Golden Handcuff Insurance

A Deferred Income Plan (DIP) is a nonqualified deferred compensation plan between an employer and a key employee that provides extra retirement income to the employee. Usually, a DIP is funded through an election by the employee to defer a portion of their current compensation. Amounts deferred by an employee are put in a “phantom account” that accumulates based on the applicable interest rate. At the distribution date specified in the agreement, the employee receives the balance of their account, as specified in the agreement.

An employer may consider implementing a DIP if they wish to:

• Provide incentive to encourage key employees to remain with the employer;
• Allow key employees to supplement their retirement income by forgoing current salary increases.
• Protect a key employee’s family in the event of their death.

To implement a DIP, the employer and the key employee enter into a written DIP agreement, drafted to comply with Internal Revenue Code (IRC) § 409A (Section 409A). Under this agreement, the key employee agrees to defer a portion of their salary and the employer agrees to contribute the deferred amounts to the employee’s phantom account. In some situations, the employer may elect to match deferrals made by the employee. The agreement defines the duties and obligations of the employer and the employee. The key employee will be 100% vested in their salary deferrals.

At the distribution date in the agreement, for example the employee's retirement, distributions are made to the employee based on the value of the employee’s phantom account. The agreement can also provide a survivor benefit to the employee’s family if the employee dies prior to the time benefits under the agreement are paid in full.

A DIP must be unfunded for Section 409A and Employee Retirement Income Security Act of 1974(ERISA) purposes to avoid current income taxation. An agreement is often considered unfunded if the employer’s obligation is merely an unsecured promise to pay. This requires that the assets backing the agreement be subject to the claims of general creditors of the employer. The employee is a general creditor of the employer with respect to claims under the agreement.

Various assets are used to informally fund a DIP such as savings accounts, bonds, stocks, mutual funds, and annuities. However, these assets would be subject to current income taxation and possibly to market value fluctuation. Also, such assets generally do not allow for cost recovery, survivor benefits, and provide no guarantees.

Also, permanent insurance on the life of the key employee is often used to informally fund a DIP. The employer is owner and beneficiary of the life insurance policy and can access the policy’s cash values to fund the promised benefits to the employee. The cash value of the life insurance policy accumulates on an income tax-deferred basis.

The death benefit can provide cost recovery to the employer as well as the funds necessary to provide the promised survivor benefits. If the employer purchased insurance on the life of an employee, the employer must follow the “Notice and Consent” requirements under IRC § 101(j) to preserve the income tax-free nature of the life insurance policy’s death benefit for the employer.

Income Tax Considerations- Employer

The employer receives an income tax deduction when they pay benefits to the key employee, but only if the benefits are considered reasonable compensation in light of the services provided.

Income Tax Considerations- Employee

If there is no tax on the hypothetical income of the deferred amounts and the employee does not possess an economic benefit, there should be no current income tax consequence to the employee upon deferral. To avoid the tax on the hypothetical income on the amounts deferred, the employee deferral agreement must be entered into before the compensation is earned or services are performed.

If life insurance will be used to informally fund a DIP, to guarantee the employee does not economically benefit, they should have no beneficial interest in the policy, including the right to name the beneficiary for any part of the death benefit proceeds. The employer should be sole applicant, owner, beneficiary and premium payer of any policy used.

If properly structured, an employee will not include any deferred compensation in taxable income until it is received. Once received, the entire amount received will be included in taxable income for that year. Similarly, any amount received by the employee’s beneficiary after death will be treated as income in respect of a decedent and will be taxable to the beneficiary in the year received. The beneficiary will be entitled to an income tax deduction for any estate tax paid resulting from the benefits being included in the decedent’s estate.

If an employee dies prior to receiving all benefits, the present value of any obligation payable to their estate or beneficiaries is included in their taxable estate. If the benefit is paid to a surviving spouse, the benefit may qualify for the unlimited marital deduction.

A supplemental executive retirement plan (SERP) is also a nonqualified deferred compensation plan between an employer and a key employee that provides supplemental retirement income to the employee. With an employer funded SERP, the employer makes contributions to the plan and, with some plans, the employee may also be able to contribute to the plan.

At the distribution date as specified in the agreement, the employee will receive the benefit promised under the plan. An employer may consider implementing a SERP if the employer wishes to:

• Attract, retain and reward key employees who are important to the company’s success;
• Provide an incentive for key employees to remain with the company;
• Create “golden handcuffs” for key employees, making it costly for them to leave or become a competitor of the company; or
• Provide employees with supplemental retirement benefits in addition to other retirement plans currently in place.

A defined benefit SERP is similar to a traditional pension plan where the employer provides a specified benefit to the employee based on a specific formula, such as percentage of the employee’s income. Defined benefit SERPs are generally funded only with employer contributions. The plan design can be specifically customized for the employer and employee; however, distributions are usually designed to align with the employee’s retirement.

It is designed to operate like a 401(k) plan where the employer makes predetermined contributions to the plan and the benefit the employee receives changes depending on the accumulated value of the employee’s account at the designated distribution date. The amount of contributions could be based on company profits or the employee’s achievement of certain performance goals.

Defined contribution SERPs are usually funded with contributions from the employer, but with some plans the employee may also contribute to their account. As with a defined benefit SERP, a defined contribution SERP can be customized to the specific needs of the employer and employee; however, distributions are usually designed to align with the employee’s retirement.

To implement a SERP, the employer and the key employee enter into a written SERP agreement, drafted to comply with Internal Revenue Code (IRC) §409A (Section 409A). The agreement defines the duties and obligations of the employer and the employee, including benefit amounts and when benefits will be paid.

Usually, the agreement provides that the employee must remain with the company for a certain term of years or until his/her retirement; however, the agreement may allow the employee to vest in certain percentages of the benefit at stated time intervals. At the distribution date as stated in the plan (such as the employee’s retirement), the plan would pay income to the key employee for a period of years, as defined in the agreement. The plan can be structured such that the employee will forfeit all or part of the benefit if he/she leaves employment prior to the date specified in the agreement. The plan can also provide a survivor benefit to the employee’s family in the event the employee dies prior to the time benefits under the plan are paid in full.

Methods of Informal Funding

Various investment vehicles can be used to informally fund a SERP including savings accounts, bonds, stocks, mutual funds, and annuities. However, such assets would be subject to current income taxation and may be subject to market value fluctuation. Also, such assets generally provide no cost recovery, no survivor benefit, and no guarantees.

Accordingly, permanent insurance on the life of the key employee is often utilized to informally fund a SERP. The employer is owner and beneficiary of the life insurance policy and may access the policy’s cash values to fund the promised benefits to the employee. The cash value of the life insurance policy accumulates on an income tax-deferred basis. Depending on the product, the cash values may be credited based on a guaranteed crediting rate. The death benefit may provide both cost recovery to the employer as well as the funds needed to provide the promised survivor benefits.

If the employer purchased insurance on the life of an employee, the employer must follow the “Notice and Consent” requirements under IRC §101(j) to preserve the income tax-free nature of the life insurance policy’s death benefit.

The employer receives an income tax deduction when the benefits are paid to the key employee, as long as the benefits, when taken together with all other compensation paid to the key employee, are considered reasonable compensation for the services provided.

As long as employer deferrals are subject to a substantial risk of forfeiture (e.g., subject to the claims of the employer’s general creditors) and if the employee is not in “constructive receipt” of deferred amounts and does not possess an economic benefit, there should be no income tax consequence to the employee upon deferral.

To avoid constructive receipt on amounts deferred, the employee deferral agreement must be entered into before the compensation is earned or services are performed. If life insurance will be used to informally fund a deferred compensation agreement, to ensure the employee has no economic benefit, they should have no beneficial interest in the policy, including the right to name the beneficiary for any part of the death benefit proceeds.

The employer should be the sole applicant, owner, beneficiary and premium payer of any policy used. If properly structured, an employee will not include any deferred compensation in taxable income until they receive it. Once received, the entire amount received will be included in taxable income for that year. Similarly, any amount received by the employee’s beneficiary after death will be treated as income in respect of a decedent and will be taxable to the beneficiary in the year received. The beneficiary will be entitled to an income tax deduction for any estate tax paid resulting from the benefits being included in the decedent’s estate.