Nonqualified Retirement Plans

ERISA requirements with nonqualified deferred compensation plans

2 types of nonqualified deferred compensation plans are eligible for at least partial exemptions from the ERISA requirements: 1) Unfunded excess benefit plan-- not subject to any ERISA requirements 2) Top-hat plan-- exempt from all ERISA provisions except for the reporting and disclosure requirements

Stock Options

A formal, written offer to sell stock at a specified price within specified time limits Typically granted to an employee as additional compensation Granted at a favorable price, either below or near the current market value, with an expectation that the value of the stock will rise Typically remain outstanding for 10 years Taxation is deferred to the time when the stock is purchased or later

ERISA requirements with split dollar life insurance plans

A split dollar plan is considered an employee welfare benefit plan and is subject to the ERISA rules Welfare plan can escape the ERISA reporting and disclosure requirements by: Form 5500 filing and summary plan description (SPD) requirement, if it is an insured plan maintained for a select group of management or highly compensated employees If the plan covers more than a select group, it has to provide SPDs to participants If it covers fewer than 100 participants, SPD need not be filed with the DOL ERISA also requires a written document, a named fiduciary, and a formal claims procedure for split dollar plans

Benefit to employees of phantom stock

A way to give key employees benefits that are measured by the value of company stock without actually giving them stock If the business grows and prospers, so will the benefit for the employee No immediate income taxation-- employees will recognize taxable income when the benefit is paid or made available Employee is not required to make any cash contributions Employee receives "equity-type" interest in the business If the employer funds the phantom stock plan with life insurance, it can provide the employee with a death benefit

Taxation considerations of nonqualified deferred compensation plans

Amounts are deductible by the employer when the amount is includible in the employee's income Interest or earnings credited to the amounts deferred are added to the additional deferred compensation and are deductible when the employee is taxed on the distribution

Nonqualified Deferred Compensation Plan

Any employer retirement, savings, or deferred compensation plan for employees that does not meet the tax and labor law (ERISA) requirements applicable to qualified pension and profit sharing plans Usually provide retirement benefits to a select group of executives, or provide such a select group with supplemental benefits beyond those provided in the employer's qualified retirement plans Do not provide the same type of tax benefit as qualified plans because in the nonqualified plan the employer's income tax deduction generally cannot be taken up front

When is a nonqualified plan used?

Can be designed for key employees without the sometimes prohibitive cost of covering a broad group of employees Can provide benefits to executives beyond the limits allowed in qualified plans Can provide "customized" retirement savings benefits for selected executives

Timing of corporate tax deduction

Corporation receives a deduction when the employees RECEIVE benefits, or otherwise when the funds are made available

Funded plan

Generally exists if assets are set aside from the claims of the employer's creditor's Ex:) a trust or escrow account Amounts in the fund are taxable to the employee at the time the employee's rights to the fund become substantially vested Generally subject to the ERISA vesting and fiduciary requirements

Employee Stock Purchase Plan (ESPP)

Generally is brought about by deductions in salary in the offering period ranging from 3 to 27 months Price is normally 15% less than the market price

When is a SERP used?

Generally provide a flat amount per year to participating employees Seek to replace the retirement benefits that highly compensated employees lose because of IRC or ERISA limitations

Phantom Stock

Generally refers to a plan formula based upon an amount of shares of stock, established for an employee when the plan is adopted, with a provision that the employee receives the actual shares or equivalent cash at the date of payment Units can be settled in cash and/or stock Settlement date could include: termination of employment or a fixed date set in advance and not controlled by the individual

Tax implications with SERPs

Generally the employer is not entitled to an income tax deduction until such time as amounts are actually or constructively received by the employee When payments are made to the employee, upon retirement or otherwise, or to his/her heirs in the case of death, the employer may take a deduction for the payments to the extent that they are deemed reasonable compensation Payments are treated as ordinary income to the employee when the employee actually or constructively receives them If an employee was receiving or was entitled to receive payments prior to his/her death, and if the agreement provided that these payments were to continue after death, the present value of the remaining payments normally would be included in the decedent's gross estate-- if payments ceased on death, there would be nothing to include in the gross estate

Tax implications of ISOs

Generally the executive is not subject to federal income tax on an ISO either at the time the option is granted or at the time he exercises the option To receive ISO tax treatment, Section 422 rules are: Options must be granted under a written plan specifying the number of shares to be issued and the class of employees covered under the plan Only the first $100,000 worth of ISO stock granted to any one employee is entitled to the favorable ISO treatment-- any amount over is treated as a non-statutory or regular stock option No option may be exercisable more than 10 years from the date of the grant Person receiving the option must be employed by the company granting the option at all times between the grant of the option and 3 months before the date of exercise Stock acquired must be held for at least 2 years after the grant of the option and 1 year from the date stock is transferred to the employee-- gain is taxed at long-term capital gains rates Option must not be transferable Exercise price must be at least equal to the FMV of the stock on the date the option is granted ISOs may not be granted to any employee who owns more than 10% of the corporation Excess of the stock's FMV over the option price at the time of exercise is included in the individual's AMT income Corporation does not get a tax deduction for granting an ISO

Loans to Executives

Loans usually restricted to specified purposes Typically such loans are interest free or made at a favorable interest rate

Disadvantages of loans to executives

Tax rules for below-market loans are complicated and result in increased administrative costs Tax treatment of term loans as opposed to demand loans is unfavorable-- employee has to include a substantial portion of the loan in income immediately in some cases Employer must bear the cost of administering the loan

Incentive stock options (ISOs)

Tax-favored plan for compensating executives by granting options to buy company stock at specific exercise prices Generally do not result in taxable income to executives either at the time of the grant or the time of the exercise of the option Executive is taxed only when stock purchased under the ISO is sold The difference between the market price and the exercise price is a tax preference item and gets added back for AMT calculation

Federal estate tax treatment

The amount of any death benefit payable to a beneficiary under a nonqualified deferred compensation plan is generally included in the deceased employee's estate for federal estate tax purposes, at its then present To the extent that payments are made to the employee's spouse in a qualifying manner, the unlimited marital deduction eliminates any federal estate tax value

Who must be covered?

The corporation is free to discriminate as it sees fit Plan may cover only independent contractors or members of management or highly compensated employees

Tax treatment of earnings

The earnings of plan assets set aside to informally fund a nonqualified deferred compensation plan are taxed currently to the employer unless the use of assets that provide a deferral of taxation is used Employer is entitled to a tax deduction when the benefits are made available to the employee

Disadvantages of split dollar life insurance plan

The employer receives no current tax deduction for its share of premium payments under the split dollar plan The employee must pay income taxes each year on the current cost of life insurance protection under the plan, less any premiums paid by the employee The plan must remain in effect for a reasonably long time, that is 10 to 20 years, in order for policy cash values to rise to a level sufficient to maximize plan benefits If the employer relinquishes the rights to the policy, there will be a taxable event at that time to the employee

When are benefits forfeitable?

The qualified plan vesting rules apply only if the plan covers rank-and-file employees If the plan covers only independent contractors or a select group of management or highly compensated employees, benefits must be forfeitable in full at all times or subject to current taxation to the employee

When are ISOs used?

To compensate executives, larger corporations primarily use ISOs Generally not suitable for closely held corporations because: 1) no ready market for closely held stock 2) shareholders of closely held corporations do not want unrelated outsiders to become shareholders of the company

Employer objectives with nonqualified deferred compensation plans

Usually to provide an incentive to hire key employees, to keep key employees, and to provide performance incentives

Advantages of split dollar life insurance plan

Plan allows an executive to receive a benefit of current value, namely life insurance coverage, using employer funds with reduced cost to the executive In most plans, the employer's outlay is at all times fully secured-- net cost to the employer is merely the loss of the net after-tax income the funds could have earned while the plan was in effect

Disadvantages of nonqualified stock options

Price falling below the option price Fluctuation in the price could weaken the effectiveness of the plan as a performance incentive Executive bears the market risk Executive must have a source of funds to purchase the stock and pay taxes due in the year of exercise in order to benefit from the plan Employer's tax deduction is generally delayed until the executive exercises the option and purchases stock

Employee objectives with nonqualified deferred compensation plans

Primarily to obtain additional forms of compensation for which income tax is deferred as long as possible, preferably until the money is actually received The tax deferral, and therefore the compounding of dollars that otherwise would be paid currently in taxes is a major benefit of the plan Employee would favor plan with following provisions: benefit certainty, benefit that is immediately 100% vested without forfeiture provisions, funds available for various purposes during employment, and/or financing or informal funding arrangements such as corporate-owned life insurance, rabbi trust, or surety bonds

Nonqualified stock options

Provide a right to purchase shares of company stock at a stated price that is the option price for a given period of time, frequently 10 years Option exercise price normally equals 100% of the stock's FMV on date of grant, but may be set below or above this level Recipients normally must wait a period of time, 1-4 years, before they can exercise options

Nonqualified retirement plans

Provide employees additional retirement benefits Do not meet ERISA requirements and are discriminatory Provide tax deferral for the employee Employer can decide who is to be included in the plan Earnings are taxed currently to the employer-- not tax deductible Employer receives a tax deduction only once the employee has received the benefits of the plan or the benefits have been made available Earnings are taxable to the employee when the funds are distributed to the employee or made available

Advantages of loans to executives

Provide extremely valuable employee benefit No discrimination rules Make cash available where regular bank loans might be difficult to obtain Providing loans at a favorable rate of interest Cost of loan program to the employer is only the administrative cost plus the loss of interest on the loan

Advantages of ISOs

Provides greater deferral of taxes to the executive than a nonqualified stock option Income from the sale of the stock obtained through exercise of an ISO may be eligible for preferential capital gains treatment ISO is a form of compensation with little or no out-of-pocket cost to the company

Financing techniques for nonqualified deferred compensation plan

1) Reserve account maintained by the employer-- employer maintains an actual account, invested in securities of various types Fund are fully accessible to the employer and its creditors Plan is considered unfunded 2) Employer reserve account with employee investment direction-- employee has right to direct or select investments in the account Ability to choose may lead to constructive receipt by the employee 3) Corporate-owned life insurance-- policies on the employee's life, owned by and payable to the employer corporation Plan can provide a substantial death benefit Common because the cash value buildup is tax-deferred 4) Rabbi trust-- set up to hold property used for financing where the funds set aside are subject to the employer's creditors 5) Third-party guarantees-- guarantee from a third party to pay the employee if the employer defaults Guarantor could be an insurance company or some other entity

Types of benefit and contribution formulas for nonqualified deferred compensation plans

1) salary continuation formula-- plan provides a specified deferred amount payable in the future Requires no reduction in the covered employee's salary ex:) plan will pay you or beneficiary $50,000 a year for 10 years starting at age 65 2) salary reduction formula-- involves an elective deferral of a specified amount of the compensation that the employee would have otherwise received employer contribution under this type of plan could be in the form of a bonus, without actual reduction of salary employer has no obligation to actually set assets aside-- when payment becomes due, employer pays it from its current assets 3) excess benefit plan-- makes up the difference between the percentage of pay that top executives are allowed under Section 415 and that which rank and file employees are allowed highly compensated employees receive the difference between the amounts payable under their qualified plan and the amount they would have received if there were no benefit limitations under Code Section 415 4) stock appreciation rights/phantom stock formula-- benefit formula in the plan can be determined on the basis of the value of a specified number of shares of employer stock Generally no actual shares are set aside, nor are shares of stock necessarily actually distributed—the value of employer stock simply is the measure by which the benefits are valued Employee's future benefits are to be determined by a formula based on the appreciation value of the company's stock over the period between adoption of the plan and date of payment

Supplemental Executive Retirement Plans (SERPs)

A nonqualified retirement plan that provides retirement benefits to selected employees only Not qualified under the IRC or ERISA so greater flexibility Benefits can be set at any level desired and can be paid for life or for a set number of years

Social Security (FICA) taxes

Amounts deferred under nonqualified deferred compensation plans are not subject to Social Security taxes until the year in which the employee no longer has any substantial risk of forfeiting the amount-- as soon as the covered executive cannot lose his interest in the plan SS taxable wage base has an annual upper limit of $118,500-- tax rate is 6.2% Medicare hospital insurance portion is unlimited-- tax rate is 1.45% for employer and employee

Split Dollar Life Insurance

An arrangement typically between an employer and an employee in which there is a sharing of the costs and benefits of the life insurance policy-- involve a splitting of premiums, death benefits, and/or cash values Most common form will have the employer own the policy and all of the cash value Employer gets enough of the death benefit to pay back their costs

When are nonqualified stock options used?

An employer can use options when it compensates employees with company shares-- common in large corporations whose stock is publicly traded Can also be used in a situation where the employer wants to reward performance with equity-type compensation-- compensation increases in value as the employer stock increases in value

Tax implications of ESPPs

Depends on whether they meet the holding period requirements Participant is generally not taxed until the sale of the shares Participant will pay ordinary income tax on a portion or the entire purchase price discount and will recognize a capital gain or loss for the value difference between their basis in the stock and the proceeds from the sale

When is a split dollar life insurance plan used?

Can be used to provide cost-effective life insurance, preretirement death benefits, fringe benefits, and to help shareholder employees Conditions for using split dollar life insurance: When an employer wishes to provide an executive with a life insurance benefit at low cost and low outlay to the executive When a preretirement death benefit for an employee is a major objective When an employer is seeking a totally selective executive fringe benefit, the "loan regime" approach is attractive particularly in a low interest rate environment When an employer wants to make it easier for shareholder-employees to finance a buyout of stock under a cross purchase buy-sell agreement, or make it possible for non-stockholding employees to effect a one-way stock purchase at an existing shareholder's death

Vested vs. Unvested NQSO

Considered vested if you have the ability to transfer the stock to another person without any restrictions or you have the right to keep the stock if you are terminated or leave the company Considered unvested if you have a "substantial risk of forfeiture"-- if you terminate employment you may lose some or all of the value of your NQSO

Disadvantages of ISOs

Corporation granting an ISO does not ordinarily receive a tax deduction for it at any time Plan must meet complex technical requirements of Code Section 422 Exercise price of an ISO must be at least equal to the FMV of the stock when the option is granted Executive gets no benefit unless he is able to come up with enough cash to exercise the option Executive may incur an AMT liability when an ISO option is exercised, thus increasing the executive's cash requirements in the year of exercise

Advantages of a nonqualified deferred compensation plan

Design is much more flexible than qualified plans Involves minimal IRS, ERISA, and other governmental regulatory requirements Provides deferral of taxes to employees, but the employer's deduction is also deferred Can use nonqualified plan to bind the employee to the company-- vesting rules do not apply Plan can provide security to executive through informal financing arrangements

Income taxation of benefits and contributions within a nonqualified deferred compensation plan

Employees must pay ordinary income tax on benefits from unfunded nonqualified deferred compensation plans in the first year in which the benefit is actually or constructively received Death benefits from nonqualified plans that are payable to a beneficiary are taxable as income in respect as a decedent to a recipient

Taxation of employer with a nonqualified deferred compensation plan

Employer does not receive a tax deduction until its tax year, which includes the year in which the compensation is includable in the employee's taxable income If the plan is unfunded, the year of inclusion is the year in which the compensation is actually or constructively received For a formally funded plan, compensation is included in income in the year in which it becomes substantially vested

Disadvantages of SERPs

Employer is not entitled to an income tax deduction until the amounts are actually or constructively received by the employee Investments cannot be separated from the employer's general assets without creating unfavorable current income tax consequences for SERP participants so the assets set aside to informally fund the plan must remain subject to the claims of the employer's creditors

Disadvantages of nonqualified deferred compensation plans

Employer's tax deduction is generally not available for the year in which compensation is earned-- it must be deferred until the year in which income is taxable to the employee From executive's point of view, lack of security as a result of depending only on the employer's unsecured promise to pay Most of the protection of federal tax and labor law are not applicable Some disclosure of executive nonqualified plans on financial statements may be required-- reduce confidentiality of the arrangement Not all employers are equally suited to take advantage of nonqualified plans-- S corp/partnership bc of pass-through tax structure

Advantages of nonqualified stock options

Few tax or other government regulatory constraints No discrimination coverage or benefit rules Form of compensation with little or no out-of-pocket cost to the company-- real cost is that the company forgoes the opportunity to sell the same stock on the market Tax to the employee is deferred-- generally taxed when option is exercised

Tax rules associated with loans to executives

Following rules apply if a loan is: a below-market loan, compensation-related, and/or a demand loan Demand loan is payable in full at any time upon demand of the lender Interest actually paid by the executive borrower is taxable income to the company and that interest payment may be deductible by the borrower Employer is treated as if it paid additional compensation to the employee in the amount of the difference between the actual rate of interest and the applicable federal rate Executive is treated as if he paid the amount in the second deemed transaction to the employer-- amount is additional taxable income to the employer **rules do not apply to certain mortgage and bridge loans used to help an employee purchase a house in connection with the employee's transfer to a new principal place of work

Tax implications of phantom stock

Follows general tax rules that are applicable to nonqualified deferred compensation plans Employee will have no tax consequences when they receive phantom stock units Will recognize income when the phantom stock units are paid or made available Employer is allowed to take a deduction for the benefits in the year in which they are paid or when they are made available to the employee

Economic benefit doctrine

If an individual receives any economic or financial benefit or property as compensation for services, the value of the benefit or property is currently includible in the individual's gross income Used with funded plans

Tax implications of nonqualified deferred stock options

If the option does not have an ascertainable fair market price, it is not considered taxable income to the executive at the date of the grant Employee has taxable compensation income in the year of purchase of the stock-- amount of taxable income is the difference between the FMV of the shares at the date of purchase and the option price that is the amount the executive actually pays for the shares No tax deduction at the time when the option is granted-- employer receives tax deduction in the same year in which the employee has taxable income as a result of exercising the option and purchasing the shares

Loan regime

In an employer/employee relationship the employee would be the owner of the contract from inception and thus would enjoy the normal tax benefits associated with a life insurance contract The employer is deemed to be making a loan to the employee In the future the loan must either be repaid or forgiven and treated as compensation or a dividend This assumes that the life insurance policy is not a MEC, modified endowment contract, whose loans are treated as ordinary income and subject to a 10% penalty if the employee is under age 59

Tax implications of nonqualified deferred compensation plans

In the case of constructive receipt, an amount is considered for taxation if it is put aside or credited to the employee's account unless the employees control of the receipt is subject to a substantial limitation or restriction According to the economic benefit doctrine, a compensation agreement that provide a current economic benefit to an employee is taxed as soon as the employee is vested in contributions made to the fund, even when the employee does not have a right to withdraw cash at that time

ERISA and other regulatory requirements for loan to executives

Loan program does not fall within definition of either a welfare benefit plan or a pension plan and therefore ERISA requirements do not apply and a Form 5500 need not be filed Federal Truth in Lending requirements may apply-- primarily involve additional paperwork

When are loans to executives used?

Loans are typically offered for the following: Mortgage or bridge loan to help in the purchase of a home College or private school tuition for members of executive's family Purchase of the employer's stock through a company stock purchase plan or otherwise Meeting extraordinary medical needs, tax bills, or other personal or family emergencies Purchase of life insurance Purchase of a car, vacation home, or other expensive item

Doctrine of constructive receipt

Means that the income is made available to the taxpayer so that he may draw upon it at any time Income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions Used with unfunded plans

Requirements of ESPP

Must meet following requirements of Section 423 of the IRC: Options are to be granted only to employees of the employer corporation or of its parent or subsidiary Plan is approved by the stockholders of the granting corporation within 12 months before or after the date that such plan is adopted No employee can be granted an option if he/she owns 5% or more of the total combined voting power or value of all classes of stock Options are to be granted to all employees of the sponsoring employer-- some exclusions All employees granted such options shall have the same rights and privileges Option price is not less than the lesser of an amount equal to 85% of the FMV of the stock at the time such option is granted Options cannot be exercised after the expiration of 5 years from the date such option is granted No employee may be granted an option which permits his right to purchase stock to accrue at a rate which exceeds $25,000 of FMV Option is not transferable

Form of benefits

Nonqualified deferred compensation plans usually provide payments at retirement in a lump sum or a series of annual payments Life annuities or joint and survivor annuities for the participant and spouse can also

Cashless exercise of options

Often used by executives who have NQSOs and want to sell and exercise all or enough of the shares to cover the exercise costs which include any transaction fees or commissions, taxes, and the strike price In the "sell-all case, the executive has cash left over after paying all the applicable costs In the "sell-to-cover" case, the executive still retains the remaining shares In either case, the sale of the stock and the exercise of options occur at the same time

Unfunded plan

One where the employee has only the employer's "mere promise to pay" the deferred compensation benefits in the future and the promise is not secured in any way

Advantages of SERPs

To employers: attractive benefit for recruiting, retaining, and rewarding key employees, flexibility in selecting individual benefit levels, minimal reporting and filing requirements, option to selectively single out plan participants to participate, and the continuation of existing retirement plans without changing their plan documents To employees: an increase in retirement benefits received, do not have to change current compensation, plan design allows for survivor benefits during retirement and/or employment, and the plan provides the opportunity to receive additional or accelerated benefits upon a change in corporate control or ownership

When is a nonqualified deferred compensation plan used?

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 Plan is ideal for many companies that do not have or cannot afford qualified plans but want to provide key employees with retirement income When an employer wants to provide additional deferred compensation benefits to an executive already receiving the maximum benefits or contributions under the employer's qualified retirement plan When the business wants to provide certain key employees with tax deferred compensation under terms or conditions different from those applicable to other employees When an employer needs to solve the Four R's-- recruit, retain, reward, and retire When a closely held corporation wants to attract and hold non-shareholder employees

SERP plan design

When creating a SERP, an organization agrees to pay a chosen group of highly compensated or key employees a supplemental retirement benefit If the participant dies before reaching retirement age, usually the company will also pay a survivor benefit to a named beneficiary To establish a SERP, the employer signs a written agreement to pay certain participants an annual sum beginning at retirement-- employer purchases a life insurance policy on each covered participant and they are the owner and beneficiary of the policy When the participant is ready to retire, the employer makes benefit payments to the participants, which are tax-deductible to the employer-- benefits are taxed as ordinary income to the participant

Withdrawals during employment of nonqualified deferred compensation plan

Withdrawals must be subject to a restriction or limitation that prevents them from being currently available within the constructive receipt doctrine Commonly used withdrawal provisions: 1) penalty or haircut provisions are no longer permitted-- penalties that are based on a percentage of withdrawal (haircut) are not permitted 2) suspension of participation provision-- suspends employee's participation in the plan for a period such as 6 months after withdrawing money 3) hardship withdrawal provision-- provision can be quite broad as long as it provides a significant limitation or restriction on the employee's ability to gain access to the plans funds