Funding non-qualified deferred compensation plans with life insurance
By Julius Giarmarco
Giarmarco, Mullins & Horton, P.C.
A non-qualified deferred compensation plan cannot be formally funded without causing the employee to have reportable income immediately – even though the actual benefits are not paid until a future date. Thus, NQDC plans create an unfunded liability on the employer's balance sheet. There are two ways for an employer to handle the liability under an NQDC plan.
A non-qualified deferred compensation plan is an agreement whereby an employer promises to pay a select group of employees a retirement, disability and/or pre-retirement death benefit in the future. There are two broad categories of NQDC plans. In a deferral plan, the employee elects (prior to the period that the compensation is actually earned) to receive less current compensation than he or she would have received otherwise. Thus, the employee defers receipt of the reduced amount to a future tax year. In a salary continuation plan, the employer promises to pay a retirement, disability and/or death benefit without any deferral of compensation from the employee.
As the name implies, NQDC plans are not subject to ERISA's strict requirements for qualified plans. Employers can avoid the participation, vesting and funding requirements of ERISA either through an excess benefit plan or a top-hat exemption.
An excess benefit plan, sometimes referred to as a supplemental employee retirement plan, provides benefits to certain employees in excess of the IRC Section 415 limits for qualified retirement plans. A top-hat plan is the most common type of NQDC plan. It is maintained primarily for a select group of management or highly-compensated employees.
NQDC plans are most often used as an incentive or golden handcuff to attract and retain key employees. They can be custom tailored to help both the employer and employee achieve their specific business and financial objectives. The employee does not report any income (and the employer does not receive a tax deduction) until the benefits are paid. But the employer's promise to pay must be unsecured. Thus, the employee remains an unsecured creditor of the employer.
An NQDC plan cannot be formally funded without causing the employee to have reportable income immediately – even though the actual benefits are not paid until a future date. Thus, NQDC plans create an unfunded liability on the employer's balance sheet. In addition, the employee (as an unsecured creditor of the employer) faces risks if the unfunded promise to pay benefits is thwarted by downturns in profitability. To offset this liability and to provide the employee with some certainty that the plan will pay out as promised, many employers choose to informally fund their NQDC plans.
There are two ways for an employer to handle the liability under an NQDC plan: 1) purchase taxable investments (e.g., stocks, bonds and mutual funds); or 2) purchase permanent life insurance on the employee's life. In either case, the assets or life insurance policy are the property of the employer and, therefore, subject to the claims of the employer's creditors. Life insurance has several advantages over taxable investments as a funding vehicle for NQDC plans. First, the inside build up of cash value occurs tax free (unless the employer is subject to the alternative minimum tax discussed below). Second, the owner of a life insurance policy can make tax-free withdrawals from the policy up to the amount of the owner's basis and, thereafter, can take a tax-free policy loan (subject to contract limitations and charges). Third, life insurance death benefits are income tax free to the employer (subject to the AMT). However, regular C corporations (with annual gross receipts of $7.5 million) may be subject to an effective AMT rate of 15 percent on the inside build-up in a policy and on the death benefit when received.
At the employee's retirement, disability or death, the employer can use the death benefit (or cash values) to: 1) pay retirement or disability benefits through distributions of policy cash values; 2) pay pre-retirement survivor income benefits to a deceased employee's beneficiaries; 3) pay the employee's beneficiaries the remainder of the retirement or disability benefits should death occur during the retirement or disability income period specified in the plan; and 4) help reimburse the employer for funds paid out for policy premiums and retirement or disability benefits.
Permanent life insurance is a popular choice for informally funding an NQDC plan for many reasons. The three major tax advantages of life insurance (discussed above) are important factors: the tax-free build-up of cash values, tax-free access to cash values and the tax-free receipt of the death benefit (subject to the AMT). In addition, life insurance provides safety of principal and flexibility in the amount and frequency of premium payments.
THIS ARTICLE MAY NOT BE USED FOR PENALTY PROTECTION. THE MATERIAL IS BASED UPON GENERAL TAX RULES AND FOR INFORMATION PURPOSES ONLY. IT IS NOT INTENDED AS LEGAL OR TAX ADVICE AND TAXPAYERS SHOULD CONSULT THEIR OWN LEGAL AND TAX ADVISORS AS TO THEIR SPECIFIC SITUATION.