Rethinking Executive Comp Plans When Cash Is Tight

“Many VUL-funded programs will be in trouble because of declining asset values resulting from huge negative returns in the equities markets,” says Beatty. “If you have to invade the policy to pay the premium, then that further destroys its value.”

Assuming a deferred comp package is in place and it’s viewed as too expensive, the business can also convert the plan to an IRC Section 162 executive bonus arrangement, observers say. Widely adopted among small firms because of its low cost of administration, the bonus plan is funded via employer-paid premiums to a life insurance policy owned by the employee/executive. The employer gets an income tax deduction on contributions, though the employee must pay income taxes on the premiums. To cover the tax, the employer can (finances permitting) increase the bonus.

Converting to an executive bonus plan, market-watchers say, yields another benefit: a way to sidestep the potentially onerous requirements of IRC Section 409A rules governing deferred comp plans. An outgrowth of the American Jobs Creation Act of 2004, the rules impose numerous restrictions on the timing of deferral elections, payment schedules and triggering events that result in payouts.

A renegotiated plan that calls for a change in the timing and form of payment cannot, for example, take effect for at least 12 months. In some cases, the change may delay payment for 5 years or more. A “material modification,” such as a change in the form of distribution from a life annuity to a lump sum payment, will also subject benefits to an income tax and a 20% tax penalty unless the payout falls under one of 409A’s exceptions, such as separation from service, or the death or the disability of the executive.

“Much of 409A was put into effect to curb perceived abuses in deferred comp planning that was carried out by large corporations during good times,” says Gary Underwood, a chartered financial consultant and advanced marketing leader at
Genworth Financial, Lynchburg, Va. “Now that times are not so good, 409A can create additional hurdles and hardships for small employers. There’s no relief from these provisions in bad times.”

Little relief should be expected, too, in the event the firm should have to declare bankruptcy. When a company files under chapters 11 or 13, the company’s assets–non-qualified executive comp arrangements included–become subject to the claims of creditors. Whether those arrangements are liquidated to satisfy such claims or are distributed to the executives for whom they were intended will depend on what a bankruptcy judge decides.

In many cases, says Underwood, plan participants will receive only a fraction of what is owed them–pennies on the dollar–because secured creditors and administrative priority claims generally take most of the bankruptcy estate’s value. These bankruptcy priority rules, he adds, apply to amounts voluntarily deferred by employees out of their salary as well as money contributed by the employer.

The rabbi trust, a vehicle commonly used to shield deferred compensation from use by the business, particularly after a change in ownership, won’t offer protection either in bankruptcy. The same, says Underwood, goes for old rabbicular trusts, which were essentially eliminated by 409A.

To be sure, all is not necessarily lost when a business enters bankruptcy court. Underwood notes that a judge can approve a “preferential transfer” of plans assets if the transfer meets the bankruptcy code’s requirements. Among them: that the transfer be made on or within 90 days before the date of filing of a petition for bankruptcy or between 90 days and one year before the filing, if the creditor at the time of the transfer was an “insider.”

“Since many or most [non-qualified deferred compensation] participants will be insiders, transferring a policy that informally funded a NQDC plan within one year of bankruptcy filing date may be considered a preferential transfer,” says Underwood. “Assuming no conflict with IRC ?409A, you may want to terminate the plan and distribute the life insurance policy to the employee at least one year before a bankruptcy filing and probably one year after termination of the plan. That’s two years.”

AXA’s DiPiazza notes that state statutes limit the amount of time during which creditors can seek to attach assets that were removed from the business prior to bankruptcy. Such statute of limitations do not apply, however, if one can demonstrate the assets were placed into trust specifically to protect them from future attachment by creditors.

“Most people don’t know this,” says DiPiazza. “If there was a valid reason, apart from securing protection from creditors, for placing the plan assets in trust, then those might be safe. The advisor should give only one piece of advice to the business client: consult legal counsel. Assume there is nothing the business can do, except for what the bankruptcy judge allows.”