deferred compensation (nonqualified) chapter 48 tools & techniques of estate planning copyright...

Deferred Compensation (Nonqualified)

Chapter 48Tools & Techniques of

Estate Planning

Copyright 2011, The National Underwriter Company 1

• An arrangement whereby an employer promises to pay an employee in the future for services rendered currently

• The plan is generally set up to provide for the employee’s salary to be continued over a period of years after retirement or other termination of employment

• The plan is “nonqualified” because it does not attempt to meet the stringent coverage and contribution requirements necessary to gain government approval and the very favorable tax treatment available only to qualified plans

What Is Nonqualified Deferred Compensation?



Estate Planning


• A business does not have a government approved qualified retirement plan to offer key employees and would like to provide those key employees with retirement benefits

• A business has a qualified retirement plan and would like to provide additional retirement benefits for key employees above and beyond those permissible under a qualified plan

When Is Use Of Nonqualified Deferred Compensation Appropriate?



Estate Planning


• A highly paid employee or executive would like to defer the taxation on income from peak earning years to a future date when he might be in a lower income tax bracket (e.g. retirement)

• When an executive or other highly paid employee would like to use his employer to provide a forced savings program for his retirement




Estate Planning


• When the corporate rates at the top brackets are lower than individual rates at the top bracket

• When there are stringent limitations on the maximum benefits under qualified plans, the use of nonqualified plans will be stimulated

• An employer would like the ability to pick and choose who will be covered and determine on a person-by-person basis the benefit levels and terms and conditions of coverage




Estate Planning


• To successfully defer income tax and avoid constructive receipt of income– The agreement should contain a contingency that may

cause the employee to forfeit rights to future payments

• An employee will not be deemed to be in constructive receipt of income if– The agreement is entered into before the employee earns

the compensation in question, and– The employer’s promise to pay is not secured in any way

• The agreement cannot be formally funded without causing the money to be immediately taxable

What Are The Requirements?



Estate Planning


• It is permissible for a corporation to finance its obligation under the agreement by – Purchasing a life insurance contract, annuities, mutual

funds, securities, or a combination thereof

– Assets used to finance the employer’s obligation must remain the unrestricted property of the corporation, subject to claims of corporate creditors

– Employee must not be given an interest or specific rights in the assets set aside to meet the obligation




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• Use of a “Rabbi Trust” is permissible to provide some protection of loss of benefits in the event of a hostile takeover, but does not protect against the employer’s general creditors in the case of insolvency

• All agreements must now comply with the requirements of IRC Section 409A to achieve deferral and avoid penalties and interest




Estate Planning


Example:– Selected employee enters into an employment contract with his

employer– Contract stipulates payments will be made to the employee or the

employee’s beneficiaries in the event of death, disability, or retirement

– In exchange for the employer promised benefits, the employee agrees to continue in the service of the company

– Employer will purchase life insurance or other savings vehicles to provide for the required benefits

• Employer maintains ownership and is the beneficiary of the life policy• Cash values can be used to pay retirement or disability benefits, and• Death proceeds can be used to make required payments to the

deceased employee’s family

How Is It Done?



Estate Planning


Example:– Assume a premium of $3,300 would purchase approximately

$185,000 of whole life insurance on a male age 45– If the employee under a deferred compensation arrangement

dies at age 50, after five years of premium payments the following would result

• Corporation would receive $185,000 of tax free policy proceeds• Corporation would have paid five years of premiums totaling

$16,500, and• Under the agreement corporation is obligated to pay the

employee’s spouse $5,000 per year for 5 years, totaling $25,000– Company’s after-tax cost of payments to deceased employee’s

spouse is only $16,500 (66% of $25,000)• Result: A net gain to the company of $152,000

How Is It Done?



Estate Planning


• The American Jobs Creation Act of 2004 created new IRC Section 409A that imposes new rules on non-qualified plans:– Limitations on distributions– Limitations on deferral elections– Limitations on funding– Penalties and Interest

Tax Implications - IRC Section 409A



Estate Planning


• Limitations on Distributions– A participant may only receive a distribution of previously deferred

compensation upon• Separation from service• The date the participant becomes disabled• Death• A fixed time (or pursuant to a fixed schedule)• A change in ownership or effective control of the corporation• The occurrence of an unforeseeable emergency

– Key employees (IRC Section 416(i)) of publicly traded companies may not take distributions until six months after separation from service (or, if earlier, the date of death of the employee)




Estate Planning


• Limitations on Deferral Elections– Participants must generally make elections to defer

compensation prior to the end of the preceding taxable year– New participants may make an election within 30 days of

eligibility, but only with respect to services performed subsequent to the election

– Plans may allow participants to subsequently elect to delay distributions or change the form of distributions

• The new election must be made at least 12 months in advance• Any delayed distribution must occur at least 5 years from the

date of the new election




Estate Planning


• Limitations on Funding– Securing or distributing deferred compensation

based upon the employer’s falling net worth or other financial events is not permitted

• This includes hybrid rabbi/secular trust arrangements that distribute assets from nominal rabbi trusts to secular trusts upon the occurrence of triggering events

– Setting aside assets in an offshore trust to directly or indirectly fund deferred compensation is not permitted




Estate Planning


• Penalties and effective date– Any violation of the requirements results in retroactive

constructive receipt of the deferred income– The previously deferred income is subject to a 20% excise

tax– Interest is charged at 1% higher than the normal

underpayment rate– The requirements of IRC Section 409A generally apply to

amounts deferred after December 31, 2004




Estate Planning


• Guidance and Proposed Regulations– The IRS released Notice 2005-1 in early 2005

– The IRS released proposed regulations in September 2005

– Final regulations issued by IRS effective January 1, 2008




Estate Planning


• Premiums paid on life insurance are not deductible since the policy is an asset of the employer

• When the executive reaches retirement age the employer may choose to make benefit payments out of current or accumulated earnings and continue the policy in force until the employee dies to receive death proceeds tax free, or

Tax Implications - Employer



Estate Planning


• The employer as owner of the policy may surrender the policy and choose one of the settlement options to fulfill its obligation under the deferred compensation plan– A portion of each installment payment received by the

employer will be taxable to the employer under annuity rules

– For a lump sum payment, that portion which exceeds the employer’s cost (net premiums paid) is treated as ordinary income




Estate Planning


• At the employee’s death, the entire policy proceeds receivable by the employer are generally income tax free

• When benefits are paid by the employer under the deferred compensation plan, either to the employee or the employee’s family,– Payments are deductible by the corporation provided they constitute

reasonable additional compensation

• Deferred payment amounts will be considered wages and will be subject to FICA tax in the year in which they are no longer subject to a substantial risk of forfeiture by the employer




Estate Planning


• During employment, the employee is not taxed on amounts set aside by the employer to meet its financial obligation

• Benefits received from the deferred compensation plan by the employee (or family) are taxable as compensation, subject to FICA, and ordinary income tax rates as received– Whether the OASDI portion of Social Security tax will apply

depends on whether the participant’s other earnings for the year equal or exceed that year’s OASDI taxable wage base

Tax Implications - Employee



Estate Planning


• The commuted value of benefit payments remaining at a covered employee’s death will be included in the employee’s gross estate for federal estate tax purposes– This is IRD and an income tax deduction will be allowed to

the recipient of such income for additional federal estate tax attributable to the inclusion of the deferred compensation

– If the death benefit is payable to the employee’s spouse in a qualifying manner, there will be no estate tax due because of the unlimited marital deduction, therefore there will be no deduction of IRD

Tax Implications - Employee



Estate Planning


• Earnings of a resident husband or wife are generally treated as community property

• Deferred compensation paid currently would be community property

• Be careful of separate property turned into community property by a “community property agreement” possibly triggering state gift tax consequences

Issues In Community Property States



Estate Planning


• If the spouses divorce or one of the spouse’s dies, it may be necessary to compute the PV of the deferred amount in order to divide the community assets

Note: Current analysis establishes that there is “property” subject to division even though there is no certainty the compensation will ever be received

Issues In Community Property States

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