CFP Course 102 - Unit 9: Nonqualified Deferred Compensation NEEDS EDITING

salary continuation approach.

Here, the plan is funded with money that the employer has set aside from its current earnings to benefit the executive. As might be expected, the salary continuation approach is preferred by most executives because they are not sacrificing any of their own promised compensation to fund the ultimate benefit.

substantial risk of forfeiture

If there is a substantial risk of forfeiture with respect to the set-aside assets in a nonqualified plan, the deferred compensation will not be treated as constructively received. In turn, the executive will not have any currently taxable income.

salary reduction or pure deferred compensation arrangement.

In this approach, the plan uses some portion of the executive's current compensation to fund the promised compensation benefit, usually payable at the executive's retirement date.

pure unfunded

In this type of plan, only a mere promise is made by the employer to pay the benefit to the executive; in other words, no assets are set aside to make good on this promise. Obviously, this places the executive in a difficult position because he is trading the uncertainty of future payment for the income tax deferral of current compensation.

economic benefit doctrine.

Planners should distin- guish between the constructive receipt rule and the economic benefit doctrine. Constructive receipt indicates when income is taxable. Alternatively, the economic benefit doctrine defines what constitutes income. One of the tests for determining whether the economic benefit doctrine applies to NQDC is whether the plan grants to the executive greater rights to the employer's property than those of other parties, most notably the general creditors of the employer. In practical terms, if funds placed in a nonqualified plan remain subject to potential attachment by the employer's general creditors, the economic benefit doctrine will not apply.

nonqualified plan may be structured in two ways.

The first is as a salary reduction or pure deferred compensation arrangement. Alternatively, the plan may be structured using a salary continuation approach.

Two major forms of nonqualified deferred compensation (structured using the salary con- tinuation approach) are designed to pay benefits at the time of the executive's retirement.

They are an excess benefit plan and a supplemental executive retirement plan, or SERP.

excess benefit plan

is a nonqualified plan that focuses on providing retirement income to executives. Specifically, the plan provides the executive with a benefit over and above the IRC Section 415 defined benefit plan limit ($210,000 in 2016*). The plan pro- vides the executive with the difference between the amount payable under a qualified plan and the potential amount received if the Section 415 plan limitation did not exist. A major advantage of an excess benefit plan is that, as a purely unfunded plan, it is not subject to the reporting and disclosure rules of ERISA. In addition, the plan can discrimi- nate in favor of highly compensated individuals. However, from an executive's standpoint, the principal problem with an excess benefit plan is the lack of security that arises from the employer's mere promise to pay the additional retirement benefit.

surety bond

if there is concern with regards to receiving the payment of the deferred compensation from the former employer. This bond ensures that the benefit will be paid if, for any reason, the employer is unable to make good on its promise. However, the executive must pay the premium for the bond without being reimbursed by the employer. If so, the IRS has ruled that the purchase of the bond does not create a current vested right to the deferred compensation which would result in current income taxation.

unfunded plan

is a nonqualified deferred compensation plan in which the benefits typically do not vest until the employee retires from the company. Generally, there are two types of unfunded nonqualified plans. The first is a pure unfunded plan. The second and more popular type of unfunded NQDC is an informally funded plan.

rabbi trust

is an arrangement under which the employer places assets into an irrevo- cable trust to fund the payment of promised deferred compensation to selected employees (usually valued executives). The trust agreement states that the assets placed in the trust remain subject to the claims of the employer's general creditors in the event of its insolvency or bankruptcy. As previously discussed, this risk of possible forfeiture of the benefit to the executive is considered substantial and will operate to defer taxation on the set-aside funds to the executive. The employer must still pay tax each year on the trust earnings, unless the trust assets consist of cash value life insurance or some similar asset. Taxation occurs to the executive when the payments are received from the trust, and the employer is entitled to a commensurate income tax deduction at the same time. The benefit payable under a rabbi trust to the executive also may be triggered by the merger or acquisition of the present employer/sponsor. Specifically, if there is a fear that the new owner or management might refuse to honor the trust agreement, it may be structured so as to compensate the executive in the event of employer takeover. This triggering event also makes sense where there is a concern on the part of the executive that litigation to enforce the payment of the deferred compensation benefit would likely be too costly to be practical.

secular trust

is an irrevocable trust established for the exclusive benefit of the employee/executive. As such, it is not really a deferred compensation vehicle at all but rather an investment management vehicle used to grow the assets within the trust. The trust is irrevocable, and the funds inside the trust are not subject to the claims of the employer's general creditors. As might be expected, the executive who benefits from such a trust also does not have a substantial risk of forfeiture and is taxed immediately on the employer contribution and annually on the trust earnings. The employer also receives an immediate income tax deduction for amounts contributed to the trust. Secular trusts are a more popular planning vehicle when corporate marginal income tax rates are higher than those for individuals. Accordingly, tax arbitrage can occur in leveraging the higher corporate income tax deduction against the lower individual income tax inclu- sion. However, when the corporate and individual income tax rates are more level, secular trusts are not widely used. Some planners feel it is better to pay out the promised benefit now in cash or securities and allow the employee to move on to the financial planning stage rather than focusing on the income tax considerations associated with this benefit.

corporate-owned life insurance (COLI)

policies provide funds to pay the benefit in the event of the executive's death before retirement while also accumulating cash value to pay the benefit at retirement (or some other future date) if the executive is still alive. The employer is neither allowed a deduction for the premiums paid on corporate-owned life insurance, nor may deduct interest paid on any loans borrowed from these policies, except under limited circumstances. Finally, care must be taken not to place COLI in trust or in escrow for the unconditional payment to the executive. If the policy is owned by a trust, the strategy triggers the economic benefit doctrine and results in immediate taxation of the cash value accumulation to the executive/trust beneficiary.

If the plan is funded (typically where the fund set aside on behalf of the executive is held in trust or in escrow), the execu- tive is taxed at the later of:

■ the date the employer contributions to the trust or escrow fund are made; or ■ the date there is no longer a substantial risk of forfeiture associated with the fund.

For a nonqualified plan to defer the taxable compensation of the executive from the cur- rent year to sometime in the future, it must not run afoul of three basic income tax doctrines.

The first of these doctrines is constructive receipt. The second of these doctrines is the economic benefit doctrine. The third income tax doctrine that must be considered when implementing a nonqualified plan is substantial risk of forfeiture.

informally funded plan

Informal funding is considered as unfunded because the underlying assets funding the plan are owned by the employer (rather than the executive) and are subject to the claims of the employer's general creditors. Therefore, an informally funded plan essentially meets the executive halfway—that is, it provides some security of future payment (absent the employer's bankruptcy or acquisition by another company) while also deferring taxation on the executive's current compensation. The most popular type of an informally funded nonqualified plan is the so-called rabbi trust, which will be discussed in the next section.

constructive receipt

This occurs within a nonqualified plan if the executive has unrestricted access to the funds set aside by the plan. The funds deemed to be constructively received are required to be reported immediately as taxable income to the executive, thus defeating a primary tax advantage of a deferred compensation arrangement.

Nonqualified deferred compensation plans

are arrangements that do not meet the requirements of IRC Section 401(a) or qualified retirement plans. Normally, nonqualified plans are used to benefit key executives to the exclusion of rank-and-file employees, hence the term executive compensation that is often used interchangeably. The major advantage of a nonqualified plan is that it does not have to comply with the general nondiscrimination rules that apply to qualified plans. In addition, NQDC is not subject to all of the reporting and disclosure requirements that pertain to qualified plans (for example, a nonqualified plan does not have to file a Form 5500 like a qualified plan). NQDC is most appropriate when an employer wishes to provide a deferred compensation benefit to an executive or group of executives at a fraction of the administrative cost that would otherwise apply if the employer had to include all employees as in a qualified plan.

supplemental executive retirement plan (SERP)

is the prototypical nonqualified sal- ary continuation plan. This plan provides benefits to executives over and above the benefits available from a qualified plan and is funded entirely with employer money. A SERP can be either completely unfunded (like an excess benefit plan) or informally funded. Most are informally funded and reward continued employment or encourage the early retirement of the executive. A SERP may also be established to protect the executive from involuntary termination if the company changes ownership by awarding an increased benefit from the plan. Unlike an excess benefit plan, a SERP is designed to provide a specified percentage of retirement income to the executive without regard to the Section 415 benefit limit. Benefit formulas and other plan provisions are similar to those for qualified defined benefit plans (for example, a retirement benefit equal to a percentage of highest average compensation) but without the applicable annual benefit limit.

Important provisions from the AJCA include the following.

■ A participant can no longer determine, immediately before leaving the company, when he will receive distributions from the plan; rather, the period over which the dis- tribution will be paid must be specified in the plan document. ■ Plan distributions are generally payable only upon separation of service, death, disabil- ity, change in ownership of the company, or unforeseeable emergency (as defined by the IRS). ■ Key employees who leave the company cannot take a distribution from the plan for at least six months after the date of separation. ■ The act imposed a significant restriction on the use of offshore rabbi trusts that are designed to avoid U.S. income tax. Finally, the AJCA nonqualified plan distribution provisions, as codified in IRC Section 409A, make it clear that domestic rabbi trusts must comply with existing law and direct the IRS to issue new regulations explaining how to properly implement such trusts.

Informal funding of a nonqualified plan creates taxation to the sponsoring employer in two ways.

■ The employer owns the underlying asset used to fund the plan, so any earnings gener- ated from these assets are taxed to the employer and, if the employer is a regular cor- poration, taxed at separate corporate income tax rates. ■ Depending on the type of asset used to fund the plan, the set-aside reserve may create an additional tax. As discussed in Unit 2 of this course, if a nonqualified annuity is owned by a non-natural person such as a corporation, the earnings on that annuity do not receive the tax deferred status and are taxed currently to the employer/corporation. To avoid generating any additional tax on earnings within the plan, many employers prefer to fund NQDC plans with a tax-favored vehicle such as cash value life insurance.

the following situations describe when the implementation of a nonquali- fied plan is most appropriate for a corporate executive client:

■ When an employer wants to provide a deferred compensation benefit to an executive or group of executives, but the cost of a qualified plan would be prohibitive because of the large number of rank-and-file employees who would need to be covered ■ When an employer wants to provide additional deferred compensation benefits to an executive who is already receiving the maximum benefits or contributions under the employer's qualified retirement plan ■ When the employer wants to provide certain key employees with tax-deferred com- pensation benefits different from those provided to other employees ■ When an executive wants the employer to help with meeting certain financial plan- ning goals ■ When an employer needs to recruit, retain, or reward certain executives or other key employees