maintaining life insurance as a source of funding may be retention of the policy by the employer at all times with the property remaining a general unrestricted business asset subject to the claims of the company’s general creditors. Taxation to Participant at Retirement Avoiding Current Taxation Taxation of Death Benefits The employee should not be currently taxed on the premiums paid for such a policy or on the value of such policy as long as the employer is the owner and beneficiary of the policy and the employee has no interest in the policy. (Note: if the employee is given unrestricted rights to the property securing the deferred benefit, Section 83 of the Internal Revenue Code will be triggered.) This section provides that when there is a transfer of property in connection with the performance of services the value of such property must be included in an employee’s gross income in the first taxable year in which such property is transferable by the employee or is not subject to a substantial risk of forfeiture. When are an employee’s rights in property subject to “ a substantial risk of forfeiture”? When they are conditioned upon the future performance of substantial services. Consequently a deferred compensation arrangement generally should not include a formal vesting schedule which gives absolute rights to assets. Does this mean that a vesting schedule may not be part of the plan agreement? No. The key, however, may be to make sure that the vesting schedule is not giving specific rights to a fund nor is it securing the participant’s benefits. Rather, the vesting schedule can represent a measure of the benefit that is to be provided to the participant. When an executive (or his/her beneficiary) receives non-qualified plan distributions, the benefits will be taxable as ordinary income. Ideally, at that point in time -- because of retirement -- the executive may be in a lower tax bracket, and typically the payments may be spread over a period of years. 1. Income Tax Death benefits paid from a non-qualified deferred compensation plan are taxable income to the beneficiary even if the plan is informally funded with employer owned life insurance. Payments to be made to the executive’s surviving beneficiary constitute “income in respect of a decedent.”7 Since they are taxable to the decedent participant’s beneficiary, these payments may be entitled to be claimed as a deduction on the beneficiary’s income tax return to the extent of the portion of federal estate tax attributable to the income included in the executive’s estate.8 2. Estate Tax For estate tax purposes, the amount includible in the decedent - executive’s gross estate is generally the present value of the future payments to be made at or after the executive’s death.9 Social Security (FICA) and Federal Unemployment Taxes (FUTA) Any amount deferred under a non-qualified deferred compensation plan is considered wages subject to FICA and FUTA at the later of: (i) the year in which the services are performed or (ii) the year in which there is 10 no substantial risk of forfeiture. As to what constitutes a “substantial risk or forfeiture”, IRC Sec 83, as mentioned above, defines the term as an individual’s right to full enjoyment of property subject to a substantial risk of forfeiture, which is conditioned upon the future performance of substantial services by any individual. Typically, amounts deferred under an unfunded or informally funded non-qualified deferred compensation arrangement will not be designed to include a substantial risk of forfeiture provision. The omission of such a clause is advantageous for the executive since it is probable that an executive’s compensation will exceed his FICA taxable wage ceiling ($84,900 for 2002) during his/her employment years. As a result, amounts deferred can be 11 earned and received free of FICA taxes. This is also the case with respect to FUTA. Federal Income Tax Withholding Although not specifically referenced in the Internal Revenue Code, as is the case with FICA and FUTA, non-qualified deferred compensation arrangements are considered wages for withholding tax purposes. Consequently taxable distributions when received are subject to withholding. Income Tax - Employer If an employer-owned life insurance policy is used to informally fund the deferred compensation arrangement are the premiums paid by the employer currently deductible? Not only are the premiums not currently deductible by the employer, they are not deductible period. Why? … because the employer is directly or indirectly a beneficiary of a policy insuring the 12 life of an employee. Whether the employer owns the policy as part of an endorsement split dollar plan, entity buy sell agreement or simply as a key person policy, the premiums are not deductible. 1. Pre-Retirement Death Benefits The employer will receive an income tax deduction for any amount actually paid to the decedent employee’s beneficiary. Generally, the employer will have received the death proceeds from a key person life insurance 4 Deferred Compensation in a Nutshell policy. Under IRC Section 101 (a), such proceeds are received by the employer income tax free. (The alternative minimum tax (AMT) may apply to the death benefits received by the corporation). However, recent legislation has provided small corporations with an exemption from AMT if average annual gross receipts for the previous three years does not 13 exceed $5 million. 2. Retirement Benefits The employer is entitled to an income tax deduction for benefits paid to the employee under the plan. However, the deferred compensation payments will be deductible only to the extent the payments are not considered unreasonable compensation. Although there is no hard and fast rule in determining what is reasonable, court cases have indicated certain factors that should be considered including: (1) compensation paid by similar businesses for comparable services; (2) pattern of prior compensation paid; (3) the degree and nature of the work performed by the employee; (4) time devoted to work, both currently and in prior years; (5) results obtained; (6) the need for unusual skill and ability; and, (7) inadequate salary paid in prior years in relation to the work effort involved. Life Insurance vs. Other Sources of Informal Funding The bottom line for any non-qualified deferred compensation arrangement is to avoid current taxation of benefits to be received in the future. To accomplish this result both the constructive receipt and economic benefit doctrines must be circumvented. Use of an informal funding vehicle may be useful in non-qualified deferred compensation arrangements. Three methods come to mind: corporate savings, corporate borrowing and of October 2002 twofold purpose: as a source of funds to pay death benefits to the executive’s family, and as a means of recovering the costs of the plan due in large part to the income-tax free nature of the life insurance proceeds received by the employer upon the death of the 14 insured employee. In addition, retirement benefits paid by the employer pursuant to a non-qualified deferred plan are deductible by 15 the employer. The life insurance proceeds are received income tax free to the corporation, although the alternative minimum tax may apply. course, our old friend, corporate owned life insurance. Let’s briefly compare these approaches: 1. Corporate Savings - the corporation can set up some type of reserve or informal sinking fund to accumulate the funds necessary to pay the promised benefits down the road. Whatever interest is earned under this arrangement may be taxable currently and the corporation’s retirement benefit costs and opportunity cost of money may never be recovered due to the effect of such factors as inflation, the turnover rate, employee mortality and disability and administrative costs associated with a self-funding program. In addition the corporation must consider the after tax cost of the deferred compensation paid. What if the corporation has a down period – will there be enough accumulated to fund a pre - retirement death benefit? 2. Borrowing - is this a viable alternative? Yes and no-- the interest paid is deductible but like the savings approach, the corporation’s costs may never be recovered (see “(a)” above.) What degree of certainty is there that the corporation will be able to borrow the funds when needed? Moreover, there is no way to know with any reasonable assurance what interest rates will be charged when the funds are required in the future? 3. Life insurance - corporate owned life insurance as the informal funding mechanism may avoid many of the problems associated with the above two methods. Since the insurance will be owned by and payable to the corporation, the cash values may be borrowed against as the funding source to pay lifetime benefits. Of course, loans will impact the death benefit. Also, if the policy is surrendered or lapses, the amount of outstanding loan that represents gain in the contract is immediately taxable to the corporation. The proceeds can serve a 4. Annuities - In the past, corporate owned deferred annuities have been used as the funding mechanism to secure the employer’s promise to pay future benefits under a nonqualified deferred compensation plan. However, with the introduction of the “nonnatural person” rule into the tax law (TRA 1986 - - see previous discussion under “constructive receipt doctrine” at page 2,) the inside buildup of cash value is taxable annually. How To “Feel” A Bit More Secured As mentioned earlier when discussing the “constructive receipt doctrine, for a typical nonqualified deferred compensation arrangement to work, it must be an unfunded plan – i.e., the executive has no guarantee that future payments will be made. The employee or beneficiary stands in the same line as the general creditors of the corporation and must deal with the possibility of corporate insolvency or bankruptcy. Formally funding the plan, however, may lead to unfavorable tax and ERISA implications. Let’s look at some alternatives to formal funding: 1. Rabbi Trusts - Use of this arrangement (originally stemming from an IRS ruling involving the security of post - retirement benefits for a rabbi) as the informal funding vehicle generally involves an irrevocable trust established by an employer to which annual deferrals are transferred. For tax purposes, the trust is considered a grantoremployer’s trust so that the income earned 5 Deferred Compensation in a Nutshell by the trust will be taxable to the employer. Contributions made to the trust are not currently deductible by the corporation nor currently includible in the employee’s income. Rather, the deduction and inclusion occur in the year that payments are made, or otherwise made available, to the employee. The deferred tax treatment is only available if the assets held in the rabbi trust remain subject to the claims of the employer’s general creditors. Essentially, the rabbi trust will be considered unfunded even though the employer can make contributions to the trusts to specifically meet its deferred compensation obligations. For the key employees, the rabbi trust can provide a psychological buffer to the fears that a hostile takeover equates with a loss of benefits. In fact, many rabbi trusts include provisions which require the employer to make an irrevocable contribution to the trust upon a change in corporate control. But remember, since the assets maintained by these trusts remain subject to the claims of the employer’s general creditors, the executive is not insulated against the possible loss of deferred benefits in the event of bankruptcy or insolvency. Note, use of the IRS model Rabbi Trust (Rev. Proc. 92-64) provisions provides employers and employee/ beneficiaries with a greater degree of certainty as to the tax and legal issues involved in non-qualified deferred compensation arrangements because it is intended to serve as a safe harbor if followed. 2. Surety Bonding - At times a surety bond is purchased as protection in the event an employer cannot provide promised future benefits. Does this October 2002 guarantee that a non-qualified deferred plan will be unfunded, and thus avoid current tax and ERISA consequences? The answer is unclear but may depend on whether the surety bond is employee or employer provided. If employer-provided, the plan may be viewed as a funded plan; if employee-provided, the arrangement may be unfunded, but this outcome is uncertain. Impact of ERISA The Employee Retirement Income Security Act (ERISA) was enacted in 1974 and is designed to protect the interest of employees in both pension and welfare benefit plans sponsored by their employers. The term employee pension benefit plan (pension plan) is defined in part to mean any plan, fund, or program which is established or maintained by an employer to the extent such plan, fund or program “results in a deferral of income by employees for periods extending to the termination of covered 16 employment or beyond….” Thus, ERISA clearly covers deferred compensation arrangements that provide for distribution of the deferred amount at termination of employment. Generally that means that a deferred compensation plan must comply with certain ERISA requirements including: (1) reporting and disclosure; (2) participation and vesting; (3) funding; (4) fiduciary responsibility; and (5) plan termination insurance. However, if a non-qualified deferred compensation plan is unfunded and established only for a select group of management or highly compensated employees it will be excluded from coverage under most or all of these rules. For example, an unfunded excess benefit plan, (one that provides benefits to any executive who has maxed out under his / her qualified plan IRC Section 415 benefits), is generally exempt from all ERISA requirements. Excess benefit plans are not limited to a select group of management or highly compensated employees. Also a “top hat” plan, which is an unfunded deferred compensation plan maintained primarily for a select group of management or highly compensated employees, may provide a safe harbor from most of the ERISA requirements governing qualified plans. All that is required for ERISA purposes is limited reporting and disclosure (i.e., notice to the Secretary of Labor within 120 days of adopting the plan that the plan exists and that, if requested by the DOL, necessary documents will be submitted.) Accounting Aspects of Deferred Compensation In addition to the tax consequences of a nonqualified deferred compensation arrangement, the accounting treatment by an employer is often a critical element in deciding whether to implement the plan. The record keeping activity of a business for accounting purposes is ultimately reflected in the financial statements of the employer, the two most important statements being the Balance Sheet and the Income Statement (often referred to as the Profit and Loss Statement). The Financial Accounting Standards Board (FASB), through a number of FASB Statements they have issued, generally conclude that the most appropriate way for an employer to reflect deferred compensation liabilities on the balance sheet that accrue from year to year as the benefits accrue, is to spread the entire cost of the projected benefits ratably over the working life of the participating employee. The Balance Sheet is a measure of the employer’s financial position on a specific date. In effect, it is a picture of the company’s status at a given point in time as represented by the accounting equation, which puts the “balance” in Balance Sheet: ASSETS = LIABILITIES + OWNER’S EQUITY. On the other hand, the Income Statement is a report that indicates the company’s revenue, expenses, and resulting net income over a specific period of time. 6 Deferred Compensation in a Nutshell When life insurance is used to fund the deferred compensation arrangement, the accounting must be separated into two parts: Accounting for the deferred benefits Accounting for Employer Owned Life Insurance 1. Accounting for Deferred Benefits According to the Accounting Principles Board in APB Opinion Number 12 (APB No. 12), which is applicable to deferred compensation plans, the after-tax present value of the employee-participant’s expected future benefits must be spread over the working life of the employeeparticipant in a “systematic and rational” method. The annual amounts expensed should be sufficient to generate a fund, which is equal to or greater than the present value of the promised benefits to be paid after retirement. October 2002 Premium payments are considered to be an expense for financial statement purposes. Cash surrender value increases are treated as financial statement income. In practice the policy premium expense is netted against the cash value increase to generate a net life insurance income or expense. Typically, whole life insurance policies generate little or no value in the policy’s early years. In later years, when the cash value is greater than the premium paid, no expense will be recognized. CASH SURRENDER VALUES ARE BOOKED AS LONG TERM ASSETS FOR BALANCE SHEET PURPOSES. When a policy matures by reason of the death of the insured, the excess of the policy’s death benefit over the cash surrender value generates a substantial nontaxable increase in earnings. Policy loans have accounting treatments. received varying APB No. 12 requires a company to subtract the annual projected cost of deferred compensation benefits (including an assumed interest rate), from current corporate earnings. For accounting or book purposes the accountant will reflect an annual deferred compensation expense on the Income Statement and an accrued deferred compensation liability on the Balance Sheet. Frequently, accountants net policy loans against the cash surrender value on the balance sheet. Other accountants treat a policy loan as the equivalent of a loan from a bank. Under the latter approach, the balance sheet would reflect the amount of the policy loan as a liability while the full amount of cash surrender value would be recorded as an asset. 2. Where’s The Market? Accounting for Employer -Owned Life Insurance As mentioned above, when insurance contracts are maintained in connection with a deferred compensation arrangement, the policies must be accounted for separately. The accounting treatment afforded these assets is set forth under FASB Technical Bulletin Number 85-4 and is known as the “cash surrender value” (CSV) method of accounting. Under the CSV method: Premium Payments Non-qualified deferred compensation arrangements informally funded with life insurance can be effective in any one or more of the following situations: 1. For executives earning a high salary and who are in a high personal income tax bracket. The assumption is that the business is stable and the executives are confident of the employer’s continuing life and economic health. (Note: large corporations with multiple executives also provide an excellent source for a deferred benefit plan.) 2. To act in lieu of a qualified retirement plan. For the small employer not wanting to get enmeshed with the complex requirements of getting a plan qualified, a non-qualified deferred compensation arrangement provides an attractive alternative. 3. To supplement a qualified retirement plan. Because qualified plan limits have become more restrictive in recent years, nonqualified deferred compensation is more attractive than ever to augment retirement income in appropriate circumstances. 4. To retain key employees. This can be either in the context of persuading a key employee not to leave before retirement, or keeping a key employee after retirement as a consultant. 5. To attract new employees. When an employer is in a competitive hiring environment, the addition of a salary continuation plan can provide the advantage needed to tip the scales in his or her favor. 6. To make executive compensation more meaningful. As a significant portion of an executive’s salary could be exposed to high tax rates currently, deferring receipt of some income until a later time may be what the executive prefers. 7. As a substitute for stock ownership. Generally, in a close corporation few or no dividends are paid. A potential minority shareholder may prefer to be covered by a generous deferred compensation plan instead of receiving stock. “S” Corporation Note: Generally speaking, use of a non-qualified deferred compensation in a “C” corporation works quite well. However, the same does not necessarily hold true with a “S” corporation. The reason - - a double tax problem - - once, when a shareholder-participant is taxed on his / her share of the “S” corporation’s income used to pay the non-deductible premium and, later, when the shareholder, or his / her beneficiary, is taxed again as the corporation pays out the 7 Deferred Compensation in a Nutshell deferred plan benefits. However, these plans may still remain attractive for key non-owner employees as well as stockholders who hold minimal equity interests. Deferred Compensation and Split Dollar Life Insurance Agreement The basic deferred compensation concept can be enhanced in several ways to accomplish more than the postponement of the receipt of some income. For example, the employee who agrees to defer some earnings may want to be assured that his designated beneficiaries will receive a lump sum benefit if he dies before retirement. A tax-free death benefit may be preferable to taxable deferred salary or bonuses. Endorsement Split Dollar Although there have been several recent changes affecting the taxation and usage of 17 split dollar , an endorsement method split dollar arrangement may provide the answer to this need. The employer applies October 2002 for and it is the owner of the policy and pays for the entire premium. The employee would have to include in income the value of the economic benefit conferred upon him (the life insurance protection provided) by his employer. To avoid an “equity” split dollar problem, the employer should be the beneficiary to the extent of the greater of premiums paid or the policy’s cash surrender value and the employee’s chosen beneficiaries for the balance. The death benefits paid to the beneficiaries are proceeds of a life insurance policy and are income tax-free. A split dollar agreement is maintained during the active working career of the employee. Upon the employee’s retirement, disability or termination of service other than due to death, the split dollar arrangement is terminated and the policy may revert to a key employee policy owned by the employer. Thus there should be no tax consequences to the employee since the policy was not “transferred” to the employee. The split dollar insurance arrangement has thus served its purpose of providing income tax-free protection for the employee during pre-retirement years while the resulting key employee insurance allows the employer to “fund” compensation obligation. its deferred Documentation In general, the following documents must be executed to establish a non-qualified deferred compensation arrangement: 1. Plan agreement - sets forth the basic contract between the employer and the executive. It describes in detail the amount and nature of the deferral and the manner in which the deferred compensation will be paid. 2. Corporate Resolution - usually a one-page document indicating the intent of the employer to establish a non-qualified deferred compensation plan. 3. DOL letter - filed with the Department of Labor for ERISA purposes. For additional forms which are or may be required by New York Life (including a Rabbi Trust), please refer to the “Advanced Planning Applications Manual” under the heading “Deferred Compensation.” This update is prepared for the general information and education of the Agents and Registered Representatives of New York Life Insurance Company to assist them in understanding the issues that may arise in connection with the sale of New York Life and New York Life Insurance and Annuity Corporation products. It reports current developments and sets forth generally accepted concepts or principles. No attempt is made to offer tax, accounting or legal advice or set forth solutions to individual problems. For such advice and specific applications to individual cases, individuals to whom agents make presentations must rely on the advice of their own professional advisors. 8 Deferred Compensation in a Nutshell 1 Reg. Sec. 1.451 – 2 (a) 2 Rev. Proc. 92 –64, page 422 (1992 – 2 CB) 3 Rev. Proc. 71 – 19, as amplified by Rev. Proc. 92 –65; see also Rev. Ruls. 70 –435 and 60 – 31. October 2002 4 Casale v. Comm, 247 F2d 440 (CA2, 1957); Moline Properties, Inc. v. Comm; 319 U.S. 436 (1943); Rev. Rul. 59-184. 5 Rev. Proc. 97-3, Sec. 3.01 (30) 1997-1 CB 507. 6 586 Fd 810 (1978) 7 IRC Section 691(a) 8 IRC Section 691(c ). 9 IRC Section 2039 (a) an (b) 10 [The IRS released proposed regulations providing guidance on FICA and FUTA taxation of non-qualified deferred compensation. Prop. Regs. Sections 31.3121 (v) (2)-1, 31.3306® (2)-1(a), effective fir amounts deferred and benefits paid on or after 1/1/98.} 11 ( A note of caution: FICA is composed of two parts: (1) Medicare, (2) OASDI – Old Age, Survivors, and Disability Insurance. For 1994 and later years, the wage base cap for Medicare portion of FICA tax (1.45% for the employer and 1.45% for the employee), had been removed. Although this change may put a dent in the above mentioned favorable situation enjoyed by executives exceeding their annual OASDI taxable wage base, the largest portion of the OASDI tax due may still be avoided.) 12 IRC Section 264 (a) (I) 13 IRC Section 55 (e). 14 IRC Section 101 (a). 15 IRC Sections 404 (a) (5) and 162. 16 ERISA, Title I, Subtitle A, Section 3 (2) (A) (ii) 17 See Field News Supplement – Split Dollar – Recent Developments (08/19/02) 9