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A Win-Win Retirement Plan

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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.

What’s in the Restrictive Endorsement?

The restrictive endorsement is an agreement between the company and the executive that is filed with the insurance company and dictates the executive’s limited rights in the policy.

Generally, during the period the endorsement is in effect, the executive is not permitted to:

  • Surrender the policy for its cash value;
  • Take a policy loan or cash withdrawal;
  • Assign the policy as collateral;
  • Change the ownership of the policy.

These restrictions end on a specified date stated in the endorsement. If the executive terminates employment prior to this date, the executive still owns the policy; however, while the endorsement is still in force, the executive will not be able to access the policy values.

The employer does not have any financial rights to the policy benefits, even during the restrictive period. The executive retains the rights to name and change the beneficiary and receive the entire death benefit. Additionally, during the term of the endorsement, the executive retains the sole right to change the allocations in the policy’s sub-accounts.

What’s in the Contract?

The second major component of the REBA is the employment contract. The contract dictates that the employer will pay the bonuses (premium payments) in exchange for the executive’s unsecured promise to continue employment. It is in this contract that provisions of a tax gross-up payment to cover additional income tax are noted.

Repayment is the key obligation of the employment contract; the golden handcuffs, if you will. With this clause, the executive agrees that if the specified employment obligations are not met, then some or all of the bonuses will be repaid to the employer. This obligation is typically accomplished through the use of a vesting schedule (see “Don’t Mention It” sidebar).

The repayment obligation in the employment contract does not have to match the term during which policy rights are restricted under the endorsement. For example, a repayment obligation may require that an employee have five years of service, whereas the restrictive endorsement may remain filed with the insurance company for 10 years. To avoid the look of a pension plan (and the application of ERISA), releases should not be tied to retirement age.

REBA’s Tax Considerations

If the arrangement does not meet the definition of a split dollar loan plan, the employer’s premium payment is considered a bonus. Under IRC Section 61, when the executive receives payments as a bonus, the payments are taxed as ordinary income. Since these bonus payments are included in the executive’s income, they are also subject to payroll taxes such as FICA/FUTA.

It has also been suggested that a REBA with a repayment obligation and vesting schedule is subject to taxation under IRC Section 83, which applies when property is transferred in connection with the performance of services. Some planners question whether the premium payment on behalf of a policy owned by the executive represents a property transfer and triggers the application of Section 83; however, many advisors take the position that Section 83 does not apply to a REBA because the company does not own the policy and therefore does not transfer property. This view suggests that the premium payment is merely a transfer of money resulting in the immediate taxation of the employee–Section 61 treatment.

If Section 83 applies to a REBA, recognition of income to the executive and the employer’s corresponding tax deduction are delayed until the property is no longer subject to a “substantial risk of forfeiture,” which is typically when the restrictive endorsement is released. (Property is considered to be subject to a substantial risk of forfeiture if the employee forfeits property if employment is terminated prematurely.)

With this tax treatment, the fair market value of the policy–at the time the risk of forfeiture lapses–is treated as employee income. The use of an immediate vesting schedule, as opposed to a delay in vesting, helps minimize this risk.

If the contract does not require the employee to forfeit the policy or reimburse the employer’s premium payments, however, then immediate taxation of bonus payments to the employee and the deduction to the employer should be available. In this case, Section 83 would not apply. As always, clients should consult their tax advisor to assess the potential tax effects.

Some advisors address this issue by recommending to clients that they make a Section 83(b) election, which allows the employee to voluntarily elect to be taxed immediately upon receiving the bonus. This election spreads out the employee’s tax liability and avoids lump-sum taxation on the policy’s value when the restriction is lifted.

Vesting schedules and employer reimbursement rights complicate the tax implications of a REBA for both the employer and employee. Both sides need to take extra steps to ensure that they achieve the intended tax effect. For example, the executive’s repayment promise should be an unsecured obligation to be repaid from any assets the executive chooses. The business should not be entitled to receive any cash value from the policy.

ERISA Considerations

One of a REBA’s most attractive features is how simple it is to administer. To preserve this advantage, REBAs are typically designed to avoid most of the burdensome requirements of Title 1 of ERISA. All employee benefit plans fall under Title 1 of ERISA and are divided into two categories–welfare plans and pension plans. For ERISA to apply, a formal plan must be in place. Some observers believe that if a REBA is strictly an arrangement between a company and a single employee, then ERISA does not apply because there is no plan. REBA arrangements that cover multiple employees are usually considered plans for ERISA purposes.

The safe and conservative approach is to treat a REBA as a welfare benefit plan. When considered such a plan, a REBA may qualify as a “top hat” plan if participants are limited to select management. In that case, the ERISA reporting requirements would be limited. The actual application of ERISA requirements can only be determined based on the facts and circumstances of each plan. Due to litigation in this area, an ERISA expert should be consulted to achieve the desired classification of the arrangement.

Structured properly the REBA benefits both employer and employee and offers simplicity in implementation and administration. For the employer, it offers a current income tax deduction, while helping to retain key employees. For the selected executive, the insurance policy provides a death benefit, tax-deferred growth of the cash value, and tax-free income during retirement through policy withdrawals and loans. By using a double bonus payment, the employer can further enhance the benefit with no out-of-pocket expense for the executive.

David Juliano is an advanced planning specialist at Commonwealth Financial Network in Waltham, Massachusetts. He can be reached at [email protected].


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