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IRS Tightens Deferred Compensation Rules for Tax-Exempt OrganizationsThe IRS is planning to follow some of the recently-finalized rules under section §409A of the Revenue Code.William L. MacDonald
The regulations governing nonqualified deferred compensation under Section §409A of the Internal Revenue Code were finalized on April 22, 2007. The finalization of these regulations will require employers to amend their nonqualified deferred compensation arrangements before the end of 2007. Recently, the IRS extended certain aspects until the end of 2008; however, the majority of the changes must be made this year. Section 457 establishes rules for deferred compensation paid by state and local governments and other tax-exempt employers. Under that section, tax-exempt employers can establish nonqualified deferred compensation plans up to the limits applicable to 401(k) plans (e.g., $15,500 in 2007). These plans are usually referred to as “eligible plans” or “section 457(b) plans.” Eligible plans are commonly used to permit employees of tax-exempt organizations to make elective deferrals as they would under a 401(k) plan (even if the organization also has a 401(k) plan). Often tax-exempt organizations also have qualified plans, such as the 403(b), which are not subject to the section 457 rules. However, beyond those types of plans, the rules in section 457(f) greatly restrict the ability of tax-exempt organizations to provide deferred compensation arrangements for their employees. These restrictive rules were created in 1978 by Congress on the theory that, because the tax-exempt organization does not obtain a deduction for the deferred compensation promised, it does not have any incentive to limit the deferred compensation arrangements of its employees (taxable employers must defer their deduction for these types of plans). Therefore, Congress restricted the ability of tax-exempt organizations to provide deferred compensation to employees. Section 457(f) implements these restrictive rules by providing that deferred compensation is taxable in the first taxable year in which there is no substantial risk of forfeiture. The employee is subject to tax even if the deferred amount is not payable and has not been constructively received. In effect, the employee is taxed on the accrued promise to pay benefits. Some tax-exempt employers have designed their deferred compensation plans specifically to avoid the reach of these restrictions. Among these arrangements are so-called “rolling risk of forfeiture” plans in which employees elect to extend the substantial risk of forfeiture applicable to their deferred compensation for a limited period of time, presumably to avoid being taxed on those deferred amounts. The rigid rules in the recently-adopted section §409A also impact plans for tax-exempt organizations. As a consequence, such organizations are now subject to the restrictive rules of both section §409A and section 457(f). A major blow stemming from the final regulations under §409A approved on April 22, 2007, is that “rolling-risk-of forfeiture arrangements and any other arrangements that extend a substantial risk of forfeiture will not be recognized for purposes of that section.” The final regulations under section §409A also provide specific rules for severance plans, which were based in large part on the ERISA severance plan definition. The IRS has indicated informally for some months that it was considering extending some parts of the section §409A final regulations to section 457(f). Although the IRS has not formally proposed those rules yet, it has announced, in Notice 2007-62, that in the near future they will be proposed. It also indicated that these new rules will be prospective. Notice 2007-62 focuses on two specific issues that the IRS has indicated will be changed under section 457. One relates to the definition of bona fide severance pay plans and the other to the definition of “substantial risk of forfeiture.” It is the definition of substantial risk of forfeiture that will adversely impact tax-exempted employer’s deferred compensation arrangements. Based on the Notice, it appears that the revised definition of substantial risk of forfeiture will eliminate a number of design features, including the no-compete agreements and the rolling vesting flexibility. The IRS is simply saying, if you have a right to the compensation, you will be taxed at that time. They indicated in the Notice that a “rational participant” would not subject amounts such as current compensation to a substantial risk of forfeiture absent tax considerations. The Internal Revenue Service concluded that the taxpayer must therefore be “confident” that there is no real risk of forfeiture and is only attempting to avoid taxation.
Filling the Retirement GapSo with these new restrictions, how can not-for-profit organizations compete for top talent? Studies suggest that individuals will need 80% of their pre-retirement income to maintain their current lifestyle after retirement. Qualified retirement plans provide a tax-smart way to save for retirement, but qualified plans have limitations that prevent highly compensated individuals from reaching their retirement income goals. Those limitations have traditionally been overcome through the use of nonqualified plans. However, as discussed above, not-for-profit organizations cannot offer many of the retirement benefits available to corporate America. These issues bring up two important questions for not-for-profit entities.
Not-for-Profit Vehicles for “Filling the Retirement Gap”For many years, not-for-profit entities have found ways to compete with private practice and corporate America by offering benefits exclusively available to tax-exempt organizations (i.e., 457(f) plans) and additional benefits such as Split Dollar Life Insurance plans. However, recent regulations have retracted some advantages of both 457(f) and Split Dollar plans, and not-for-profit entities are looking for available alternatives.
457(f) PlansNot-for-profit entities have developed 457(f) plans to allow their key employees to defer their salaries and bonuses beyond the limits of 401(k)/403(b) plans. Contributions are made pre-tax and enjoy tax-deferred growth. These assets are subject to the claims of the organization’s creditors, and could be lost. As discussed above, once the participant vests and there is no longer a “substantial risk of forfeiture,” the participant is taxed. Although the recent passage of §409A does not discredit this vehicle completely, it has made 457(f) plans less attractive. The new guidelines limit the flexibility participants have in planning when they will have full access to their money, thus limiting their options with regard to efficient tax planning.
Split Dollar Life Insurance PlansIn its most common form, a Split Dollar plan offers the participant a life insurance policy paid for by the employer. The employer pays premiums into the policy, which the participant owns and for which the employee can name their own beneficiary. In doing so, the employer provides an “interest free loan” to the participant. The participant assigns the cash value in the policy to his employer as collateral until the loan is repaid or, in some cases, forgiven. At retirement or the participant’s death, the employer receives, out of the policy values or death proceeds, the amount equal to premiums paid. Under the old rules, the participant was required to recognize the value of the death benefit as income each year based on the “economic benefit cost,” which usually equaled the cost of one year term insurance—a very low cost to participant. Recent regulations have also changed the tax treatment of Split Dollar plans, characterizing the employer-paid-premiums as a loan, and taxing the employee on any foregone interest on that loan. A standard market interest rate is attached to the loan amount (total premiums paid) and the participant must pay taxes due each year based on the interest rate on the total loan balance. Therefore, each year the participant’s tax liability increases as the total premium increases. The key employees of many not-for-profit organizations currently hold policies under a Split Dollar design. How are they to be treated? There are essentially two options:
The Insured Security Option Plan (ISOP®)Many not-for-profits are exploring an alternative known as the ISOP® as a solution to the limited options available in 457(f) and Split Dollar plans (Chart I).
The ISOP®:
The ISOP® was designed to help the highly-compensated work toward tax and asset diversification and financial independence.
What Is the ISOP®?The ISOP® is an alternative that provides the opportunity for individuals to supplement their retirement income. It provides the power of pre-tax savings and tax-deferred growth, without the limits imposed by qualified plans. The ISOP® differs from a traditional nonqualified deferred compensation plan (i.e., 457(f)) in the sense that the participant’s contributions are made with after-tax dollars like in a Roth plan. This means that distributions from the ISOP® are non-taxable. By contrast, in the 457(f) plan, the participant pays no taxes up front, but pays them when they withdraw the money during retirement, which could be at a higher tax rate. During the accumulation phase, the ISOP® provides tax-deferred savings power through its unique funding strategy (Chart II). Participants defer the impact of taxes.
The ISOP® achieves its tax-advantaged status as a result of being powered by an institutionally-priced Variable Universal Life (VUL) insurance policy not generally available to individuals. “Institutionally priced” means that the policy’s charges are lower than would be the case in comparable retail VUL products. The VUL policy is owned by the participant and has 100% cash value (invested in the subaccounts) in year one with no-surrender charges. If your employer has a Split Dollar plan that they would like to terminate, they can do an IRC 1035 non-taxable exchange to the ISOP®. The ISOP® helps the participant defer the impact of their taxes by offering the participant a non-recourse “tax-replacement” policy loan to compensate for the taxes paid on the amount of any after-tax deposit (Chart III).
The loan is secured against the policy’s death benefit. The loan, and any associated interest, is simply deducted from the death benefit, assuming that the policy is held until death.
SummaryMany organizations are using both 457(f) plans and the ISOP® to develop a more powerful retirement planning strategy to help attract, retain, and reward the talent needed to compete. The strategy is to use the underlining qualified plans, such as the 403(b)/401(k), and then defer excess dollars to the 457(b) plan (Chart IV).
Once the deferrals hit the IRS limit ($15,500 for both plans), voluntary deferrals can go to the ISOP®. To help retain key employees, employer contributions can go into a 457(f) plan with a 3- to 5-year vesting schedule. Once participants vest, and therefore are taxed, those dollars can flow into the ISOP® too. The ISOP® can be an important part of a participant’s overall retirement planning strategy.
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