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.

Sarbanes-Oxley & Tax Shelter Rules

The Enron scandal was followed by the demise of WorldCom, the Rigas family of Adelphia, and others. The congressional response to these additional scandals was the Sarbanes-Oxley Act of 2002.

This non-tax legislation was adopted to deter and punish corporate and accounting fraud and corruption and to protect employees and shareholders. The initial reaction to Sarbanes-Oxley was swift and negative. But businesses are learning to live within its confines and are managing to maintain their legitimate executive benefit plans without hindrance from the Act.

Just when legislative activity in the compensation area appeared to be slowing down, the IRS issued final tax shelter disclosure, registration and listing rules in 2003. These include the prohibited “listed transactions.”

Increasingly, the IRS is using the tax shelter rules to combat what it perceives as abusive employee benefit plans. Although certain Internal Revenue Code sections are found in the list of abusive transactions (Sections 412(i) and 419, for example), the rules do not eliminate all uses of the plans based upon these code sections.

In the executive benefits world, these rules are intended to punish (by penalties and disallowed tax benefits) those clients and financial professionals who stray outside of the well-defined rules.

What’s Left? Executive Bonus Plans

As long as the government allows employers to compensate employees, executive compensation bonus plans under IRC Code Section 162 are on firm ground. But is the “terra” all that “firma”?

When designing executive bonus plans, particularly those with restrictive endorsements placed upon the life insurance policy purchased with the bonus, care should be taken to avoid the application of ERISA to the plan.

Factors to consider in designing a bonus plan include which employees participate, how and when benefits are paid, how policy premiums are paid and by whom, and the operation and administration of the plan. Given the broad flexibility available for bonus plan design, planners and clients easily can minimize the risk of potential ERISA issues.

Despite all of this activity, executive benefit plans continue to flourish. The apparent conflict that has arisen between the need to provide executive benefits to recruit, retain and reward key employees and the perceived need to prevent abuses is moderating.

The most important point for the planner and the client is that none of this activity completely has eliminated any form of executive benefit plans. In fact, the time is ripe for executive benefit planning because now there are firm and explicit rules to follow. And the rules remain broad enough to allow for the needed creativity to design the right plan for the client.

Executive benefit techniques will continue to be invaluable in providing the best possible tax planning to employers and employees. The reports of the Golden Goose’s demise are greatly exaggerated. Executive benefit planning lives on!

Janice A. Forgays, Esq., CLU, is vice president, advanced markets, at Sun Life Financial, Wellesley Hills, Mass. You can e-mail her at janice.forgays@sunlife.com.

Some Rules

? Split-dollar arrangements: IRS regulations leave

non-equity split-dollar plans largely unaffected.

? COLI: Businesses may still purchase life insurance on employees, owners, officers and directors to fund necessary and beneficial employee fringe benefits.

? Sarbanes-Oxley & Tax Shelter Rules: Although certain Internal Revenue Code sections are found in the list of abusive transactions (Sections 412(i) and 419, for example), the rules do not eliminate all uses of the plans based upon these code sections.

? Executive Bonus Plans: When designing executive bonus plans, particularly those with restrictive endorsements placed upon the life insurance policy purchased with the bonus, care should be taken to avoid the application of ERISA to the plan.