The New Golden Handcuffs
How a split-dollar strategy allows deferred compensation for small- to mid-sized companies
With all the changes to executive benefit arrangements in the past decade, can a smallto medium-sized employer on a budget provide a meaningful benefit to key employees to ensure loyalty and compete with larger corporations? The answer is a resounding “yes.” The passage of the American Jobs Creation Act and subsequent codification of significantly more substantial deferred compensation rules under Internal Revenue Code Section 409A (hereinafter Section 409A) added a great deal of complexity to the establishment and administration of nonqualified supplemental retirement plans. The compliance costs associated with installing a deferred compensation arrangement, ongoing Section 409A annual requirements and the draconian penalties for failure to comply requires employers to invest in either upgrading internal compliance resources or contracting with a third party administrator. Small- to medium-sized firms often do not have the budget for these additional costs. However, despite these hurdles, deferred compensation plans remain popular methods for rewarding senior management and an attractive tool for recruiting top talent because management can be discriminatory. The costs of Section 409A compliance are most onerous on those small-to-medium but rapidly growing businesses where the need to attract and maintain major revenue drivers is greatest. It is these organizations, heavily dependent on a top salesperson or a critical intellectual employee, where the loss to a competitor can be devastating. The necessity for a “Golden Handcuff”-type plan is crucial to their survival, but the expense of administering such a plan in addition to the informal funding of the promise can put it out of reach. Likewise,
This strain on resources is accentuated in smaller and intermediate-sized nonprofits that want to retain their chief rainmakers who bring in the majority of donations. In order to level the playing field with larger corporations, these employers need an alternative to traditional deferred compensation plans that fall outside of the scope of Section 409A that allows them the opportunity to compete for and retain personnel with large corporations with nonqualified executive benefits budget. The ability to create such a program may be found within Section 409A itself. It is the “short-term deferral” (Section 409A, Reg. 1.409A-1(b)(4)) exception which, when combined with an endorsement split-dollar plan, has the potential to be a very lucrative benefit with strings attached. The “short-term deferral” exception refers to the timing of the distribution of plan assets upon plan termination. That is the key to escaping the Section 409A umbrella. The employee must receive the policy used
In the split-dollar arrangement within two and half months of the end of the corporate tax year in which the service requirement was completed (20 years, age 65, etc.). This rule has to be adhered to strictly but, as long as it is, Section 409A does not apply. Now that we’re outside of Section 409A, it is the endorsement split-dollar that adds the golden handcuff. Before the completion of the service requirement, the business owns a life insurance contract on the desired employee and is beneficiary to premiums paid or policy cash value, whichever is greater. (Section 101(j) requirements must be met in order for the death benefit to remain tax free.) The employee’s beneficiares will receive the balance of the death benefit income tax-free, provided that the employee recognizes as income the economic benefit charges on the net amount of risk as measured by Table 2001 (or a carrier’s alternative term rates if published and regularly sold).
THe policy is transferred to the employee as compensation for its Fair Market Value. (See Revenue Procedure 2005-25.) The business enjoys a deduction for the fair market value at that time. The employee can take a withdrawal from the policy to pay the income tax or the employer can make a bonus to pay the tax. The annual tax on the economic benefit may be added to the employee’s salary as a annual bonus making it tax neutral to the employee.
An actual placed case will help to illustrate the power of this conept. ABC Co. is a small business with a key employee who is vital to its success. The business was growing dramatically and assets were being reinvested in order to sustain the growth. We discussed the idea of combining an endorsement split-dollar plan with the “short-term deferral” exception. THe owner was pleased that the approach provided golden handcuffs, the potential for cost recovery in the form of key person protection during the employment years, and was inexpensive relative to other executive benefit programs they explored.
The key employee was a male, age 43, in good health. The business applied for a policy on the key employee for 500K of coverage with an annual premium of 10K to age 65. In year one the business retained $10,000 of the death benefit (greater of premium paid or cash value) with the balance endorsed by the key employee. Based on the IRS Table 2001, the employee paid tax on the imputed income of $632. If the key employee dies, the his beneficiaries will the net benefit income tax-free.
if and when the key employee satisfies the predetermined service requirement, the policy will be distributed to him whith two and half months of the end of the calendar year in which this requirement is met. Again, this will avoid 409A compliance concerns altogether.
At that time, the business will enjoy a tax deduction equal to the fair market value of the policy. The key employee will be taxed on the same amount, which in our example is projected to be $314,598. A withdrawal from the policy of $94,379 could cover the tax liability (assuming a 30% tax bracket). At this point, the key employee could surrent the policy out for the cash, use for estate planning or take loans in order to supplement his retirement.
Life insurance represents an excellent vehicle for funding a nonqualified executive benefit for two primary reasons: first, the cash values grow on a tax-deferred basis; second, if the employee passes away before completion of the plan, the employer recoups its costs income tax free. The “golden rule” of business accounting is that if you can’t get a tax deduction, make sure you get a cost recovery. The company is guaranteed cost recovery in the event of premature death of the employee, the contract is cash if the employee departs prematurely and there is a tax deduction at plan termination.
Execute compensation arrangements such as split-dollar and deferred compensation have gone through substantial regulatory changes over the past decade, but nonqualified executive benefit plans, thanks to short-term deferral rule, represent an inexpensive technique for small to mid-sized firms to compete with larger corporations for top talent and maintain employee loyalty.
The authors would like to thank Meredith Garcia-Tunon, CLU, FLMI, ACS for her comments and invaluable contribution to this article.
By Stephen O Kroeger, Jack F Elder and Ryan Mattern of Crump Life Insurance services for the September 2012 issue of InsuranceNewsNet Magazine.