1. business and industrial
2. business operations
3. human resources
4. compensation and benefits

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(Note: Advanced Underwriting Bulletins 806 and 7/24/86 have been superseded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
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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