Many closely held corporations have a difficult time finding cost-efficient executive benefit programs to attract and retain top personnel. For most corporations, the alternative is either to try and supercharge a 401(k) plan using the safe harbor exemptions or to offer a deferred supplemental bonus plan with a vesting schedule and a match. Another method is to use synthetic stock tied to the actual performance of the company. These strategies are done to avoid selling stock.
Although recent pension legislation provides new opportunities to do substantial retirement planning for the highly compensated, recent changes to IRC Section 409(A) rules have placed new restrictions on non-qualified deferred compensation plans. The changes have forced companies to rethink and, in some cases, eliminate these plans.
In 2003, the IRS finalized split-dollar regulations. After several years in limbo, the IRS action gave guidance to the implementation of equity split-dollar, which has been a mainstay for executive compensation. This new regulation (IRC 7872) increased the cost of retaining key employees using this benefit.
Companies typically have 2 major objections to “top hat” plans for senior executives. The first is the lack of tax deductibility; the second is the potential creditor risk. Tax deductibility has been a hurdle many owners have failed to scale. They are unwilling to do anything that costs them more money, even if they recapture the deduction in future years.
Their unwillingness to accept additional plans costs has always been a hindrance to non-qualified deferral plans and supplemental pension plans for senior management. A greater problem is the potential loss of the account should the company have severe financial problems. And creditor risk is a real and present danger to executive wealth accumulation
The solution to these problems is the capital split-dollar (CSD) plan. Stan Mountford, a long-time member of Million Dollar Round Table and qualifier for the organization’s Top of the Table, created this strategy in the 80s with the guidance of Alan Jensen, chairman of the American Bar Association Committee on the Taxation of Life Insurance and a partner in the law firm Holland and Knight. They developed a leveraged split-dollar plan that was very successful for Standard of Oregon until 1997, when the IRS formally announced their investigation of split-dollar.
In 2003, after reading the new regulations, Mountford realized that the new rules were tailor-made to a new generation of split-dollar. After consulting with Jensen, we concluded the new split-dollar regulations provided a unique way to overcome the 2 greatest obstacles to executive compensation: tax deductibility and creditor risk.
Under the CSD strategy, corporate payments are deductible to the corporation in the year paid. In addition, the benefits to employees are beyond the reach of creditors and are owned by the employees. They control the funding and distribution–hence no 409(A) issues. The corporation acts as a pass through mechanism to help the executives build substantial wealth in what we call the “tax-free zone.”
Here is how CSD works: The executive establishes a cash-rich life insurance policy where the annual credit rate is based on the S&P 500 index. The account must guarantee the safety of principal, and there can be no risk of capital. The account is credited interest each year based on the annual performance of the S&P 500 Index.
If the index is up one year, the account is credited with 100% of the upside to a maximum cap. This cap varies from year to year depending upon interest rates. The higher the interest rates, the higher the cap.
What happens if the index falls below zero? No effect. There is a stop loss, using an investment collar to protect the account from ever losing money. This is why we say the capital is guaranteed. There is no way to lose capital. This can only be accomplished through a cash-rich life insurance policy. Only a few carriers offer a product that can provide a guarantee of principal plus an equity based return.
Once the policy is in force, the corporation will then loan the executive under IRC 7872 (the new split-dollar regulations) a lump sum amount of, say, $1 million. Where does the corporation get this sum? It could, of course, distribute money from retained earnings.
However, most corporations won’t do this. So we arrange for a lender to lend $1 million to the corporation. This loan can be renewed annually. Assuming the corporation qualifies for the loan, there will be an interest payment due from the corporation to the lender. This interest is deductible to the corporation. Deductibility has always been a major objection to providing a benefit for the top executives. At retirement, the loan is repaid from the cash values of the policy. The “profit”–the earnings in the policy above the loan amount–belongs to the executive. The executive can then use these monies in any way deemed appropriate.
What are the economics of CSD? The employee must pay tax on the imputed 7872 interest attributed to this loan. The interest is based on the applicable federal rate, which changes annually. The cost to the employee is his or her effective tax rate on this increased income. So, for instance, if the current AFR is 4.71% and the loan is $1 million, then the imputed income would be $47,100. If the employee’s effective tax rate is 35%, then the tax on the AFR imputed income for this policy is $14,200. Remember, this rate can rise and fall as interest rates fluctuate.
In addition to the employee tax on the imputed income, the employee needs to make a premium contribution to the policy each year. This premium is to satisfy the IRC 7702 accumulated premium test for insuring the policy is not considered a modified endowment contract (MEC).
The final cost is the interest the corporation pays on the loan to the lender. This interest is usually tied to the London Inter Bank Offered Rate (LIBOR). The interest is deductible as a business expense.
The bottom line: Whether your client owns a C Corporation, S Corporation, LLC or partnership, the interest on the loan is deductible.
Capital split-dollar is a unique and exciting way for owners of large, privately held companies to attract and retain top talent. CSD overcomes the 2 biggest objections most owners have to implementing a plan for their top people: tax deductibility and creditor risk. Neither applies to the CSD program. We believe that business owners should be made aware of this unique benefit and assess whether the program is right for them.