New Regulations Affect '457 Plans for Non Profits

The proposed regulations provide that a bona fide death benefit plan, which is treated as not providing for the deferral of compensation pursuant to '457(e)(11)(A)(i), is a plan providing for death benefits as defined in '31.3121(v)(2)-1(b)(4)(iv)(C) (relating to the application of the Federal Insurance Contributions Act to nonqualified deferred compensation). The proposed regulations further provide that benefits under a bona fide death benefit plan may be provided through insurance, and that any lifetime benefits payable under the plan that may be includible in gross income will not be treated as including the value of any term life insurance coverage provided under the plan.

Section 457(e)(12) provides that '457 does not apply to certain non-elective deferred compensation of nonemployees.

In Notice 2007-62 (2007-2 CB 331 (Aug. 6, 2007)), the Treasury Department and the IRS announced the intent to issue guidance under '457, including providing definitions of a bona fide severance pay plan under '457(e)(11) and substantial risk of forfeiture under '457(f)(3)(B). In response to comments received from a request in Notice 2007-62 (on subjects including but not limited to severance pay, covenants not to compete, and the definition of substantial risk of forfeiture), the rules in these proposed regulations have been modified from the proposals announced in that notice.

Announcement 2000-1'(2000-1 CB 294 (Jan. 1, 2000)), provides transitional guidance on the reporting requirements for certain broad-based, non-elective deferred compensation plans maintained by State or local governments. The announcement states that, pending the issuance of further guidance, a State or local government should not report amounts for any year before the year in which a participant or beneficiary is in actual or constructive receipt of those amounts, if the amounts are provided under a plan that the State or local government has been treating as a bona fide severance pay plan under '457(e)(11) for years before calendar year 1999.'To be eligible for this transitional relief, the plan must satisfy certain requirements described in the announcement.

The '457(e)11 Plan for Non-Profits is an arrangement in which the employer, a 501(c) non-profit organization, agrees to pay the actuarially determined cost of the current death benefit on a permanent life insurance policy to be owned by the employee or employer. Under this arrangement, no lifetime benefit is provided by the employer, so the new rules are followed. The employer and employee enter into a written agreement that ordinarily requires the employer to make premium payments as long as the employee works for the employer. The employment agreement also requires the employee to execute a “co-ownership” or “restrictive endorsement” at the time the policy is purchased. The co-ownership agreement would set forth the terms of the restrictive endorsement and the timing of its release. The employee or employer will own the policy. The co-ownership agreement sets forth the limitation to the policy by the employee, and the actuarial cost of the current death benefit will be deductible by the employer and not taxable to the employee. The economic benefit of the death benefit coverage will also be taxable to the employee. Any monies contributed by the employee or otherwise taxable to the employee will be a credit against the employee's economic benefit taxation. The non-profit executive benefit paid by the employer received by the employee is the death benefit owned, and the life insurance policy can be continued after the employee's disability or retirement. The employee's named beneficiary may receive the life insurance proceeds income tax-free.

The cash value of a permanent life insurance policy grows on a tax-deferred basis. Because the coverage funded by the employer's contribution will terminate upon the employee's retirement, the executive will not be in constructive receipt of any benefit, and there will be no benefits provided that are not covered by the new rules. Unlike most forms of traditional non-qualified deferred compensation, the employee receives immediate benefits under the '457(e)11 Plan, and as permitted by the new rules. The employee can immediately name the beneficiary of the death benefit. The Plan may require the employee to reimburse the employer for some or all of the premiums paid if the employee terminates employment early.

Qualified retirement plans are subject to restrictions on the amount of money that can be contributed by (or on behalf of) an employee. When distributions are taken from a qualified plan, they may be subject to certain penalties, such as the 10% penalty tax on early (prior to age 59') withdrawals. The Plan is not a qualified plan: Once a participant is no longer in the Plan, access to the policy's cash value (by withdrawal up to basis or by loan) is not ordinarily subject to income or penalty taxes. The death benefit only plan is in compliance with the deferred compensation rules under '409A as it is defined as a welfare benefit plan under Treasury Reg. '31.3121.

The '457(e)11 Plan can play a very important role in a compensation package by combining the advantages of current death benefit protection and immediate vesting of the policy's cash value. Immediate vesting of the policy's cash value differentiates the Plan from traditional non-qualified deferred compensation plans where the employee usually receives little more than the employer's promise to pay future benefits. Moreover, the tax-favorable growth of policy cash values makes permanent insurance an attractive source of supplemental retirement dollars. One major disadvantage of qualified plans is the strict rules pertaining to participation that require an employer to make the plan available to most (or all) employees. The Plan is not a qualified plan, therefore, the employer can select which employee, or group of employees, to cover. The Plan can be tailored to fit each employee's needs and can reflect each employee's value to the employer. The use of the Plan also complies with '409A. See, Notice 2005-01 and the Final Regulations covering deferred compensation. Unlike qualified plans and some types of traditional non-qualified deferred compensation plans, once established, minimal annual reports and administration should be required.'The ERISA implications of the Plan are discussed below.'As long as the employee's total compensation package is “reasonable,” the employer's premium payments providing the current death benefit should constitute compensation and be a currently deductible expense. This differs from traditional non-qualified deferred compensation arrangements where benefits are not deductible to the employer until paid to the employee.

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Tax Consequences of The '457(e)11 Plan for Non-Profits

Section 61 Taxation. Premium payments made by the employer are generally believed to be compensation to the employee under IRS '61. Therefore, subject to “reasonable compensation” limitations, the likely tax treatment should be current income for the employee equal to the premium paid, and a corresponding current deduction for the employer. When a “double bonus” arrangement is utilized, the employer will also bonus the employee an amount necessary to cover the employee's income tax liability. This additional bonus should also be subject to current income taxation.

Section 457 Taxation. Notice 2002-8 and Prop. Reg. 1.457-11, dealing with '457(f) deferred compensation, set forth the permissible benefit areas and the Plan complies with those rules. As a '457(e)11 death benefit plan, it is not required to have a risk of forfeiture contingency as required under '457(f). Additionally, when the Plan is integrated into a group-carve out arrangement, the Final Regs permit treatment under '79, and are specifically excluded from being affected by '1.61(b)(2)(ii). The IRS ruled in Technical Advice Memorandum (TAM) 200002047 that the rules of '79 will apply to coverage provided to certain employees as covered under the DBO Plan and Department of Labor Advisory Opinion 2003-08A (June 26, 2003).

Section 409A, Taxation Notice 2005-1, and the Final Regulations gave bright line test for exceptions to complying with the deferred compensation rules. See, '31.3121.

Tax Shelter Issues. The Plan is not a “listed transaction” under Treas. Regs. ”1.6011-4(b)(2) and 301.611-2(b)(2), Notice 2007-83, a “tax shelter” under IRC 6111(c) and 6111d) and Treas. Reg. 301.6111-1T,Q&A 4, a “potentially abusive tax shelter” under 6112(b) and Treas. Reg. 301.6112-1(b), or a “reportable transaction” under Treas Reg. 1.6011-4(b). Additionally, the Plan does not violate the Economic Substance Doctrine as codified in new Internal Revenue Code '7701(o)

Tax Circular 230 Issues. Because the Plan is not a listed transaction, there are no conditions of confidentiality or contractual protection, the covered opinion requirements of 10.35 do not apply. Because the employer is not subject to income tax as a nonprofit employer, the principal purpose or significant purpose is not tax avoidance or tax evasion.

ERISA Implications of the '457(e)11 Plan for Non-Profits

Title 1 of ERISA covers all employee benefit plans and divides them into welfare plans and pension plans. To be covered by ERISA, there must be a 'plan.' If the Plan is a negotiated arrangement between an employer and a single employee, there is a strong argument that there is no 'plan' and ERISA does not govern the arrangement. ERISA reporting requirements for 'top hat' plans are limited. Whether the DBO Plan is subject to ERISA must be determined on a case-by-case basis. In any event, if so it is subject only to the reporting and disclosure requirements then it is not an ERISA plan for income tax purposes.

A comparison of non-profit deferred compensation programs is below:

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Conclusion

For non-profit employers looking for a relatively simple way to reward key employees and recruit prospective employees, the '457(e)11 Plan may be an answer. The Plan offers many of the best features of a '162 bonus plan with less costs (e.g., current death benefit, current employer tax deduction, and immediate employee vesting), while serving as a “golden handcuff” that encourages employee loyalty. In addition to providing an employee with current death benefit protection, the insurance policy's cash value may be available as a source of supplemental retirement income.

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.