Blog #114: Leveraged Deferred Compensation (Part 1)

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blog 114  leverage deferred compensation and taxes strategies image

 

Leveraged Deferred Compensation is used by highly compensated executives who want to reduce current taxable compensation (or forego scheduled increases) in exchange for tax free income in the future.  Not only is this plan extraordinarily efficient for an executive, the employer who utilizes it has a significantly lower charge to earnings than it otherwise would have if the compensation were not deferred.

Background

Designers of executive benefit plans for top earners are constantly in search of legitimate planning techniques that can defer the income tax on ordinary income.  One popular variation is called Deferred Compensation funded with corporate-owned life insurance in which an executive trades a portion of current compensation for the employer’s promise to make it up during retirement years when the executive will be -- presumably -- in a lower tax bracket.

There are three problems associated with this approach:

  • Limited vesting is allowed;
  • The employer may not be able to make good on its promise to pay;
  • Income tax is still due when the compensation is taken later.

All three problems can be solved if the deferred values are owned by the covered executive.  Normally, such ownership would trigger immediate taxation; however, InsMark’s Leveraged Deferred Compensation uses a technique in which the executive can own the plan’s values.  Three factors are involved:

  • The employer loans the executive the policy premiums using guidelines established in the final Split Dollar Regulations issued by the Treasury Department in 2003;
  • The policy benefits are collaterally assigned to the employer as security for the loans;
  • The executive (or his/her family) is entitled to the balance.

Plan Specifics

The owner of the policy is usually the insured executive who either reduces current compensation or declines a planned increase equal to the amount of the employer’s loans.

Interest on the loans is typically set to the Applicable Federal Rate established under IRC Section 7872 (also referred to throughout this Blog as the “AFR”).  Generally, the employer uses an unrelated compensation adjustment to assist with the cost of the loan interest.

So long as the loan interest rate paid by the executive equals or exceeds the Applicable Federal Rate, no further loan interest is imputed by the IRS on the transaction.  Generally, the loans are long-term loans (greater than 9 years), although mid-term loans (over 3 years but not over 9 years) or short-term loans (3 years or less) can be used.  Demand loans with annually changing interest rates can also be used; however, in most cases, term loans are preferred since interest rates can be tied down for longer periods of time.  With long-term loans, loan durations of 20 years or more can easily be accommodated.

Note:  Some commentators have made the recommendation that term loans be avoided.  In the case of below-market term loans, this is good advice -- due to the Original Issue Discount (“OID”) rules of IRC Sections 1271-1275.  If, however, the loans are interest-bearing term loans with interest at or above the AFR, the OID rules do not apply -- and the advantage of locking down favorable loan interest rates for long periods of time can be achieved without OID penalty.

The Plan’s Leverage for the Covered Executive

Through the voluntary compensation adjustment at the inception of the plan, the executive avoids income tax that would otherwise be due on the compensation.  So far, no income tax . . .

Assuming the plan is properly structured and designed, the executive-owned life insurance policy’s tax deferred cash values are not taxed as they accrue.  So far, no income tax . . .

Policy cash values can be accessed by the executive using policy loans which are not subject to income tax.  So far, no income tax . . .

At death, the policy proceeds payable to the executive’s beneficiaries avoid income tax.  So far, no income tax . . .

The Employer

If the employer is a profit-making organization, income tax is due on the compensation not paid to the executive.  In this case, if the employer then loans the executive an amount equal to the gross amount of compensation adjustment, it has an out-of-pocket cost equal to its income tax on that foregone compensation.

If the employer is a tax exempt entity, when the executive makes the compensation adjustment, the employer pays no taxes on the compensation not paid, and it can use all the resulting dollars for plan funding.

Case Study

Arthur Lee is being recruited as Chief Executive Officer of Ryder Manufacturing Co., Inc. (“Ryder”), a successful, privately-owned C corporation.  He has been offered a very generous five-year, no-cut, high six-figure compensation package which includes significant stock options.  He is interested in deferring $250,000 of his salary for five years, and he and the firm are considering a strategy called Leveraged Deferred Compensation.

Classic Deferred Compensation funded with corporate-owned life insurance could be a possible alternative, but Arthur does not like: 1) the lack of minimal pre-retirement vesting and 2) the retirement benefit is taxed as ordinary income.  As you will see, InsMark’s Leveraged Deferred Compensation can provide a much better alternative.

With this plan, Arthur agrees to a $250,000 reduction in compensation in each of the next five years.  In return, Ryder loans Arthur $250,000 a year for five years ($1,250,000) which he uses to fund a personally-owned $5.7 million indexed universal life (“IUL”) policy illustrated at 6.85%.  The policy is collaterally assigned to Ryder as security for the loans.

Below is a graphic of the policy values:

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Click here to review the details of the policy illustration.

Click here to review a Flow Chart of the Leveraged Deferred Compensation transaction.
Below is a graphic that illustrates Arthur’s costs and benefits:

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In his 45% marginal income tax bracket, the $250,000 compensation adjustment costs Arthur $137,500 a year for five years for a total of $687,500.  Arthur is scheduled to begin participating policy loans in year 21.  The first loan is planned at $1,400,000, of which $1,250,000 will be used to repay the outstanding split dollar loans due Ryder; the remaining $150,000 provides cash flow for Arthur during his first retirement year.  In subsequent retirement years, gradually increasing loans are scheduled which level out at $377,000 at age 85.  By his age 95, they total $8,723,541 in cumulative spendable cash flow for Arthur from age 65 to 95.  At that point, Arthur’s residual net cash value is $1,824,573 surrounded by a net death benefit of $2,076,566 for his heirs.

Click here to review the full reports for this Case Study.  The key summary report is on illustration Pages 7 and 8.  Be sure to notice in Column (4) on Page 7 that there is a negative charge to earnings to Ryder in all years.  (A negative indicates a credit to earnings.)  I have outlined several columns in red throughout the report relating to the effect on Ryder’s earnings.  You also need to examine carefully the Employer’s Net Payment Analysis on Page 13 and the Executive’s Net Payment Analysis on Page 15 to understand fully the makeup of each party’s contribution to the plan.

Severance

The plan includes an optional severance benefit for Arthur on Pages 17 and 18 whereby Ryder repays Arthur’s $1,250,000 compensation reduction ($250,000 x 5 years) in the event his employment ceases for any reason prior to retirement.  In the event of his prior death, the severance will be paid to his named beneficiaries.  Notice on Page 17 of the full report that this optional feature reverses the negative charge to earnings in Column (5) creating the charge to earnings noted in Column (6).  Should Ryder wish to maintain a negative charge to earnings in all years including the severance, it could do so by reducing the severance benefit from $1,250,000 to $900,000 ($150,000 x 5 years).

An Alternative Analysis

A key question Arthur might ask is this:  “Would I be better off just taking the additional $250,000 compensation for five years, paying the income tax on it of $112,500, and investing the remaining $137,500?” Let’s see . . .

Each of our executive benefit plans can export the executive’s share of costs and benefits to InsMark Source Data Storage.  This is accomplished by using this prompt in the lower right corner of any of our executive benefit plans when in edit mode:

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This routine stores that data in our Source Data storage files where it can be accessed by the InsMark Illustration System.  In Arthur’s case, I imported that data into Other Investments vs. Your Policy.

Let’s assume Arthur could invest the $137,500 annually for five years in an equity account earning the same 6.85% as the credited yield of the life insurance.  The indexes available for IUL generally don’t credit a dividend, so let’s include a 2.00% dividend and add that to the Equity Account growth rate for a total yield of 8.85%, 200 basis points greater than the IUL.  This will be compared to Arthur’s costs and benefits of his Leveraged Deferred Compensation arrangement.

Below is a graphic of the comparison:

blog-114-img-5-cumulative-payments-and-cumulative-after-tax-cash-flow-comparison

 

It’s not even close as the equity account collapses at Arthur’s age 77.  The IUL produces $6.2 million more in spendable retirement cash flow and contains over $1.8 million of residual cash value at age 95.

In order to match the IUL, the equity account would need a growth rate of 10.78% plus the 2.00% dividend for a total yield of 12.78% (593 basis points higher than the 6.85% of the IUL).

Click here to review the year-by-year details of the comparison.

Also of significant importance, the equity account has no life insurance death benefit associated with it.  If you factor in a premium for, say, 20-year level term insurance (you can do this in the Permanent vs. Term module in the InsMark Illustration System), the comparison looks even more dramatic.  I’ll illustrate this next week in Blog #115.

Note:  Leveraged Deferred Compensation works just as dramatically for a tax exempt organization.  (See Blog #40 for a Case Study involving a doctor employed by a tax exempt hospital.)

Conclusion

If you have clients in a position to attract high-end performers, Leveraged Deferred Compensation can be a showstopper.  Think of executives, of course, but also recruiting of professional athletes, college coaches, physicians and other professionals who have decided to join medical providers and, believe it or not, certain politicians like mayors and governors.

Other Illustrations in InsMark’s Leveraged Compensation System

The Leveraged Executive Bonus Plan uses loan-based split dollar to fund the income tax on the bonuses.

The Leveraged 401(k) Look-A-Like Plan uses a loan-based split dollar structure similar to the Leveraged Deferred Compensation discussed in this Blog.

Specimen Documents

Plans designed in our Leveraged Compensation Plan System require their own unique documentation, and specimen examples are included in Version 21.0 (or higher) in our cloud-based Documents On A Disk.  (See Key Employee Benefit Plans and Business Owner Benefit Plans.)

 

InsMark’s Digital Workbook Files

If you would like some help creating customized versions of the presentations in this Blog for your clients, watch the video below on how to download and use InsMark’s Digital Workbook Files.

Digital Workbook Files For This Blog

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Important Note #1:  The hypothetical life insurance illustrations associated with this Blog assumes the nonguaranteed values shown continue in all years.  This is not likely, and actual results may be more or less favorable.  Actual illustrations are not valid unless accompanied by a basic illustration from the issuing life insurance company.

Important Note #2:  Many of you are rightly concerned about the potential tax bomb in life insurance that can accidentally be triggered by a careless policyowner.  Click here to read Blog #51: Avoiding the Tax Bomb in Life Insurance.

Important Note #3:  The information in this Blog is for educational purposes only.  In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.

 

 

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