Historically for nonqualified retirement plans the tax and pension rules have been relatively few and easy to meet, compared with the extensive statutory constraints imposed upon qualified retirement plans.

The landscape has changed recently with the enactment of Internal Revenue Code Section 409A, and now most nonqualified plans must meet specific requirements related to such things as timing of deferral, events of payout, acceleration of benefits, re-deferrals, funding and governmental reporting. For a practitioner who is engaged to assist in the design of a tax-exempt employer, however, there has been, since 1987, a statutory overlay in the form of Internal Revenue Code Section 457.

Taxation of ineligible Section 457 plans

Section 457 creates two forms of nonqualified deferred compensation plans by setting forth requirements for a plan to be “eligible.” These requirements include limitations on amounts that may be deferred annually, which are similar in amount to limitations imposed on 401(k) deferrals and required distribution structures that parallel the rules applicable to qualified accounts. Amounts deferred other than through an eligible plan will not enjoy deferral of taxation to the executive unless those amounts remain subject to a substantial risk of forfeiture.

This generally proves problematical for voluntary deferral arrangements but may be of value to tax-exempt employers wishing to create “golden handcuffs” to retain valued executives. Thus, the employer may create an “ineligible” plan, one wherein the full value of the promised benefits are non-vested, i.e., subject to a substantial risk of forfeiture, until the occurrence of one or more events, such as death, disability or retirement.

(Note that Section 409A, which limits permissible payout events, applies only to ineligible Section 457 plans. Under Section 409A, amounts are not considered deferred until the service provider has a “legally binding right” to the compensation. If Section 409A is not complied with, deferred amounts are taxable when they are not subject to a risk of forfeiture.)

Because of the specific requirements that plan values remain subject to a risk of forfeiture, post-retirement distribution planning may become problematical. Irrespective of the chosen payout scheme, the full value of the plan, if vested at retirement, will be includable in the retiree executive’s income.

Installments as received will, in part, constitute tax-free recovery of plan values already taxed. An employer may attempt to defer vesting, post-retirement, by imposing continuing duties on the executive. This raises the issue as to whether the risk of forfeiture continues to be “substantial,” which under applicable tax regulations is a facts and circumstances test.

Since the enactment of Section 409A, it may be risky to create a plan that meets the separation-from-service payout definition while continuing to defer vesting by imposing service-related duties intended to be “substantial.” As a result a conservative plan structure might entail, since the executive will be taxed immediately in any event, the distribution of a lump sum at retirement.

Plan funding

Employer-owned life insurance is often the preferred vehicle for informal funding of nonqualified plans. For tax-paying employers, life insurance is valued for its income-tax characteristics, i.e., tax-deferral on cash value buildup, distributions on a return-of-investment-first basis (if a non-modified endowment contract) and ultimate tax-free receipt of death benefits.

For the tax-exempt employer, these tax benefits are generally of no relevance so long as the policy is employer-owned. Where there is no independent basis for holding life insurance for its death protection element, the tax-exempt employer may be reluctant to expend funds for a product which it, rightly or wrongly, perceives to carry higher cost and expense structures than other available funding media.

Why fund with life insurance?

In some circumstances, particularly cases involving smaller tax-exempt employers, life insurance may provide benefits that other funding media cannot readily duplicate. These include:

–Enhanced survivor benefits

Regardless of the tax status of the employer, executive benefit planning conventionally entails the provision of a pre-retirement death benefit whose value will exceed the accrued liability of the retirement benefit. Thus, in-service death of the executive may create an unexpected element of additional plan cost, for which life insurance may provide an offset.

–Income tax-free survivor benefit Particularly for a tax-exempt employer, it may be prudent to make a portion or all of the pre-retirement death benefit as a tax-free insurance benefit. For a tax-paying employer, if the benefit is funded with life insurance in the amount of the net after-tax cost of the benefit, the employer is able to “gross-up” the plan death benefit to leave the employee’s beneficiary in the same relative position as he or she would have been in were the benefit provided through insurance. Not so, if the employer is tax-exempt.

As an example, suppose both an employer and employee are in a 40% combined state and federal tax bracket. The desire is to leave the employee’s beneficiaries with a $600,000 after-tax sum, which if paid as a taxable plan benefit, will necessitate a $1,000,000 pretax sum. The employer’s after-tax cost is $600,000. The tax-paying employer can back-stop the potential liability through the acquisition of life insurance.

A $600,000 death benefit, payable to the employer, will fully offset the cost, since the death proceeds are receivable tax-free. In the same situation involving a tax-exempt employer, the “after-tax” cost is $1,000,000, if paid as a taxable benefit.

Instead, the tax-exempt employer could acquire $600,000 in death benefits and make it payable to the executive’s beneficiaries, income tax-free under an endorsement split-dollar arrangement. (This should not raise any Section 409A issues if the executive has no other interest in the policy.) The employee’s cost is annual taxability of the value of the death protection. Without insurance funding this would not be possible.

–An attractive post-retirement asset

As discussed above, prudent plan design for an ineligible “golden handcuff” plan may entail distribution of a lump sum benefit at retirement. This may be accomplished through distribution of the life insurance policy that has been used to fund the plan informally. A mature policy will have had its start-up costs paid for by the time of distribution.

There may be no remaining surrender charges if the contract is a universal life policy, and the executive may have free access to the policy to pay income taxes on the value of the distribution. The tax basis of the policy will be its full value, and the executive will be able to withdraw cash through withdrawals or loans without those amounts constituting taxable income.

There are no minimum amounts that must be taken annually, and whatever remaining death benefit is ultimately paid will be income tax-free. The retired executive can allow the policy cash values to grow, and if in the future there is no longer a need for the mortality gain, the policy could be exchanged for an immediate annuity, with no tax on the exchange and ratable recovery of tax basis over the annuity’s expected payout period.

In contrast, if the executive were paid cash and at that time decided to acquire insurance to take advantage of the above benefits, the start-up costs would be borne by the executive.

–Key person coverage for the employer

The smaller the tax-exempt employer, the greater is the likelihood that its continued financial health will be linked to the continuing presence of a few key employees. As a result, the employer may suffer losses at the untimely death of a key employee in the form of organizational disruption, costs to find and train replacements, and possible reduction in revenue from charitable donations. Thus, a portion of the death benefit of the insurance policy acquired to fund the employee’s benefits could be used to offset such key person losses.

Conclusion

Even though the income tax benefits of using life insurance to fund executive retirement plans informally are not important to tax-exempt employers, the death protection unique to insurance and the post-retirement income tax benefits available to the employee can make life insurance a viable option to consider when funding executive retirement plans in the tax-exempt realm.