Ch 15 Nonqualified Plans
457 b participation limited to service providers
Only employees and independent contractors who perform services for the employer may participate.
Two major types of nonqualified plans
Salary Reduction Plan Supplemental Executive Retirement Plan (SERP)
Funded plans
when, in order to meet its promise of providing benefits under the nonqualified plan, the company contributes specific assets to an escrow or trust account in which the executive has a current beneficial interes
Informally funded plans
§ A plan is informally funded when a reserve is set up to pay the nonqualified benefit, but the assets of the reserve are retained as assets of the company, subject to the claims of the company's creditors § In other words, as long as the executive does not have a current beneficial interest, the plan is considered unfunded for tax purposes. When a plan is informally funded, it is important to consider the other side of the equation—the company's deduction.
Benefit or contribution structure
§ Can be designed as DB or DC plans § Salary reduction plans usually DC plans because they allow execs to defer portion of salaries § SERPS also set as DC, but usually DB Benefit formula should be consistent with employer's objective
Executive Bonus Life Insurance plans- Sec 162 Plan
§ Can be provided on a discriminatory basis to help execs save for retirement § Does not provide deferral of income § Pay a bonus to exec for purpose of purchasing cash value insurance § Exec is owner, insured, and whoever designates beneficiary § Corporation's connection is to fund payments and in few cases to secure applications § Bonuses can be paid in two ways □ Can pay premiums directly □ Or pay bonus to execs § Both cases, corporation deducts contribution when it is made § Bonuses subject to all taxes § Implementation □ Easily done □ Corporate resolution has to authorize business expenditure □ Those in charge should select which execs are included in plan and how much they receive □ Either exec or corporation should secure application for insurance Exec then applies for policy
Death benefits
§ Can cover preretirement, post retirement, or both Determine what life insurance and what type of annuity for distribution
Evergreen elections also permitted
Deferral election for one year remains in effect for following year unless terminated or changed before last day of the year preceding the year.
Two Types of Sec 457 Plans
457b eligible plans 457f ineligible plan
Unfunded plans
A nonqualified plan is considered unfunded for tax purposes if there is no reserve set aside to pay the promised benefit under the plan
457b property rights
All amounts of compensation deferred under the plan, all property and rights purchased with such amounts, and all income attributable to such amounts must remain solely the property of the employer, subject to the claims of the employer's general creditors, until the deferred compensation is made available to the participants and beneficiaries.
457b Timing of distributions
Amounts cannot be made available under the plan to participants or beneficiaries earlier than (i) the calendar year in which the participant attains age 70½, (ii) when the participant has a severance from employment with the employer, or (iii) when the participant is faced with an unforeseeable emergency. In addition, the plan must comply with the minimum-distribution requirements of Sec. 409(a)(9). Finally, a plan may permit a distribution of benefits pursuant to a qualified domestic relations order. If an amount becomes available pursuant to one of the distribution events described in (i), (ii) or (iii), above, a participant can elect, but only once, to defer commencement of distributions, provided that payments have not yet begun. Participants in a nongovernmental 457(b) eligible plan cannot avoid taxation by rolling over a distribution into an IRA or another plan.
457b Timing of deferral election
The plan must provide that compensation will be deferred for a calendar month only if an agreement providing for such deferral has been entered into before the beginning of the month. However, with respect to a new employee, a plan may provide that compensation is to be deferred for the calendar month during which the participant first becomes an employee if an agreement providing for such deferral is entered into on or before the first day on which the participant becomes an employee.
457b Max annual deferral amount
The plan must provide that the maximum amount of compensation which may be deferred under the plan for the taxable year may not exceed the lesser of $18,000 (the applicable dollar amount for 2017) or 100 percent of the participant's includible compensation. (457(b) contributions can be made in addition to 403(b) or 401(k) salary deferrals, as these limits are not aggregated.) The term includible compensation means compensation for services performed for the employer which is currently includible in gross income (after taking into account the deductions allowed under Sec. 457 and other similar income tax provisions.) Prior to 2002, amounts excluded from income under Section 403(b) and Sec. 401(k) plans were required to reduce the maximum allowable Sec. 457(b) deferral. This was a major deterrent to the use of 457(b) eligible plans. However, since 2002 this is no longer the case, and it has provided a significant impetus to the adoption of 457(b) eligible plans as supplemental plans in recent years.
Executive Bonus Life Insurance plans- Double Bonus Plans
§ Concern over receipt of additional taxable income from executive bonus life insurance has caused employers to provide second bonus to alleviate tax that business owner or exec may pay There will be tax on second bonus.
Rabbi trust
§ Contributions made to separate trust § Assets cannot revert to company even with new company § To avoid current taxation, trust's assets remain subject to claims of employer's creditors § Employers wanting to rule on validity, had to request private letter ruling from IRS § Today, all must use IRS model rabbi trust form □ Springing irrevocability; if change in employer ownership, becomes irrevocable □ Permits trust to own employer stock □ Does not allow insolvency triggers that hasten payments to execs when employer's net worth falls between point □ Can give ivnestment control over change in control □ Can take withdrawal from rabbi trust without constructive receipt □ Other reqs ® The assets in a rabbi trust must be available to all general creditors of the company if the company files for bankruptcy or becomes insolvent. • ® The participants must not have greater rights than unsecured creditors. • ® The plan must provide clear rules describing when benefits will be paid. • ® The company must notify the trustee of any bankruptcy or financial hardship that the company is undergoing. When a bankruptcy or financial hardship occurs, the trustee should suspend payment to the trust beneficiary and hold assets for the employer's general creditors □ Goals: defer taxation, providing measure of retirement security for execs □ Disadvantage No benefit security if employer goes bankrupt and/or insolvent
COLI
§ Corporate owned life insurance COLI is popular way for most companies to set up reserve against future obligations under non qual plan Most prefer policies with premium and investment flexibility and low mortality expense cost
Nonqualified plans favored over qualified plans despite tax comparison
§ Design flexibility § Lower administrative costs Cost savings through coverage to execs
Retirement age
§ Determine whether "young" 50-62 or "old "65-70 is chosen § If wants to control salary costs, choose young If they want knowledge and experience, choose old
Disability provisions
§ Employer can stipulate whether disability will be treated like any other termination of employment or whether special provisions will apply. § Most DI policy reduces the insured benefits § Must choose whether service will continue to accrue Define disability right
Installation process
§ Employer should adopt corporate resolution authorizing purchase of life insurance to indemnify business for expenses it is likely to incur § Authorize production of eitehr contract or plan document that spells out plan § Rabbi trust or secular trust document should be created ERISA statement should be completed and sent to DOL
Surety bonds
§ For execs who feel uncomfortable with the possibility of benefits going unpaid from a rabbi trust because of an employer bankruptcy but who wants to avoid the use of a secular trust because of the tax consequences, § provides for a bonding company to pay promised benefits if the employer defaults on the promise to pay nonqualified benefits—thus providing the executive with an indirect means of securing the employer's unsecured promise § Precautions must be taken □ Exec must bear cost of surety bond □ Employer has no involvement with company □ Expensive and difficult to obtain § Premiumx one to 3 % of annual amount deferred § Few insurance companies provide § Issued from 3 to 5 years May not be renewed if bankruptcy is on horizon
Economic benefit doctrine
§ If benefit not subject to risk of forfeiture, taxes can still be deferred as long as the distribution does not run afoul of the economic benefit doctrine generally codified in Code Sec. 83 or the constructive receipt doctrine now codified in Code Sec. 409A § if a compensation arrangement provides a current economic benefit to an executive, that person must report the value of the benefit even if he or she has no current right to receive the benefit. § if a contribution is made to an irrevocable trust for a participant and the benefit is nonforfeitable, the amount will be subject to income tax. To avoid current income tax, any assets held to pay benefits must remain the property of the sponsor, or be placed in a trust that can be accessed to satisfy the claims of the sponsor's creditors (typically called a rabbi trust).
457f Ineligible Plan
§ If does not meet reqs of 457(b), then deferred comp included in compensation when there is no longer substantial risk of forfeiture § Since employees don't want to pay tax on comepnsation, 457f plans provide for distributions when deferred comp vests § Broadly defined to include any agreement arangement § Must satisfy 409a restrictions on timing, acceleration of deferrals, and deferral election □ penalty for failing to meet the Sec. 409A requirements is not so much the acceleration of taxation, since employees of tax exempts are already subject to tax when the substantial risk of forfeiture lapses Rather, the real penalty is the 20-percent additional tax imposed on a service provider who has violated the requirements of Sec. 409A
Special deferral election rule applicable to newly eligible participants
§ If employee becomes newly eligible, he or she can make deferral election within 30 days after he or she becomes eligible, but only with respect to compensation payable for services performed after election § As long as certain timing requirements are satisfied, election can be made to delay the timing § The Sec. 409A regulations elaborate on this provision by authorizing a subsequent election to delay a payment or to change the form of a payment if • □ The plan requires that any such subsequent election postponing a payment must be made at least 12 months before any payment is scheduled to be made. • The plan requires that the redeferred payment must be deferred for a period of not less than 5 years from the date such payment would have otherwise been made. During that 5-year period distributions may be made on account of death, disability, or unforeseeable emergency, but not on account of separation from service or change of control
Secular Trust
§ In situations where employer's ability to pay promised benefits comes into questions § Calls for irrevocable contribution on employer's part to finance promises § Can NOT be reached by employer's creditors Contributions to trust are taxable at later date when contributions become nonforfeitable
Tax consequences
§ Nonqualified deferred comp plan that satisfies rules of sec 409a will be taxed under same rule as applied under prior law § If fails to satisfy 409a, will result in accrual based taxation for affected executive § If initially meets requirement, but then failes; executive has to pay interest charge; underpayment rate plus one percentage point § If nonqualified plan becomes funded, Sec 83 will control tax consequences of the plan □ Taxes transfer of property in connection with performance of service □ s. If, in connection with the performance of services, property is transferred to a person other than the person for whom the services are performed, the excess of ® (i) the property's fair market value at the first time the ownership rights of the person having the beneficial interest in the property are transferable or are not subject to a substantial risk of forfeiture, whichever occurs first, over ® (ii) the amount, if any, paid for the property becomes taxable income to the person providing the services Property defined as real and personal property, other than money or an unfunded and unsecured promise to pay money in future
Distribution of benefits
§ Sec 409As2A limits circumstances of which nonqual deferred comp can be paid § Will fail to satisfy distribution restrictions unless distributions cannot be made earlier than □ (i) a separation from service, □ (ii) the date a service provider becomes disabled, □ (iii) the date of a service provider's death, □ (iv) a specified time or pursuant to a fixed schedule specified in the plan, or □ (v) the occurrence of an unforeseeable emergency (hereafter together referred to as the "enumerated events") § Distribution may also be made on account of a change in control event involving any of the following □ (i) the service provider's employer, □ (ii) the service recipient or other corporation liable for the nonqualified deferred-compensation payment, or □ (iii) the parent corporation of the employer or service recipient § Permissible for plan to provide distribution of nonqualified deferred compensation on the earliest of or latest of enumerated events § Unforseeable emergency determined to hardship withdrawal like sec 401(k) plan but without safe harbors □ Only amount necessary to satisfy need can be withdrawal Has to not be relieved by insurance or other assets
Forfeiture provisions
§ Sets forth certan conditions under which employee forfeits benefits he or she would normally get under plans § Not common in salary reduction plans § Common in SERPs □ Successful transition of company leadership ® Can contain provision that requires executive to provide consulting services after retirement or else forfeit benefit □ Retention of executives ® Golden handcuffs provision can be incorporated into plan ® Longer vesting schedules help retain executives; but makes harder to recruit new execs ® Provide benefits that will be forfeited if certain performance goals are not met □ Competition from former employees ® Major problem is employee working for competitor or setting up competing business ® Covenant not to compete provision calls for forfeiture of nonqualified benefits that have not yet been paid if the employee enters into competition with the employer ◊ Must be carefully drafted ◊ Must be reasonable with geographic area Consult attorney
Income tax effects on employer
§ Taxpayer not entitled to deduction until benefits have been paid to execs § Some employers are subject to accrual method of accounting s, Reg. Sec. 1.404(b)-1T allows a deduction for nonqualified deferred compensation only in the year in which the payment is includible in the executive's gross income
Determining the company's needs
§ The client wants to provide a second tier of executive retirement benefits in addition to the qualified plan in order to attract and retain strong executives. • § The client wants to limit coverage to certain executives. • § The client wants a plan that is less of an administrative burden than a qualified plan. • § The client wants to give executives the opportunity to save more of their current income. Sometimes the program dovetails with a 401(k) plan, and only salary deferrals above the applicable 401(k) plan limit go into the nonqualified program. • § The client is an owner of a closely held business who is looking to temporarily save taxes and may want to have income retained in the company. This makes sense when the corporate tax rate is lower than the individual tax rate. Note, however, that the IRS may challenge a plan that allows a controlling (50 percent) shareholder to defer compensation.1 • § The client is the controlling owner of a closely held business that is just starting up and the company lacks the cash to pay other owner-employees their full salaries. Making the promise to pay such owner-employees' compensation later establishes the obligation to pay additional income and helps avoid problems with the IRS about "reasonable compensation" in later years when the owner-employees are receiving large payouts. The client wants to meet the organization's objectives of attracting executives, retaining executives, and providing for a graceful transition in company leadership. Although qualified plans can achieve similar objectives, nonqualified plans can be more effective because they are subject to fewer design restrictions.
Eligibility
§ Typically restricted to company executives § In order to be exempt from ERISA reqs □ "top hat exemption" of ERISA § In salary reduction plan or SERP, title or position dictates inclusion or exclusion from plan (VP or higher etc) § Second way to determine is by salary Third way is to appoint compensation committee
Choosing the right type of plans
§ golden handshakes—additional benefits that are intended to induce early retirement § golden handcuffs—additional benefits that are intended to induce an executive to remain employed, rather than leaving prematurely golden parachutes • § golden parachutes—substantial payments made to executives who are terminated upon change of ownership or corporate control incentive pay • incentive pay—bonuses given for accomplishing short-term goals that can be used by the executive for retirement purposes
Nonqualified plan objectives
§ • Alternative to qualified plan • § Second tier of benefits • § Cover a select group of highly paid employees • § Salary deferral for executives • § Instant benefit program for executives of a new company • § Meet a wide range of compensation goals • Satisfy special needs of specific highly compensated employees
Timing of deferral election
○ Must be irrevocable and must specify § (i) the amount of compensation being deferred, § (ii) the timing of when the deferred compensation will ultimately be paid out, and § (iii) the form in which the deferred compensation will ultimately be paid out Election must be made In 2016 with respect to bonus period
Protecting executive
§ • Nonqualified plans can protect the executive against involuntary termination because of a change in the control of the business by including a takeover trigger. Also, called a golden parachute, the plan can provide for additional benefits, immediate vesting, and/or immediate payouts at the time of the change in control. The challenge is to design the golden parachute provision to satisfy the Code Sec. 409A change in control provision, and to ensure that the payout is not so large as to deter potential buyers. Under Sec. 409A, a payment upon a change of control is not treated as an accelerated distribution only if the new owners control enough additional stock to own more than 50 percent of the corporation's total fair market value or of the total voting power of the corporation's stock. • § Nonqualified plans can be designed to allow withdrawals prior to termination of employment in cases of an unforeseeable emergency. As required by Section 409A, the plan should spell out the circumstances that constitute an allowable distribution, or it should provide for an independent third party to make the determination. • Y our client should ask for a binding-arbitration clause in case of a dispute. This will save on litigation costs.
Salary reduction plan
® If employer wants to permit executives to defer current income, to allow nonqual 401(k) look alike arrangement ® Option to defer compensation, bonuses, or commissions ® Candidates ◊ employers who want to provide a low-cost benefit for highly compensated and management employees (the only employer cost is the cost of the deferral of the tax deduction and the tax imposed on the earnings from the deferred amounts) • ◊ small closely held businesses whose owners' individual marginal tax rate is higher than the applicable corporate tax rate • organizations that wish to set conditions on a certain amount of executives' salaries or bonuses to induce desired results
Supplemental Executive Retirement Plans SERP
® Satisfies employer's objective of complementing existing qualified plan that is not already stretched to the maximum limits by bringing executive retirement benefits (or contributions) up to desired levels. ® Can complement underlying qualified plan ◊ They can be designed to provide the "missing piece" of retirement benefit (or contribution) that the employer wants the executive to have ◊ However, in cases where the exact benefit (or contribution) is unknown, such as when an integrated unit-benefit formula is used, SERPs can be designed a second way: to provide for the desired total benefit or contribution (for example, 60 percent of final average compensation), taking into account or offsetting the benefit provided by the qualified plan. Offset SERP
457b coordination with ERISA
□ Can technically any group of employees or contractors □ Usually just covers management and highly compensated employees □ Otherwise would be subject to ERISA funding req A 457(b) eligible plan established by a state or local government is exempt from ERISA and consequently, does not have to satisfy the top-hat plan exemption.
457b government sponsored plans
□ Operate like for profit entities □ Benefits cannot be rolled over into an IRA □ In reaction to municipalities filing bankruptcy and participants losing benefits, gov 457b plans must be held in irrevocable trust □ Since gov entities other than public school cannot sponsor 403b or 401k, gov 457b have become the 401k for state and local gov ® Allows them to roll into IRA ® Can do catch up contribution after age 50 Can make Roth
Fact finder will
□ Provide a working framework for soliciting the client's goals □ Serve as a due-diligence checklist, which will ensure that important discussions have not been omitted □ • operate as a training tool for those who have little or no experience with nonqualified plans • educate the client about the various needs, objectives, and considerations that are relevant to plan selection and design
Sec 457 Plans
○ Plans for tax exempt entities ○ Tax deduction meaningless for tax exempt employer so thaty are inclined to allow employee to defer compensation ○ Tax rules found in Sec. 457 Two types sec 457 deferred comp plans
Code Sec 3121 v2
□ Provides special timing rule for determining when amounts deferred under nonqual plan must be designated as wages for purposes of other employment taxes imposed by FICA □ Once determined that benefits are being provided under nonqual plan, determination of deferred amount will be subject to employment tax dependng on whether amounts in account balance plan or non account balance □ Account balance ® principal amounts are credited to an individual account for an employee. • ® the income attributable to the principal amounts is credited (or debited) to the individual account. • ® the benefits payable to the employee are based solely on the balance credited to the individual account. □ Non account balance plan ® DB plan ® Amount taken into account is PV of future payments to which executive has obtained a legally binding right; he or she has met vesting reqs ® Employer can elect not to take into account any amount unless value is reasonably ascertainable ◊ when there are no actuarial or other assumptions needed to determine the amount deferred other than interest, mortality, or cost-of-living assumptions. □ Don't NEGLECT employment taxes employment tax rate for employers and employees is 15.3 percent on wages up to the taxable wage base, but it falls to 2.9 percent on wages over the taxable wage base
Advantages of COLI
□ The tax-free inside buildup that occurs in a life insurance policy is important to a nonqualified plan because, unlike those of a qualified plan, earnings on nonqualified plan assets are not tax deferred. • □ Life insurance proceeds received by the employer can protect the employer against an executive's premature death. This works two ways. If the executive is not fully vested in his or her promised benefit at death, or if no death benefit is provided, the excess death benefit received by the employer can be used to cushion the employer against anticipated losses owing to the executive's death. If the executive is fully vested in a substantial death benefit and dies shortly after entering the plan, the life insurance policy will be able to pay the promised benefit in full, whereas the other reserves would have been inadequate. • □ Life insurance proceeds received by the employer upon the death of the executive are generally tax free. □ Policies can be borrowed against to help pay the cost of future premiums. If cash flow is a problem, knowing that the funding of his or her benefit will not suffer should give the executive an added sense of security. • □ Life insurance funding provides the employer with flexibility. The employer can either use the policy's cash values to pay nonqualified benefits, or use other assets and keep the policy in force until death. If the latter course is taken, the employer can often receive more from the insurance company as death proceeds than it pays out under the nonqualified plan. • □ Life insurance policies can be used to provide a supplemental disability benefit. The waiver-of-premium clause in a life policy will enable the executive to get the full nonqualified benefit even if he or she becomes disabled. • □ If the life insurance policy purchased on the executive's life is owned by the employer, if the premiums are paid by the employer, and if the employer is the sole beneficiary, then constructive-receipt, economic-benefit, and Sec. 83 problems are avoided. • If the nonqualified plan requires the company to pay a life income to the executive, by electing a life-income option, the company can transfer to the insurance company the risk that the executive will live beyond his or her normal life expectancy
Disadvantages of COLI
□ if policy loans are used to pay retirement benefits, there is a limitation on the corporate deduction for interest paid on policy loans □ Second, the alternative minimum tax (AMT) offers some impediment to the use of life insurance to fund a nonqualified plan because the life insurance that is payable to the employer, although not subject to regular taxes, may be subject to the AMT. □ From Section 101j of PPA Act of 2006, The rules allow for the death benefits of the typical COLI policies on key employees issued after August 17, 2006, to remain nontaxable to the employer as long as certain requirements are satisfied. ® Policies must be limited to ◊ the insured is a director or a highly-compensated employee (among the highest paid 35 percent of all employees) when the COLI is purchased; • ◊ the insured was an employee within 12 months before death; or • ◊ the death benefits are paid to the insured's heirs or used to purchase an equity interest in the employer from the insured's heirs ® Insured must be notified of, and consent to, life isnurance coverage, Employer must file annual information return which reports info on COLI
Excess benefit plan is exempt from ERISA
□ plan maintained by an employer solely for the purpose of providing benefits for certain employees in excess of the limitations on contributions and benefits imposed by Sec. 415 on plans to which that section applies, without regard to whether the plan is funded. Unfunded excess-benefit plans are totally exempt from ERISA; those which are funded are partially exempt
Top hat exemptions
□ requires that the plan be unfunded and maintained by an employer, primarily for the purpose of providing deferred compensation for a select group of management and/or highly compensated employees □ Hard part is to determine who can be covered as highly compensated; DOL not clear UNFUNDED TOP HAR PLAN IS EXEMPT FROM erisa'S PARTICIPATION, VESTING, benefit accrual, funding, and fiduciary provision
Candidates for SERPs
◊ cut back benefits under their qualified plans due to increased costs • ◊ provide a higher income replacement ratio for executives than the employer can afford (or may want) to provide for rank-and-file employees • ◊ defeat the $270,000 cap (as indexed for 2017) on compensation that can be considered in determining benefits • ◊ provide a benefit based on total compensation for executives while continuing to provide a benefit based on base pay for rank-and-file employees • provide a COLA benefit for executives without having to provide a similar benefit to rank-and-file employees
Code Sec. 409(a)
○ Constructive receipt doctrine ○ There is a broad definition of nonqualified plan that includes any plan, agreement, or arrangement that provides for the deferral of compensation, other than a tax-qualified employer plan or any bona fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. ○ An initial election to defer compensation must be made prior to the beginning of the taxable year in which the services are to be performed. There are two exceptions to this requirement which apply to (i) deferral elections by newly eligible participants who are given a 30-day grace period and (ii) performance-based compensation where the performance period is 12 months or more. In the latter case the deferral election can be made up to 6 months prior to the end of the performance period. ○ Nonqualified deferred compensation may only be distributed upon the occurrence of any of the following six specified events: a separation from service, the participant's death or disability, a specified time (or fixed schedule) provided under the plan or elected by the participant at the date of deferral, a change in ownership or effective control of the corporation or in the ownership of a substantial portion of the assets of the corporation, or the occurrence of an unforeseen emergency (generally a severe financial hardship as defined in Sec. 457). Distributions of nonqualified deferred compensation may no longer be made based on a haircut provision under which a small penalty (such as 6 percent) was imposed on the amount withdrawn. Unfortunately, under prior law, a haircut provision was an important safeguard. If the employee felt that financial or other conditions within the company might threaten the employee's deferral compensation benefit, the employee could withdraw his or her money under the plan's haircut provision. It was a form of safety valve that no longer exists. • ○ Specified employees (as determined under Sec. 416) of a publicly traded corporation may not receive a distribution of nonqualified deferred compensation for at least 6 months following a separation from service. • A taxable event will occur if the corporation transfers assets to an offshore trust (even if the trust is otherwise subject to the claims of the corporation's creditors) used for the purpose of paying nonqualified deferred compensation.
Tax considerations
○ Employer receives deduction at time participant has taxable income ○ Substantial risk of forfeiture; limitation Requiring an executive continue to provide consulting services may or may not be substantial risk of forfeiture