1. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 1  What is it?  Contractual agreement between an employer and employee  Employer make an unsecured promise to pay a benefits in a future tax year in exchange for services rendered currently  A deferred compensation plan that does not meet the then tax and labor law requirements applicable to qualified plans  Major types  Salary continuation plans  Supplemental benefits over and above those provided by qualified plans  Salary reduction plans  Voluntary deferral of future salary and/or bonuses

2. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 2  Evaluating viable techniques for executive benefits  Criteria  What is the relative tax efficiency?  What is the probably of achieving the employers objectives?  What security is provided against employer insolvency?  Does the plan provide security in the event of management or ownership changes?  Can the employer keep or obtain the use of plan funds for an emergency or opportunity?  How easy is it to implement, explain, and maintain the plan?

3. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 3  When is the use of this tool indicated  Qualified Plan “Blues”  Increasing costs  Decreasing employer discretion and control  Limitations on qualified benefits for the highly compensated  When the employer wants to provide a retirement and/or death benefit to key employees without prohibitive cost or requirements that all employees be eligible and receive the same type of benefits (as with qualified plans)  When an employer wants to provide additional benefits to a key executive already receiving the maximum benefits or contributions under the qualified plan  When an employer wants certain key employees to have tax deferred compensation in difference amounts under different terms or under different conditions from that provided to other employees

4. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 4  When is the use of this tool indicated (cont'd)  When an employer seeks to establish an automatic and relatively painless investment program that uses corporate tax deductions to leverage the employees future benefits  To recruit, retain, and reward key employees  Advantages  Greater flexibility in plan design than that for qualified plans  Employer can pick and choose who can participate, levels of coverage, terms and conditions of coverage.  Plan benefits can be forfeited entirely according to any vesting schedule  Restrictions can be place in the plan that will enable the employer to either (1) achieve its business goals or (2) recoup its funds

5. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 5  Advantages (cont'd)  Nonqualified plans escape a variety of government requirements imposed upon qualified plans  Reporting and disclosure  Participation  Vesting  Fiduciary responsibility requirements  In general, covered employee are not taxed on benefits under nonqualified plans until they actually receive a distribution.  Employee deferrals grow tax deferred  Nonqualified plans properly funded with life insurance are not currently taxed on the inside buildup of cash value

6. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 6  Advantages (cont'd)  Employer tax deduction is based on the larger distribution amounts, not the smaller deferral amount.  Employer can access policy values on an income tax advantaged basis to help fund the distribution payment to employees.  Disadvantages  Employer's income tax deduction until the year in which income is taxable to the employee  Employee right to plans assets is unsecured  Other than a contractual promise, the employee has no assurance of being paid  If there is a corporate takeover, future management may not keep prior management’s promises

7. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 7  Disadvantages  Employee right to plans assets is unsecured (cont'd)  Rabbi Trust  Will protect employees against an employer’s change of heart or change of management, but not against employers insolvency  Life insurance payable to a “large” corporation may be subject to the Alternative Minimum Tax  Required accounting disclosures reduces confidentiality  Not all employers can take advantages of these plans  S-Corps cannot  Partnerships cannot  Sole proprietorship cannot

8. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 8  Disadvantages (cont'd)  Not all employers can take advantages of these plans  Nonprofit corporations and governmental organizations CAN use these plans  But they are subject to special, highly restrictive rules under IRC 457  What are the requirements?  Employer adopts a corporate resolution  Authorizing an agreement between the corporation and an employee to be covered  Promising to make specific benefits upon the occurrence of triggering events in return for continuing services of the employee  A second and separate corporation resolution  Authorizing the purchase of life insurance to indemnify the employer for the significant expenses it’s likely to incur

9. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 9  What are the requirements? (cont'd)  The appropriate amount of life insurance is purchased and made payable to the employer.  The employer is the policy owner  No interest is given to the employee  Policy subject to the employers creditors  Employer attorney drafts a nonqualified deferred compensation agreement  A rabbi trust could also be established to hold the life insurance  One page ERISA notice filed with the Department of Labor

10. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 10  What are the tax implications?  Employee not taxed until distributions are received from the employer  Employer can deduct plan benefit payments made to the employer (or beneficiary)  Must meet the “ordinary,” “necessary,” and “reasonable” tests applied to all compensation  The internal build-up of cash values in employer owned life insurance grows income tax deferred  Assuming policy is properly structured  Amounts received from the plan by beneficiaries are taxable as received at ordinary income rates  Exception – To extend that inclusion of the benefit results in federal estate tax upon the covered employee estate, an income tax deduction may be allowed to the recipients  Amounts deferred subject to Social Security tax when  The services are performed or  When employee no longer has a substantial risk of forfeiture

11. Nonqualified Deferred Compensation Chapter 33 Tools & Techniques of Life Insurance Planning 33 - 11  What are the tax implications? (cont’d)  The American Jobs Creation Act of 2004 added new IRC Section 409A  Participants must generally make deferral elections prior to the end of the preceding taxable year.  New participants have 30 days to make an election with respect to future earnings  Distributions must only be made upon the occurrence of certain events:  Separation from service  Disability  Death of the employee  At a time specified under the plan  A change in ownership or control  Unforseeable emergency  Accelerated distributions are only permitted under limited circumstances  IRC Section 409A imposes substantial penalties for failing to meet its requirements  Immediate, retroactive taxation on “deferred” compensation  20% additional penalty tax  Interest at 1% higher than normal underpayment rate