Deferred Compensation and Safe Harbor Plans

Companies are constantly looking for ways to recruit, retain and reward valued employees.

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Companies are constantly looking for ways to recruit, retain and reward valued employees. The benefits community has spent over 40 years assisting in compliance with regulatory rules — jumping through hoops to comply with qualified and nonqualified rules, ERISA and a miasma of bureaucratic roadblocks.

The Department of the Treasury issued final regulations addressing deferred compensation and safe harbor planning utilizing §§409A(d)(1), 457(e)11 and 31.3121(v)(2). These regulations set forth how plan sponsors can provide death benefits on a permissibly selective basis. Seehttp://bit.ly/2mitH38.

What is a Bona Fide Death Benefit Plan?

A bona fide death benefit plan is one that can stand alone or be integrated into an existing §409A plan. The death benefit plan uses a multidisciplinary platform following deferred compensation, welfare benefit plan structures with an actuarially determined current benefit provided for employees and independent contractors.

The participants are taxed on the economic benefit so long as the benefit is funded by the employer. A §409A plan is a nonqualified deferred compensation (see, 26 CFR1.409A, IRC 409A Examination Guidelines; http://bit.ly/2kHBlUc):

  • A plan sponsor must be a employer or service recipient (409A(1)(a));

  • A participant must be an employee or independent contractor of an employer (§1.409A-1(b)(1));

  • A 409A(d)(1) death benefit plan does not have to comply with risk of forfeiture or acceleration of income 409A requirements (IRC §4, Notice 2008-115);

  • Payments by the plan sponsor to fund a §409A(d)(1) death benefit plan are not taxable income nor deferred compensation to the participant. See, Office of Chief Counsel (OCC) Memorandum No. INFO 2003-0082 (Feb. 25, 2003). In that memo, the OCC interpreted Notice 88-68 to indicate the providing or accruing of the benefits is not a taxable event. It is only when the benefit provided to the participant is there a taxable or nontaxable event. Providing the benefit thru a §409A plan does not affect the taxation to the participant, that is addressed under other provisions of the law. The participant by the funding of the benefit is taxed on the Table 2001 rates as economic benefit. As the death benefit is the only benefit provided by participating in the plan under Treas. Reg. §1.31.3121 (v)(2)(iv)(C)(1), to the extent the benefit qualifies as life insurance under §101(a), it should not be subject to income tax as received by a beneficiary identified in the plan;

  • The plan may be elective or non-elective and a salary reduction or non-salary reduction plan (see, Treas. Reg. §1.31.3121(v)(2), Notice 1988-68, News release IR-88-96 June 9, 1988 citing Notice 87-13 Q25, 26); and

  • A §409A(d)(1) death benefit plan may be funded with life insurance (see, Reg. 147196-07 06-21-2016, Notice 2005-1).

Where Can It Be Used?

The benefit program can be provided to executives, professionals and independent contractors (“top hat” group) and service providers closely held and publicly held companies (see the proxy statement at left).

The plan sponsor can be providing services to any form of entity: the public, tax exempt entities, or state and local government organizations. The plan is deemed is a top hat plan and is available to management, highly compensated, professionals and independent contractors.

When Can It Be Used?

The benefits can be funded throughout the accounting period and within 75 days of year-end relating back to previous accounting periods, like similar plans. The commencement date is not tied into the beginning or end of any reporting period, which provides additional flexibility. Notice 87-13 Q-26 indicates “in the case of deferrals, §§409A and 457 applies to both elective and nonelective deferred compensation amounts.

In the case of deferrals that are at the election of the individual, it applies without regard to whether the deferral election is made prior to the year during which the employee performs the services to which the deferred amounts relate.”

See the Decision Tree below for assistance in determining when to use §409A.

Why Would an Employer Use This Plan?

While plan sponsors want to recruit, retain and reward highly prized management, professional and independent contractors, they also want to incur the least amount of liability and administration cost and confusion. Employers want to fund benefits for selected employees in the most economically efficient fashion (see, Notice 87-13,1987-1 CB432Q-26). The rules permit the funding by way of salary reduction in whole or in part so the non-profit employer can provide benefits with less financial responsibility that other comparative benefit plans.

The §§ 409A(d)(1) and457 (e)11 plan is different from any other plan currently being made available to sponsors as it provides a current welfare benefit to selected highly prized employees. Because of the ability to earmark the “top hat” qualified participant, the plan sponsor can permissibly provide a benefit to them and not provide that same benefit to other employees as a class or in a uniform amount.

How Does the Plan Work?

  • Employer and employee enter into mutually beneficial arrangement to provide death benefit during employment.

  • Employer funds the life insurance over agreed upon period.

  • Group arrangement uses a co-ownership format to provide coverage.

  • Plan sponsor deducts contribution.

  • Plan sponsor has no interest in cash values or death benefit.

  • Participant voluntarily requests wage reduction.

  • Participant is taxed on the economic benefit using Table 2001.

  • Program provides death benefit only coverage during the years of employment. No distributions other than death benefit allowed. Plan sponsor and participant is restricted in access.

  • Permanent life policies accrue on tax-free basis.

  • Policies are reviewed annually.

  • Economic benefit costs stop once contributions are no longer made.

  • No tax reporting upon termination of the benefit arrangement.

  • After termination of benefit plan, co-ownership arrangement is evaporated.

  • Insured may access cash values of policies, or use polices for their personal financial and estate planning.

Administration of the Plan

The death benefit plan is not a qualified plan nor deferred compensation or an ERISA plan. The DOL has specific administrative rules that require the following:

  • Name, address, including email address of plan administrator;

  • Permits, but does not require, plan name to be stated;

  • Does not require providing plan document; and

  • Requires a box to be checked if it is an amended notice.

The website to enroll is AskEBSA.DOL.gov/efile/Home/tophat. The plan administrator will electronically enroll the plan at the time of implementation and will provide proof of filing to the plan sponsor.

This planning tool integrated in to an existing plan or complementing existing benefit provides and economically efficient platform to provide benefits to valued employees.

*****

Section 409A Proxy Statement

“A deferred compensation plan must comply with IR Code §409A. These provisions define a non-qualified deferred compensation plan as any plan that provides for the deferral of compensation other than a qualified employer plan or any bona-fide vacation leave, sick leave, compensatory time, disability pay, or death benefit plan. The IRS provided the definition of “death benefit plan” on December 21, 2004 with the issuance of Notice 2005-1. The death benefit option complies with the definition as set forth in Treas. Reg. 1.31.3121(v) (2)-1(b) (4) (IV) (C).

The placement of the funds from the individual’s account to the death benefit plan should not be deemed a withdrawal as described in the deferred compensation rules. The death benefit plan was developed for the primary purpose of providing death benefits through life insurance.  The new rules target certain non-qualified deferred compensation plans and specifically excludes death benefit plans from further compliance requirements.“

(Click on the infographic below to enlarge image.)

The views expressed in the article are those of the authors and not necessarily the views of their clients or other attorneys in their firm.

Originally published on Corporate Counsel. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

Contributing Author

Lawrence L. Bell

Lawrence L. Bell, JD, LTM, CLU, ChFC, CFP®, AEP, a member of this newsletter’s Board of Editors, has served as Tax Bar liaison to the...

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