In recent years, the country has seen a significant shift with regard to retirement, placing the onus on employees to rely on self-funded defined contribution and other qualified plans, such as 401(k)s, instead of pensions that may guarantee payments to retirees for life. Nonqualified benefit plans are great opportunities for executives and highly compensated employees who have maximized their qualified plan contributions and are looking for additional benefits to stimulate retirement savings. These benefit plans are also attractive recruiting and retention tools for employers.
However, many small- and mid-size business owners find it challenging to build a competitive benefits package for executives. While qualified retirement plans enjoy preferential tax treatment, the plan must also be open to all employees and benefit all participants to the same degree. Qualified plans give executives a smaller proportion of benefits as well because of government limitations on how much money can be deferred annually–$15,500 in 2007.
Nonqualified deferred compensation plans offer more flexibility and allow employers to limit participation to a selected group, but the company does not receive a tax deduction on deferrals until employees receive distributions. Addition-ally, recently released final regulations in IRC Section 409A governing nonqualified deferred compensation plans have added administrative complexity to deferred compensation plans. What do you say to the business owner who asks for an executive benefit plan that is simple to administer, provides for a current tax deduction, and helps retain top talent with “golden handcuffs”–the Catch-22 that makes it difficult to walk away?
The REBA Solution
One answer that provides benefits to both parties involved is the restrictive executive bonus arrangement (REBA), which lets you compensate selected executives through employer-paid premiums used to purchase insurance on the executive’s life. (This arrangement also works with annuities, but this discussion focuses solely on cash value life insurance products.) If properly established, the employer’s payment of the annual premium is deductible by the employer, since it is reported as additional compensation taxable to the selected executive.
The REBA is similar to the traditional and more widely known Section 162 Bonus Plan, in that the executive owns the policy, while the employer pays the premium. Unlike a traditional bonus plan, the underlying policy carries a restrictive endorsement, which limits the employee’s ability to exercise many policy rights. This restrictive endorsement usually remains in effect until the executive satisfies the terms of a separate employment contract.
This arrangement is attractive to the executive because he owns the policy. The arrangement is also attractive to the employer because it acts as a retention tool, providing additional benefits for select executives, in exchange for the executives’ continued loyalty to the company. If the executive terminates employment prior to a predetermined date, the employer generally has the right to recover all or part of its unvested contributions.
How a REBA Works
Because a REBA is a nonqualified benefit, the company first selects executives who will participate in the arrangement. Each executive then applies for life insurance on his or her life and becomes the policyowner. The employer pays the premium in the form of a bonus. The company receives an immediate tax deduction on any vested portion of the bonus payment, and the executive pays taxes on that amount.
The company can also give the executive an additional cash bonus to cover the income tax liability that the premium payment will create. This is referred to as a double bonus arrangement or a gross-up payment. Gross-up payments are particularly effective when the primary bonus the executive receives is not actual cash. As explained by many compensation consultants, companies want to avoid saddling executives with taxes on a noncash benefit.
What’s the Employee Benefit?
These arrangements typically use insurance policies that have a permanent cash value. Since the employee owns the policy, the coverage can continue after the employee’s retirement or if she becomes disabled. Additionally, the beneficiary designated by the employee generally receives the insurance proceeds income tax-free.
Most REBAs use variable universal life insurance contracts, which feature several investment options for allocating the policy’s cash value. Employees like this because being able to choose their own investment selections gives the plan a similar “look and feel” to a qualified plan like a 401(k).
The policy’s cash value grows on a tax-deferred basis, and the selected executive can access it when the restrictive endorsement is removed–typically before retirement. This allows the executive to use the cash value as a source of supplemental retirement income. Upon retirement, the employee can make income tax-free withdrawals up to the limit of the employer’s basis in the policy. Thereafter, the employee can borrow from the policy tax-free (though this assumes that the policy is not a modified endowment contract–an MEC).
Employees also benefit from the permanent life insurance protection because of the peace of mind it can provide. As a result of this protection, an employee knows that her family is protected in the event of the employee’s untimely death. Also, traditional nonqualified deferred compensation plans require that the employee’s account is subject to the company’s creditors, whereas with a REBA, the selected executive owns the policy and is typically vested in the cash value immediately. In the event of corporate insolvency, the executive’s plan is not exposed to company creditors.
What’s the Employer Benefit?
A key feature of the REBA is that employers can select the employees to whom they wish to extend the benefit. Additionally, each employee who is covered with a REBA can receive a different contribution from the employer to reflect the employee’s value to the company. This feature provides the employer with flexibility unavailable in qualified plans, which must allow all employees to participate.
A REBA is also relatively inexpensive to implement and administer. The main expense comes from preparing a simple agreement, which dictates the terms of the arrangement. This represents a significant savings when compared with setting up a qualified plan. Also, new regulations governing nonqualified deferred compensation plans have greatly increased the need for a third-party administrator (TPA), which adds to the cost of these plans. Once established, a REBA can be administered without a TPA.
Provided that the employee’s total compensation, including the bonus payment, represents “reasonable” compensation to the IRS, the employer’s premium payment and any double bonus payment should be considered current compensation and be a deductible expense in the year the payments are made. Again, this represents an advantage over traditional nonqualified deferred compensation plans where the company must wait to take a tax deduction in the year the executive receives a distribution from the plan.
For a REBA to achieve its desired results–tax deductibility of the bonus premium payments and avoidance of strict ERISA provisions–the major components of the plan must be executed properly. These major components are the restrictive endorsement and the employment contract. We’ll take each in turn below.