Deferred Compensation Plans under Section 409A

These provisions can be applied to an existing deferred compensation plan as well as a new wealth accumulation plan. This approach will be flexible to the employer and largely estate and income tax free to the covered employee. The accrued benefit to the employee can be safeguarded from claims of creditors of the employer and employees and, upon withdrawal by the employee, can be accessed in an economically efficient manner. The death benefit need not be an asset on the books of the employer or subject to the claims of their creditors. Additionally, the employer can institute these provisions for a portion or all of the existing deferred compensation program as a new benefit plan and fund “as you go” rather than creating a liability for the employer to fund for in the future. Alternatively, this tool will permit the employer to reflect an increasing asset on its books for audit accounting purposes and not create a charge to earnings. This tool complies with both GAAP accounting as well as IAS 19.

Because this has a death benefit component, and not a deferred compensation arrangement required to comply with ”409A, 457 or 457(f), there is no maximum limitation of death benefits, asset accumulation or risk of forfeiture. The provisions of Treas. Regs. '1.31.3121 provide a current death benefit for covered employees. This is an actuarial-based structure for an employer that maximizes benefits to the employer while providing a selective benefits program for qualifying employees. This creates a versatile tool that is ideal for Golden Handcuffs, employment contracts, funds to help offset future employer financial obligations and covenants not to compete. The employer may use this tool in transactions to reduce the cost of funding employee or shareholder buy outs or future compensation packages. The employer may fund the executive benefit providing the same amount of funding and the selected employees will receive more benefit than the traditional deferred compensation method, or the employee will reduce the amount of funding and the selected employees will receive equivalent benefit. Using the safe harbors of the Treasury Regulations also avoids the Golden Parachute limitations and excise tax ( see , IRC '280G). Unlike the traditional benefit plans that have a substantial risk of forfeiture of 457(f), 409A or 83, the provisions have no contribution limitation. The arrangement also avoids the risk of forfeiture tests. The benefit program complies with the most recent legislative rules IRC '101(j), COLI BEST Practices Act of 2005, and as an exception under '72(k)(2)(B)(ii), the AJCA, IRC '409A, and Notice 2005-1.

In any planning arrangement, the Plan Sponsor must consider the death benefit, economic benefit and constructive receipt rules. Integrating these provisions with co-ownership arrangements comply with all proposed regulatory rules and the tax shelter rules as presented, assuring positive results. The arrangement is not a tax shelter, a listed transaction or a reportable transaction. The arrangement complies with the economic substance test (IRC '7701(O)), as well as case law and proposed legislation. The employer's contribution is actuarially determined and that amount is deductible ('79, '457(e)11, Treas.Reg 1.162.10, TAM 200002074 and 20050204). The employer can utilize a current death benefit arrangement with an employment or non-competition agreement to provide benefits that may reduce income and estate tax to the employee. This arrangement complies with the deferred compensation rules of '409A because it is a death benefit plan qualifying under 31.3121(v)(2)-1(b)(4)(iv)(A). Following IRC '83(e)5, an insurance arrangement between an employer and a participant in a plan does not violate the restricted property rules. The value of current annual life insurance protection is includible as taxable compensation to the insured participant each year but, in addition, in line with Rev. Proc. 2003-25 and '72, the cash surrender value of the policy would not be subject to income tax nor be a reportable event if the policy is not surrendered. See the table below.

[IMGCAP(1)]

Conclusion

Using the Treasury Regulations complies on both a legal and accounting basis and may be a tremendous economic solution to this funding and compliance situation. This approach is available for C-corps, S-corps, LLCs and Pass Thru entities. Because the program also complies with ”457, 457(f) and 457(e)11, all non-profits are eligible Plan Sponsors. This tool will allow the employer to retain equity within the business and relieve the employees from having to use personal assets to fund current death benefits and financial obligations. To hear an interview describing this approach, visit http://bit.ly/ZUdDEs.

The Deferred Compensation Plan'

1. The employer creates or amends its nonqualified deferred compensation plan to add a feature set forth in Treas. Reg. '31.3121.

2. Some or all employees may elect, prior to the time benefits under the deferred compensation plan become payable, to relinquish those benefits and have the employer contribute to the cost of the new benefits.

3. An employee or employer would apply for, obtain and own a permanent life insurance benefit. The employee or the employer would enter into a co-ownership life insurance agreement providing that the employer pay for the current death benefit. This is actuarially determined in line with qualified asset account limits. The co-owner (the employee or the employer) would pay for the remainder of the premiums and retain all other rights to the policy.

4. Unless the co-owner fails to maintain the policy (as provided in (5) immediately below) or breaches certain obligations to the employer, the current death benefit is provided to employees through the plan so long as the participant is in the plan.

5. Upon an employee participant withdrawing from the plan, or upon plan termination, the co-ownership agreement is terminated, the employer no longer funds the plan and the co-owner retains all right, title and interest in the coverage.

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions.

The American Jobs Creation Act (AJCA), signed into law on Oct. 22, 2004, created new restrictions on compensation arrangements. New Section 409A of the Internal Revenue Code (IRC) applied to compensation deferred under a non-qualified deferred compensation plan after Dec. 31, 2004. Congress directed the Internal Revenue Service (IRS or Service) to provide guidance within 60 days of enactment. The IRS issued Notice 2005-1 on Dec. 21, 2004, as revised on Jan. 6, 2005.

Section 409A applies to any arrangement that postpones payments of compensation to subsequent years. The Notice spells out what is and is not deferred compensation, Single-person Plans, “defined benefit” non-qualified plans, Supplemental Executive Retirement Plans (SERPs) and arrangements for non-employees (directors, trustees and independent contractors). See, Q&A3. Previously, government and non-profit organizations were required only to follow IRC '457 with eligible and ineligible plans. Section 457(b) plans, like qualified plans, will not have to follow '409A. Ineligible plans previously governed solely under '457(f) now will have to follow '409A also.

There are also specific statutory exceptions to the application of these new non-qualified deferred compensation rules. Question 3 of the Notice spells out what benefit arrangements do not have to comply with '409A's rigorous tests; a death benefit plan and a disability plan that comply with the definitions of Tax Regulations '31.3121(v)(2)-1(b)(4)(iv)(C). These definitional requirements provide a bright line mechanical test that will permit compliance with the laws. The language in these safe harbors indicate that where there is more life insurance death benefit or funding available upon a disability than the present value of any forum of additional benefit, i.e., cash value available if a person doesn't die or is not disabled, then the program complies. These provisions will permit compliance with '409A and converting a non deductible item at the Plan Sponsor level into a substantially deductible expense and creating tax at the particpant level of only the economic benefit as set forth under the IRC.

These provisions can be applied to an existing deferred compensation plan as well as a new wealth accumulation plan. This approach will be flexible to the employer and largely estate and income tax free to the covered employee. The accrued benefit to the employee can be safeguarded from claims of creditors of the employer and employees and, upon withdrawal by the employee, can be accessed in an economically efficient manner. The death benefit need not be an asset on the books of the employer or subject to the claims of their creditors. Additionally, the employer can institute these provisions for a portion or all of the existing deferred compensation program as a new benefit plan and fund “as you go” rather than creating a liability for the employer to fund for in the future. Alternatively, this tool will permit the employer to reflect an increasing asset on its books for audit accounting purposes and not create a charge to earnings. This tool complies with both GAAP accounting as well as IAS 19.

Because this has a death benefit component, and not a deferred compensation arrangement required to comply with ”409A, 457 or 457(f), there is no maximum limitation of death benefits, asset accumulation or risk of forfeiture. The provisions of Treas. Regs. '1.31.3121 provide a current death benefit for covered employees. This is an actuarial-based structure for an employer that maximizes benefits to the employer while providing a selective benefits program for qualifying employees. This creates a versatile tool that is ideal for Golden Handcuffs, employment contracts, funds to help offset future employer financial obligations and covenants not to compete. The employer may use this tool in transactions to reduce the cost of funding employee or shareholder buy outs or future compensation packages. The employer may fund the executive benefit providing the same amount of funding and the selected employees will receive more benefit than the traditional deferred compensation method, or the employee will reduce the amount of funding and the selected employees will receive equivalent benefit. Using the safe harbors of the Treasury Regulations also avoids the Golden Parachute limitations and excise tax ( see , IRC '280G). Unlike the traditional benefit plans that have a substantial risk of forfeiture of 457(f), 409A or 83, the provisions have no contribution limitation. The arrangement also avoids the risk of forfeiture tests. The benefit program complies with the most recent legislative rules IRC '101(j), COLI BEST Practices Act of 2005, and as an exception under '72(k)(2)(B)(ii), the AJCA, IRC '409A, and Notice 2005-1.

In any planning arrangement, the Plan Sponsor must consider the death benefit, economic benefit and constructive receipt rules. Integrating these provisions with co-ownership arrangements comply with all proposed regulatory rules and the tax shelter rules as presented, assuring positive results. The arrangement is not a tax shelter, a listed transaction or a reportable transaction. The arrangement complies with the economic substance test (IRC '7701(O)), as well as case law and proposed legislation. The employer's contribution is actuarially determined and that amount is deductible ('79, '457(e)11, Treas.Reg 1.162.10, TAM 200002074 and 20050204). The employer can utilize a current death benefit arrangement with an employment or non-competition agreement to provide benefits that may reduce income and estate tax to the employee. This arrangement complies with the deferred compensation rules of '409A because it is a death benefit plan qualifying under 31.3121(v)(2)-1(b)(4)(iv)(A). Following IRC '83(e)5, an insurance arrangement between an employer and a participant in a plan does not violate the restricted property rules. The value of current annual life insurance protection is includible as taxable compensation to the insured participant each year but, in addition, in line with Rev. Proc. 2003-25 and '72, the cash surrender value of the policy would not be subject to income tax nor be a reportable event if the policy is not surrendered. See the table below.

[IMGCAP(1)]

Conclusion

Using the Treasury Regulations complies on both a legal and accounting basis and may be a tremendous economic solution to this funding and compliance situation. This approach is available for C-corps, S-corps, LLCs and Pass Thru entities. Because the program also complies with ”457, 457(f) and 457(e)11, all non-profits are eligible Plan Sponsors. This tool will allow the employer to retain equity within the business and relieve the employees from having to use personal assets to fund current death benefits and financial obligations. To hear an interview describing this approach, visit http://bit.ly/ZUdDEs.

The Deferred Compensation Plan'

1. The employer creates or amends its nonqualified deferred compensation plan to add a feature set forth in Treas. Reg. '31.3121.

2. Some or all employees may elect, prior to the time benefits under the deferred compensation plan become payable, to relinquish those benefits and have the employer contribute to the cost of the new benefits.

3. An employee or employer would apply for, obtain and own a permanent life insurance benefit. The employee or the employer would enter into a co-ownership life insurance agreement providing that the employer pay for the current death benefit. This is actuarially determined in line with qualified asset account limits. The co-owner (the employee or the employer) would pay for the remainder of the premiums and retain all other rights to the policy.

4. Unless the co-owner fails to maintain the policy (as provided in (5) immediately below) or breaches certain obligations to the employer, the current death benefit is provided to employees through the plan so long as the participant is in the plan.

5. Upon an employee participant withdrawing from the plan, or upon plan termination, the co-ownership agreement is terminated, the employer no longer funds the plan and the co-owner retains all right, title and interest in the coverage.

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP', AEP, a member of this newsletter's Board of Editors, has served as Tax Bar liaison to the IRS for 10 years. He has received patents in actuarial product fields dealing with COLI, GASB, FASB, IASB and OPEB solutions.