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Financial Planning > Tax Planning

Expanding Your Practice Beyond the For-Profit World

By Warren S. Hersch

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For most life insurance and financial service professionals, non-qualified deferred compensation calls to mind executive benefit plans used in the for-profit world: bonus plans, split-dollar arrangements, salary-continuation and salary-reduction packages used to recruit, reward and retain top management talent.

Often overlooked among advisors who specialize in executive compensation are packages available to execs who work in government and the not-for-profit arena. These plans, governed by Internal Revenue Code Section 457, supplement 403(b) qualified plans set up for tax-exempt organizations’ rank-and-file workers.

 While they function in like fashion to their for-profit counterparts, 457 plans also have unique regulatory requirements. And these differences, sources tell National Underwriter, can have negative tax or other consequences for organizations that fail to take cognizance of them.

“A lot of executives and board members think they can implement at non-profits the same non-qualified plans as they use in the business world,” says Michael Sirkin, an attorney and co-chair of the employee benefits, executive compensation and ERISA litigation practice group of the law firm Proskauer Rose LLP, New York. “When they do this, they violate the tax laws and have to redo the plans. I’ve seen this happen many times.”

Example: Exceeding elective deferral limits imposed on IRC 457(b) public plans for state and local government employees, and private plans for a select group of managers or highly compensated “top hat” employees working at non-governmental, 501(c)(3) organizations (hospitals, charitable organizations, unions, and others) that have been widely adopted to provide supplemental retirement benefits.

Participants under age 50 can contribute up to $16,500 into a plan in 2011; those over age 50 can tack on an additional $5,500. If the plan is for government employees, then participants can defer (excluding catch-up contributions) an aggregate $33,000 in 2011 between the 457 plan and a qualified 403(b) plan.

The plans also offer tax benefits. Employees can defer compensation on a pre-tax basis. Unlike the 401(k) plan, a 457(b) plan entails no 10% tax penalty for withdrawals before the age of 59½. Additionally, 457 plans (both governmental and non-governmental) allow independent contractors to participate.

Sources point out, however, that 457(b) plans come with caveats. Whereas, for example, ERISA-governed public plans—which must be held in a trust, a qualifying annuity or custodial account for the exclusive benefit of plan participants and beneficiaries—are free from the claims of creditors, those implemented by tax-exempt organizations for top-hat execs are not.

“If I were a non-profit executive, before accepting an employee-funded 457(b) plan, I would want to know about the financial worthiness of the organization,” says Sirkin. “When the plans are employer-funded, financial issues are less important because the contributions represent extra money to the participant. But when employee-funded, the financial strength of the organization is very important.”

It is much of the time. Andy Dalgliesh, director of nonqualified benefits consulting at Principal Financial Group, Des Moines, Iowa, observes that most 457(b) plans established by Principal-affiliated advisors—the company counts 3,300 participants in the 457 plans it administers, or which about two-thirds are in (b) plans—are funded with employee deferrals.

Because of the creditor risk, Sirkin advises tax-exempt clients to first maximize contributions to 403(b) plans—which, as qualified plans, are protected from creditors—before contributing to a 457(b) plan. Many non-profit executives, he notes, fail to do this, believing the 457(b) contributions to be more advantageous.

Such creditor risk extends as well to those participating in 457(f) plans, which are available to non-profit executives who are looking defer compensation beyond the 457(b) plan contribution limit. The 457(f) plans can be (and generally are) customized to the needs of the individual executive, but sources say that IRS requirements have limited their appeal for tax-exempts.

Among the technical challenges: designing a worthwhile plan given that the deferred comp is taxed when the plan vests. Such vesting violates the IRS requirement that the plan be subject to a “substantial risk of forfeiture,” meaning that distribution of benefits are tied to a contingency (such as the performance of “substantial future services” for the company). By contrast, 457(b) plan participants enjoy tax-deferral status until benefits are distributed.

“Many non-profit executives find it difficult to defer vesting until benefits are paid out,” says Marc Stockwell, a principal of Findley Davies, Columbus, Ohio. “Nor would most execs be willing to accept this restriction. For someone who is 48 years old and has to wait 17 years before becoming vested at age 65, the requirement can be hard to stomach.”

To make the plans more palatable, Stockwell often recommends implementing a “graded” or “class-year” vesting schedules that vest every three to five years. At vesting, income tax is paid from the account value, and the after-tax amount is left in the plan. The advantage: Earnings on the after-tax balance can continue to grow tax-deferred until retirement. Thereafter, the plan balance can be rolled into an individual retirement account.

Stockwell says this technique may be widely adopted in coming years if, as he expects, the IRS issues by year-end guidance (as per IRS Notice 2007-62) extending to all 457 plans a more restrictive definition of substantial risk of forfeiture. Applicable to non-qualified deferred comp plans governed by IRC Section 409A—a body of law from which 457(f) plans have been exempted if structured as short-term deferrals—the more narrow definition would no longer permit 457(f) plan participants to create a substantial risk of forfeiture using a non-compete agreement or other promise to refrain from performance of services.

Still to be clarified by the IRS, sources add, is the method by which plan benefits are to be valued for tax purposes. Absent a substantial risk of forfeiture, the tax is based on the present value of the benefit. But Sirkin says the rules are vague as to which interest rate may be used in the present value calculation. Also unclear is the impact on present value of a benefit that “disappears” before the executive retires.

“Given the lack of clarity, we try to avoid plan designs that call for a disappearing benefit,” says Sirkin. “Other advisors use the technique, but have taken the position that the benefit is not taxable because it disappears.”

He adds that small tax-exempt organizations with limited resources tend to structure 457(f) plans as defined contribution plans, though some use a target benefit formula to emulate defined benefit plans. Larger organizations that can fund a traditional DB plan represent key prospects for life insurance professionals.

 Why so? These organizations, market-watchers say, look to life insurance to recover the cost of the benefit. The executive benefit, informally funded with an employer-owned life insurance policy, can be paid from the contract’s accumulated cash value at retirement. At the executive’s death, the income tax-free death benefit is paid to the employer, thereby reimbursing the employer for the cost of the premiums.

But sources note that life insurance is generally not used to fund 457(b) plans. The reason: Absent a cost-recovery objective, which isn’t present when the deferrals are paid for only with employee contributions, the tax-favored treatment of life insurance is of no benefit to tax-exempt organizations. Observers point out, too, that, most non-profits don’t buy key person insurance, which can be used to cover losses stemming the death of a key exec.

With or without life insurance, market-watchers say, 457 plans can be challenging to design, implement and service without running afoul of IRS tax law provisions. Hence the value of partnering with a competent plan administrator; and, when the advisor is lacking in the requisite expertise, finding a professional who has it.

“If you’re not well versed in the plans’ technical requirements, the best advice I can give is to team up someone who is,” says Sirkin. “It’s very easy to trip up when executing these plans.”

Eyeing Alternatives to 457 Plans

Not all tax-exempt organizations are candidates for 457 plans. Marc Stockwell, a principal of Findley Davies, Columbus, Ohio, says the smallest non-profits often elect other plan types because they don’t have the financial wherewithal to fulfill the obligations of a deferred comp arrangement. Among the favored alternatives, he says, is the SIMPLE IRA.

An employer-sponsored salary-reduction arrangement, the SIMPLE plan offers easier and less costly plan administration rules than do other employer-provided retirement plans. But contribution limits for SIMPLE plans also are lower than under alternatives plans: $11,500 in 2011 for participants under age 50, as compared to $16,500 for those enrolled in 457(b) plans.

Organizations desiring an alternative to the 457(f) plan to provide a supplemental retirement benefit for the most senior executives might also use an IRC Section 162 bonus arrangement. The plan, an employer-funded life insurance policy owned by the executive, is not covered by IRC Section 409A provisions governing the timing and distribution of deferred compensation, and therefore is easier to administer.

Richard Landsberg, a director of advanced sales at Nationwide Financial, Columbus, Ohio, says that many non-profits make the bonus arrangement doubly attractive to plan participants by grossing up the employer contributions to cover income tax the executive pays when benefits are distributed at retirement.

“Because of IRS restrictions, 457(f) plans can be a hard sell,” says Landsberg. “As a result, we now see a lot of non-profits using double bonus plans to compensate their top executives.”

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