Copyright © 2007, The American College. All rights reserved. Used with permission. Planning for Retirement Needs Nonqualified Deferred-Compensation Plans Chapter 15

Copyright © 2007, The American College. All rights reserved. Used with permission. Nonqualified vs Qualified Plans Less favorable tax treatment –Employer deduction when employee taxed –Deferral of tax is allowed but employer deduction deferred More design flexibility –Limit coverage to executives –Lower administrative costs

Copyright © 2007, The American College. All rights reserved. Used with permission. Tax Treatment Employer’s deduction at time employee has taxable income Plan is usually designed to defer income tax until benefit receipt Earnings on assets set aside are taxed as earnings to the employer

Copyright © 2007, The American College. All rights reserved. Used with permission. Tax Considerations Substantial risk of forfeiture (no tax) If no risk of forfeiture then tax still deferred unless –Economic benefit doctrine –Constructive receipt (409A)

Copyright © 2007, The American College. All rights reserved. Used with permission. Substantial Risk of Forfeiture Taxes deferred if substantial risk of forfeiture “A substantial risk of forfeiture is a significant limitation or duty that requires the fulfillment of a meaningful effort by the executive, and there must be a definite possibility that the event that will cause the forfeiture could occur.” –A traditional vesting provision is clearly a substantial risk of forfeiture. –-Requiring that an executive continue to provide consulting services to a company after retirement may or may not be a substantial risk of forfeiture, depending upon the specific facts and circumstances.

Copyright © 2007, The American College. All rights reserved. Used with permission. Economic Benefit Doctrine Participant has current income if arrangement provides current economic benefit even if no current right to receive benefit Irrevocable trust with nonforfeitable benefits results in current income tax Plan assets typically stay in the name of the employer Rabbi trust is allowed since assets can be accessed by claims of the sponsor’s creditors

Copyright © 2007, The American College. All rights reserved. Used with permission. Constructive Receipt 409A Failure to satisfy distribution, acceleration of distribution, and deferral election rules results in current income tax and an additional 20 percent penalty tax. Distribution only upon stated events –Separation from service –Disability –Death of the employee –A time specified under the plan. –A change in ownership or control. –Occurrence of an unforeseeable emergency.

Copyright © 2007, The American College. All rights reserved. Used with permission. 409A Plan may not allow acceleration of distributions except –Payments for domestic relations order –A de minimus cashout of up to $10,000 –Payments for FICA taxes Employees’ elections to defer –Election to defer must generally be made in preceding year –Rules require time and form of distributions determined at initial deferral –Plan can specify form and timing or give participants a choice –Exception allows a participant to delay existing benefit as long as election is made 12 months before

Copyright © 2007, The American College. All rights reserved. Used with permission. FICA Taxes FICA taxes on the later of –Date services are performed or –No longer a substantial risk of forfeiture Issues –Different timing than income tax rules –Nonduplication rule—tax only paid once

Copyright © 2007, The American College. All rights reserved. Used with permission. Plan Design--Objectives Golden handshakes—induce retirement Golden handcuffs—stay with company Golden parachutes—soften landing upon takeover Incentive pay—bonuses for meeting goals

Copyright © 2007, The American College. All rights reserved. Used with permission. Types of Deferred Compensation Salary reduction –Similar to 401(k) salary deferrals –To defer taxes –Systematic savings SERP –DB or DC –Additional benefit –Offset (reduce by qualified-plan benefits)

Copyright © 2007, The American College. All rights reserved. Used with permission. Design Considerations From the Employer’s Perspective Forfeiture (not for salary deferrals) Continued consulting Retaining executives Do-not-compete clause

Copyright © 2007, The American College. All rights reserved. Used with permission. Design Considerations From the Employee’s Perspective Takeover trigger (golden parachute) Immediate vesting Hardship withdrawals Binding arbitration for disputes

Copyright © 2007, The American College. All rights reserved. Used with permission. Other Design Considerations Benefit structure Eligibility Disability Retirement age Death benefits

Copyright © 2007, The American College. All rights reserved. Used with permission. Funding Impact of “funding” Informal funding Rabbi trusts –Defer taxation –Meet security concerns Secular trusts –Irrevocable trust –Current taxation Surety bonds

Copyright © 2007, The American College. All rights reserved. Used with permission. Rabbi Trust Assets available to creditors Irrevocable or springing irrevocability No insolvency triggers Notify trustee of pending financial problems that trigger suspension of benefits

Copyright © 2007, The American College. All rights reserved. Used with permission. Life Insurance Tax-free inside buildup Protects against premature death Life insurance proceeds tax free Funding flexibility—use cash value or keep in force and receive death benefits Company ownership eliminates tax problems

Copyright © 2007, The American College. All rights reserved. Used with permission. Installation Corporate resolution Plan document Rabbi trust ERISA notice sent to DOL

Copyright © 2007, The American College. All rights reserved. Used with permission. ERISA Considerations Generally satisfy “top-hat” exemption –“Plan must be unfunded and maintained by an employer, primarily for the purpose of providing deferred compensation for a select group of management and/or highly compensated employees.”

Copyright © 2007, The American College. All rights reserved. Used with permission. 457 Plans Nonqualified plan sponsored by tax-exempt or governmental entities subject to Code Sec (b) –Salary deferrals can’t exceed $15,500 (in 2007) –Catchup elections allowed 457(f) –Conforming salary deferrals –Tax when no substantial risk of forfeiture

Copyright © 2007, The American College. All rights reserved. Used with permission. Executive Bonus Life Insurance Also called Sec. 162 plans No coverage requirements Employee is the policyowner, insured and chooses the beneficiary Employer simply pays a bonus equal to the premium Employee has taxable income and employer gets a deduction Double bonus—employer pays premium and taxes on payment

Copyright © 2007, The American College. All rights reserved. Used with permission. Double Bonus Example Step 1: State target premium $10, Step 2: Specify the applicable tax rate.40 Step 3: Subtract step 2 from 1.00 =.60 Step 4: Divide the step 1 amount by the step 3 amount to find the amount of both bonuses: $16,666.67

Copyright © 2007, The American College. All rights reserved. Used with permission. Quick Quiz—Match the following: 1. xxIncentive stock options 2. Golden parachutes 3. Golden handshakes 4. SERP 5. Surety bonds A.Supplemental plan to replace employment income at retirement B.Options to acquire stock with no tax consequences at the time of stock acquisition C. Benefit package at retirement to induce early retirement D.Payments to an executive upon change of ownership E.Agreement by a third party to guarantee benefit payments

Copyright © 2007, The American College. All rights reserved. Used with permission. Quick Quiz—Match the following: 6. “Funded” plan 7. Golden handcuffs 8. Rabbi trust 9. Salary reduction plan 10. Constructive receipt F.Funding instrument in which assets are subject to employer’s creditor G.Plan in which executives agree to defer current compensation H. Taxation at the time contributions become vested I.Opportunity to receive compensation regardless of actual receipt J.Discouraging termination of employment by requiring additional service to vest in plan benefits

Copyright © 2007, The American College. All rights reserved. Used with permission. True/False Questions Salary deferral type nonqualified plans will typically have a deferred vesting schedule. Code Sec. 409A allows distributions at the time of a participant’s disability. Nonqualified plans may have the objective of providing benefits in excess of the qualified plan contribution or benefit limits. A nonqualified plan will be considered funded if assets owned by the corporation are earmarked for funding the required payments.

Copyright © 2007, The American College. All rights reserved. Used with permission. True/False Questions To avoid tax problems a surety bond used to secure funding in a nonqualified plan must be purchased by the executive. A nonqualified plan that is designed to make substantial benefit payments if there is a change in ownership is referred to as a golden handcuffs provision. In a nonqualified plan, income taxes can be deferred if the benefit is subject to a substantial risk of forfeiture even if the plan confers a current economic benefit.