The benefits to employers and key employees can be significant
Employee fringe benefits are considered an essential part of attracting and retaining key employees and executives. However, because the rules for qualified plans place a limitation on contributions to retirement plans, many employers look to nonqualified plans to help key employees and executives postpone payment of some compensation until the need exists and the tax consequences may be more favorable.
For this reason, nonqualified deferred compensation plans, coupled with the use of life insurance as a funding source, can provide both employers and key employees with some desirable benefits.
First Things First
Nonqualified deferred compensation plans escape restrictive Internal Revenue Code requirements, such as nondiscrimination and “top heavy” rules, that apply to qualified plans. Thus, employers are given the flexibility to provide additional benefits to key employees without the need of providing a similar benefit to every employee. However, nonqualified plans have tax consequences that generally depend on the application of the doctrine of constructive receipt.
Constructive receipt usually refers to access and degree of control. That is, if access to a deferred benefit by the employee is subject to substantial limitations or restrictions, constructive receipt generally does not exist. An employee is subject to a
substantial limitation or restriction if control of the receipt of a deferred benefit requires a trade-off of a valuable right in exchange for plan benefits. A valuable right might be an employee’s right to be a part of the plan in the future.
Thus, constructive receipt is generally avoided if benefits are agreed upon before any actual employment begins and the employer does not guarantee any benefits.
Designing Your Plan
How a plan is designed will result in different tax and benefit trade-offs. In an unfunded, unsecured plan, the employer usually makes a mere promise to pay in the future, resulting in the deferral of income recognition for the employee and the postponement of employer deductions until the compensation is actually paid.
However, an unfunded promise to pay results in an increasing liability to the company – a promise that depends on the company’s solvency and ability to pay in the future. Consequently, the employee bears the risk that the company will be unable to meet its future obligation. Moreover, in the event of bankruptcy, the unsecured nature of the promise could leave the employee vulnerable to default.
To help meet its obligations under a nonqualified deferred compensation plan, an employer can
informally “fund” such a plan with the use of life insurance. The main features of this arrangement are:
- No current income tax on cash values; and
- An income tax-free death benefit that is payable upon the employee’s
In addition, some employers use “triggers” – clauses that require immediate payment of benefits to the participant upon the occurrence of certain events (e.g., retirement or disability) – to give the employee a greater sense of security.
An Intriguing Selective Benefit
The design of employee benefit plans should be based on an evaluation of the employer’s intent, the needs of various employees, and an understanding of the benefit trade-offs. Nonqualified deferred compensation funded with life insurance may be particularly attractive as a supplement for key employees who have a greater need for future income, but whose retirement benefits are limited under the rules for qualified plans.