After tax supplemental compensation plans funded with life insurance offer a hybrid arrangement that reduces the complexity and expense associated with non-qualified deferred compensation plan. These plans are a great benefit for a company to offer to non-owner key executives to retain and reward them for their valuable services. They are especially attractive in pass through entities such as Subchapter S corporations and tax exempt organizations.
- An employer may like the benefit control afforded by a deferred compensation plan with company owned assets to informally fund the agreement and a vesting schedule in the deferred compensation agreement. But, the employer may object to the non-deductibility of deferred amounts and premium payments for tax accounting purposes. Also, the employer may object to the booking of the deferred compensation liability on the company balance sheet for GAAP and FASB purposes.
- The after tax plan gives the organization a current deduction PLUS control of the benefit provided in the form of forfeiture language in a legal agreement. If the executive leaves the company for other employment prior to the full vesting according to the written agreement, the executive may lose some or all of the benefits provided in the funding policy.
PLAN DESIGN FEATURES AND INCOME TAXATION
- A written agreement is executed where the employer agrees to pay an annual bonus subject to full or partial forfeiture of cumulative bonuses if the employee terminates during the vesting period (i.e. 5-10 years). A forfeiture during the vesting period would require the executive to reimburse some amount of the cumulative bonuses back to the corporation. The corporation would have to declare any reimbursements as taxable corporate income.
- The bonuses are used to pay premiums for a personally owned cash accumulation type of insurance policy. The policy could be current assumption universal life (UL), indexed UL, variable UL or whole life depending on preference of the employee and employer. Premiums are paid from the issue age to the earliest of termination of employment or retirement only.
- The company may provide an additional payment for all or a portion of the taxes due.
- The proposal can show a tax free income stream from policy cash values via withdrawals to cost basis, then switching to policy loans (FIFO).
- The death benefit remains income tax free to the personal beneficiary of the insured executive.
- The after tax plan is especially attractive in an S Corporation or other pass through entity situation. Since an S Corporation is a “pass-through” entity to the S Corporation owner(s) for tax purposes, the non-deductible deferrals of a deferred compensation plan would flow through as part of the K-1 “pass-through” profit to the S Corp owner personally on Schedule E of his Form 1040 U.S. Income Tax return. In essence, the S Corp owner would be using his own personal after-tax dollars to fund the deferred comp benefit of his non-owner key executive. The after tax plan avoids this K-1 accounting problem.
- The contributions are currently deductible to the corporation and currently taxable to the executive as earned income. Since the benefits of an after tax plan are subject to a risk of forfeiture if the executive terminates employment during the vesting period, the executive can make an IRC Section 83(b) election to have the bonuses taxed currently despite the risk of forfeiture.
- The after tax plan is also a solution to many of the issues that surround Section 457 plans.
- After tax plans are generally exempt from ERISA and IRC Section 409A.
For further information, contact:
Barry N. Koslow, JD, 781-939-6050 bkoslow@mkaplanners.com or
Dennis M. Sexton, 781-939-6060 dsexton@mkaplanners.com
To ensure compliance with requirements imposed by the IRS, we inform you that any federal tax advice contained in this communication, including any attachments, was not intended or written to be used, and cannot be used, for the purpose of avoiding federal tax related interest or penalties. Securities offered through Advisory Group Equity Services, Ltd., member FINRA/SIPC. Advisory services offered by Trust Advisory Group, Ltd., a registered investment advisor. 444 Washington Street, Suite 407, Woburn, MA 01801. 781-933-6100.
