Joe is a successful advisor working with many closely held business owners. He's experienced in selling life insurance and is comfortable showing the advantages of using cash value life insurance policies to provide retirement benefits to key employees. Joe's typical sales pitch to a client is "fund these policies insuring the lives of your key employees with level premiums until they retire, then take tax free withdrawals and loans to pay them retirement benefits. The business will own the policies and ultimately receive the tax-free death benefits to recover the costs of the plan. Or, to just make things easier, just give the policy to the employees when they retire and they can receive all the tax-free benefits directly." Joe will always present a series of life insurance illustrations using a current assumed rate of interest for policy growth and project the stream of tax-free distributions for a given number of years.
Simple. Effective. Popular. And…Wrong.
Non-qualified deferred compensation (NQDC) plans are frequently used tools by major corporations to retain, reward and recruit key talent. These plans may be designed to provide a multitude of benefits, including for retirement, college funding, disability and survivor income. There are numerous tax, accounting and legal requirements for the proper design, implementation and administration of NQDC plans which often intimidate advisors and their smaller, more closely-held business owner clients from using as effective solutions to their growth and succession planning needs.
Without wading into the IRS regs, practitioners should at least be aware of the rules under IRC Section 409A governing the tax treatment of deferred compensation plans. While somewhat complex, they are reasonably clear and allow companies of all sizes to create effective programs. The other key guidance is under ERISA which primarily governs who may participate in a NQDC plan under the “Top Hat” exceptions thus avoiding the more onerous reporting and fiduciary requirements of broad-based employee benefit plans. The DOL also has a simple but important requirement to record the implementation of a NQDC.
Back to our friend Joe. He’s read and witnessed many presentations over the years on NQDC plans and sees how effective they can be for his clients. Business owned life insurance (e.g. COLI, BOLI, etc.) is often used to finance the cost of these plans. Using life insurance company illustration system templates, Joe is able to generate a presentation like the one described above.
So what’s the problem?
First, the cost of making a mistake is enormous and is imposed as a tax by the IRS on the plan PARTICIPANT…not the company nor the advisor. Tax penalties may equal 100% or more of the benefits received and the reputation risk to Joe is great if things go wrong. In Joe’s “simple” world, he has implemented a plan of deferred compensation, but not followed most of the 409A requirements. More importantly, a specific written plan is needed to outline the eligibility of the participants, features, benefits, claims procedures, etc. Joe has also used an insurance policy illustration to project future benefits…projections that are almost certain to be wrong versus real world experience. This leaves both the key employees and business owner with a high level of uncertainty about the actual plan benefits and if they will be meaningful towards their goals of retention and rewarding.
In short, there must be a PLAN and then a discussion and decision about FUNDING and the role of life insurance. The plan will specify the contributions and benefits and thereby provide a clear understanding to all parties. This makes for a better result and removes uncertainty. Business owned life insurance is a tremendous funding vehicle due to the tax advantages and underlying guarantees when designed and administered correctly. Done right, deferred compensation plans funded with life insurance are highly effective programs which is why most of the Fortune 500 use these programs.
The opportunity to implement similar plans…funded with insurance…is tremendous among the over 10 million closely-held businesses in this country. Business owners should work with advisors who have a good understanding of the rules, requirements and structures best suited for each situation and advisors should partner with experts in the field to be sure they are designed and administered correctly for the life of the plan.
Call me. We’re Doing Deferred Compensation Plans Right.