Fashioning executive benefits in the post-Enron age
When it comes to the recent scrutiny of executive benefits, all roads lead to Enron.
Following the company’s collapse in 2001, the scandal that resulted led to a yearlong investigation of the Enron executives’ compensation by the Congressional Joint Committee on Taxation. This investigation resulted in a 2,700-page report that has occasioned much of the recent legislative and regulatory activity respecting taxation of executive compensation.
The report examined all aspects of Enron’s financial life and made recommendations for the regulation of nonqualified deferred compensation plans, split-dollar life insurance plans and corporate-owned life insurance (COLI).
Nonqualified Deferred Compensation Plans
The Joint Committee found the Enron executives deferred more than $150 million in compensation from 1998 through 2001. The week before Enron filed for bankruptcy, per the terms of the compensation plan, the company paid its executives $53 million in accelerated distributions.
The Enron plan allowed participants to direct their account investments and to make subsequent elections to change the timing of the benefit payout. The committee report concluded the Enron executives received benefits similar to those available from qualified plans without compliance with the ERISA qualified plan rules.
The Joint Committee’s recommendations are reflected in the nonqualified compensation provisions of the American Jobs Creation Act of 2004. When the President signed the Act on Oct. 22, 2004, one of my colleagues came into my office holding his head after conversing with a former law school classmate who has a large employee benefits practice.
The two of them were lamenting the end of nonqualified compensation plans. I found this surprising because just the opposite is true. The new rules do not eliminate the use of deferred compensation plans. They are simply intended to curb the perceived abuses, so aptly demonstrated by Enron, and they restrict the timing and acceleration of plan distributions.
In fact, the new deferred compensation rules present sales opportunities for financial professionals. It is important to visit clients with existing plans to conduct plan reviews and to discuss other planning needs.
For clients who have not yet adopted plans, encourage them to do so now. The timing has never been better for this valuable planning tool because now there are specific rules to follow that will safeguard both the client and the planner.
Split-Dollar Life Insurance
Enron owned split-dollar life insurance policies on its top three executives. These policies ranged from $5 million to $30 million in coverage. In response, the Joint Committee on Taxation’s report recommended that the split-dollar regulations that had been proposed by the Treasury Department be finalized expeditiously and they were.
The final split-dollar regulations apply to arrangements entered into after Sept. 17, 2003. It is important to recognize that the rules do not eliminate the use of split-dollar plans.
Remember that the IRS is charged with taxing transfers between parties. The IRS taxes income transfers, gift transfers and transfers at death. With the final split-dollar regulations, the IRS is imposing tax on one form of split-dollar, called equity split-dollar. This technique provides for a transfer of policy equity that had gone untaxed previously.
IRS regulations leave non-equity split-dollar plans largely unaffected. Split-dollar arrangements originally were designed so the party with the ability to pay may provide a benefit to a party in need. Using split-dollar as a valid premium paying strategy has not changed.
Corporate-Owned Life Insurance
Starting in the 1980s and continuing through the 1990s, Enron bought over 1,000 life insurance policies on its employees. By its demise in 2001, Enron had borrowed over $432 million against the contracts.
The Joint Committee did not recommend listing COLI as an abusive tax shelter as originally thought. Although it did recommend the elimination of the grandfathered, pre-1986 COLI interest deduction, which has not been enacted.
The Health Insurance Portability and Accountability Act of 1996 (HIPAA) and TRA 1997 amended Internal Revenue Code Section 264, based upon the perceived interest deduction abuses found in COLI plans.
As with the other forms of planning, the blow to COLI has not been fatal. Businesses may still purchase life insurance on employees, owners, officers and directors to fund necessary and beneficial employee fringe benefits.