Psychology Today: Here To Help

Employment Contracts: Deferred Compensation

With rules tightening up on stock bonus and stock option plans, it makes sense for all parties to look into creative ways of achieving a win/win employment relationship in the area of deferred compensation.

Stephen Bruneau of Boston 128 Companies has written a great overview of some of the new, bewildering options currently available to companies interested in attracting competent senior level talent: 401 (k) Look-Alikes, Section 162 Plans, Reverse Split Dollar, Group Term Carve Outs, and Split Dollar.

Maryanne Peabody
Boston, MA
tel: 617/371-2990
e mail:

KEYWORDS: Corporate Sponsored Career Effectiveness Consulting, Valued Executive Career Coaching, retained search.


Creative Insurance Concepts When Negotiating Your Employment Contract

If you don't believe the impact of taxation may have an even greater effect on wealth accumulation than rate of return, take out your pocket calculator and run through the following steps. Assume you'd like to save $25,000 per annum in addition to traditional company benefit plans such as 401(k), profit sharing and pension. You are 40 years old and project to be in at least the 40% combined marginal tax bracket on earned income over the next 25 years and perhaps the 30% combined marginal tax bracket on unearned income (adjusting for higher taxes on dividends and interest, lower taxes on capital gains). If you attempt to save this money on your own, you immediately have your available investment reduced from gross income of $25,000 to net investable income of $15,000 after tax. Projecting a 10% gross return (dividends and capital gains) taxed at 30% over 25 years, your net return would yield an ending balance at age 65 of $972,699 (assumes 40 basis points investment management cost). At the same tax, earnings and management assumptions, if you liquidate the lump sum in 20 equal installments, you will have an annual income of $84,171 at the end of which time there will be no funds left.

Conversely, if the full $25,000 had been invested each year and allowed to accumulate at a tax free rate of 9.6% (net of same investment management cost) the balance at age 65 would be $2,537,793 and the resulting 20 year income would be $264,590. To achieve the same pot of capital at age 65 by investing your own $15,000 per annum (after taxes) one would have to achieve a gross, annual compounded return of 18.23% to equal $2,537,793! From that point forward, a gross return (net of management costs) of 13.71% would have to be achieved to equal a net annual retirement income of $264,590 per year for 20 years.

It seems odd that otherwise sophisticated, highly educated and competent executives have a greater fixation on the return on their investments as opposed to seeking out any possible tax advantage they can gain. The ideal time to focus on creating a tax advantage for yourself is during the employment compensation negotiation. As in any negotiation, a few well chosen words and a sound strategy can potentially make a difference of millions of dollars to your bottom line. If you are a sought after talent, many employers may be willing to consider funneling a portion of your compensation through a tax favored arrangement.

As the rules have tightened up on stock bonus and stock option plans, corporate sponsored life insurance has emerged as perhaps the predominant vehicle of choice. Changes to the Internal Revenue Code in recent years have made tax avoidance and deferral more difficult than ever to achieve. There are perhaps four or five vehicles currently available on an institutional basis where some sort of tax advantage might be gained. These vehicles would include municipal bonds, annuities, qualified plans and perhaps various forms of investment oriented, permanent life insurance.

Apart from the obvious involvement of businesses in qualified plans, it is most difficult to use either municipal bonds, annuities or other traditional investments to provide tax leverage for favored executives. The greatest reason for this dilemma is that most traditional investments are one dimensional. For example, it would be difficult or impossible to separate and/or divide the tax ramifications of a savings account, bond fund or annuity. Life insurance, on the other hand is multi-dimensional. Permanent life insurance is nothing more than a piece of property with inherent contractual rights potentially running to different parties. Those rights are divisible under the law and so are the tax ramifications. For instance, the corporation may own all of the living values associated with a permanent life insurance contract but endorse or assign death benefit only to run in favor of an executive's family as beneficiary. Alternatively, the reverse could be true and the executive could own the living values while endorsing death benefit to run in favor of a corporation as beneficiary for purposes of key person insurance coverage. A considerable body of revenue rulings, opinion letters and court cases has evolved over the past 30 years to delineate the rights, obligations and tax impact of various parties under the life insurance contract. This favorable environment is further enhanced by the unique set of tax rules regarding permanent life insurance and the fact that permanent insurance products themselves have metamorphosed over the past 15 years into very attractive, flexible, investment oriented products.

While no vehicle may allow for the completely tax free deposits, return and distribution highlighted in the second of my two introductory examples, a creatively designed permanent life insurance program in conjunction with your corporation may be about as close as you will be able to come. Unlike annuities, permanent life insurance is taxed on a living basis to the owner of the contract on a FIFO basis, (first in/first out). Effectively, this means you may make tax free withdrawals of your principal while earnings are left in the contract and continue to compound on a tax deferred basis. This simple yet unique aspect to life insurance taxation provides a substantial advantage over alternative strategies. Furthermore, additional funds may be accessed from the policy cash value via low net cost loans with a borrowing spread cost of between zero and two points available from many insurance companies. Generally, corporate owned cash values on key person policies are exempt from the accumulated earnings tax and recent tax law changes have relieved many corporations from the burden of alternative minimum tax. Lastly, properly designed, the death benefit from life insurance may be received by either corporate or individual beneficiaries on an income tax free basis. Put all these variables together and you might be surprised at the kind of win/win situation that could be negotiated between yourself and a prospective employer.

Product Background

Until the mid 1970's, the life insurance industry had changed little for 125 years. The advent of computerization changed all that in dramatic fashion. With the explosion of technology came the information age, highly educated consumers and the ability for insurance companies to manage increasingly complex and sophisticated products. The first major change was the "unbundling" of the insurance product into separate term and investment components. This new concept, known as "Universal Life", coincided in the early 80's with unprecedented high interest rates and billions of dollars of universal life were sold to take advantage of the internal, tax free build-up of living cash values. The product design essentially gave the consumer a choice of a level or decreasing term insurance component and featured internal, money market like returns as high as the mid teens during some years.

By the mid 1980's Congress imposed two sets of government guidelines designed to limit abuses. Within these guidelines (TEFRA and MEC) Congress chose to presence the unique tax advantages of the life insurance product, recognizing that this vehicle served public policy by encouraging the purchase of permanent life insurance protection. Protection that kept families off of government welfare roles, raised money to pay estate taxes, kept businesses and farms solvent, and workers employed.

As interest rates came down during the 1980's, some of the larger insurance companies developed a new product known as "Variable Life". Variable Life substituted a choice of sub-accounts in place of the single option of money market or portfolio rate driven cash values. Sub-account alternatives included stock, bond and fixed interest rate choices. Early versions of the product limited investment accounts to proprietary mutual funds and separate accounts of the offering insurance company. Generally speaking, premiums were fixed and had to be paid each year. Despite these drawbacks and higher expense loading, the concept of Variable Life was revolutionary, and offered the potential of substantially higher, tax deferred returns within the cash value of permanent life insurance products.

Today, a number of insurance companies have co-ventured the variable life product with outside, household name mutual funds. Consumer education and

market pressures have substantially reduced expense loading Many products offer significant flexibility of premium with no fixed payments required. Modern Variable Life products now make possible internal returns commensurate with the S&P 500 or other mutual fund products. The tax deferred, quasi tax free nature of this vehicle further magnifies any gain in positive growth years. For example, in times of double digit gain for the S&P 500 such as we've seen from 1982-1997 the tax savings may well be greater than the administrative, management and term costs of the product. In a down market the term and administrative cost of the product would have a further drag on investment performance, but to the extent you or your corporation values the term life insurance coverage, you have received a benefit for any cost incurred.

Traditional Deferred Compensation

Perhaps the most common use of life insurance for executives is to indirectly fund a deferred compensation plan. Under this non-qualified plan, the corporation sets aside a non-deductible contribution that is pre-tax from an employee standpoint. The amount of contribution can be a set figure, or a formula tied to sales, profits, longevity or any other variable important to the negotiating parties. Vesting is completely discretionary and not subject to ERISA rules. Growth can be tied to the same benchmark as the Variable Life mutual fund sub-account, for example the S&P 500 index. Permanent life insurance is one of the only vehicles that can be owned by a corporation and enjoy tax free growth. The corporation is owner, premium payer and beneficiary of the life insurance. Typically, they would offer the employee's beneficiary a taxable, continued salary arrangement as part of the employment contract in the event of pre-mature death. In the more likely event that the executive lives to retirement (or some earlier pay-out called for under the employment contract) the corporation takes tax free withdrawals and/or wash loans to reimburse themselves for the after tax cost of the then deductible, non-qualified deferred compensation payment to the executive. The plan continues to have a residual death benefit payable to the corporation that may ultimately reimburse the business for some or all of the cost of the plan. Commonly, public corporations have implemented this type of plan for multiple high level executives and have been able to say in their proxy statement that if the actuarial assumptions of the plan are met, the program will have no net cost to shareholders.

Relating this plan to our introductory examples, a corporation crediting $25,000 per year under the same assumptions would, in fact, accumulate $2,537,793 in the deferral account at the end of 25 years. The back-up funding vehicle of life insurance would have some lesser cash value due to the term and administrative costs inherent in the policy. A generic example of the 25th year cash value under the same assumptions might be around $2,000,000. If the corporation is in the 30% tax bracket and liquidates the deferral account in twenty equal installments (same return assumption), they would pay the executive $264,590 per year at a net after tax cost of $185,213 per year. Under these assumptions the corporation can easily access $185,213 per year, income tax free (current law) from the life insurance policy to achieve a zero net cost on an annual accounting basis while maintaining significant residual death benefit, payable to the corporation for purposes of cost recovery. An additional benefit for the corporation is that they could easily build in substantial pre-retirement, key person insurance, retaining a large net gain after the present value of after tax continued salary payments to the executive's family in the event of pre-retirement death. For the executive, in the 40% tax bracket, the net after tax retirement payment received would be $158,754 per year or almost double the $84,171 per year they would have received had they taken $25,000 per year for 25 years as additional compensation and attempted to invest on their own (same assumptions as introductory example).

Traditional Split Dollar

There are many variations of Split Dollar. In it's simplest form the corporation owns the policy, using the cash value investment choices as tax advantaged corporate accounts. The corporation would usually keep a portion of the death benefit for their own key person purposes while endorsing the bulk of death benefit to the executive's beneficiaries. The executive would pay a small tax on the deemed "economic benefit" of the coverage. This technique can provide millions of dollars in income tax free death benefit for the executive's family at minimal cost, protecting and securing the future for loved ones.

A more advanced form of Split Dollar has the executive owning the policy, controlling both the living cash values and death benefit. The corporation advances premiums through a technique essentially equivalent to an interest free loan, without application of the normal imputed interest rules. The cumulative corporate premiums are effectively a lien against the cash value of the policy and are repaid to the corporation upon plan termination or the employees death. The employee, once again, would either contribute a portion of the premium or pay a tax on the deemed economic benefit of the arrangement. This type of Split Dollar structure has been common practice for many years. In 1995, a low level IRS employee issued a case specific TAM (Technical Advice Memorandum # 9604001) suggesting the employee would owe income tax on the annual one year term cost on coverage payable to the employee's beneficiary and any annual cash value build-up in excess of the amount repayable to the employer.

Most professionals have discounted the validity of the TAM 9604001 feeling that Section 83 of the IRC (cited in the TAM) is not applicable to equity split dollar and that IRC Section 72 should supersede. IRC Section 72 is much more specific to the taxation of life insurance and allows for tax free cash value growth in an unsurrendered policy.

Reverse Split Dollar

A Split Dollar technique apparently not tainted by TAM #9604001 is Reverse Split Dollar. This design is ideal for smaller business situations where traditional deferred compensation might not be appropriate due to the possibility the business may not survive to honor the obligation of deferred payments during the executive's retirement. Reverse Split Dollar may also be the preferred methodology anytime it is mutually desirable to provide the executive with greater security and control over part of the growing account values.

In a Reverse Split Dollar arrangement the executive owns the permanent life insurance from inception and assigns a large portion of the death benefit to the corporation for key person purposes. The corporation pays an offsetting portion of the premium each year for the deemed "economic benefit" of the assigned death benefit. Many CPA's and tax attorneys feel it is acceptable accounting procedure for the corporation to pre-pay portions of the premium offset some years ahead in order to secure their interest in the policy. In the event of pre-mature surrender, the corporation is entitled to any balance in the pre-paid premium account, which has been carried as an asset on the balance sheet. The same is true upon death, whereby the corporation would receive the entire assigned death benefit in addition to any unearned premium in the pre-paid premium account. The executive is responsible for any balance of premium due and has an obligation to keep the policy in force under any and all circumstances so that the assignment of death benefit to the corporation will be honored. The corporation receives key person coverage on a talented employee for the duration of the assignment and pays exactly what that benefit is worth. Properly designed, the corporation can pay a significant portion of the premium with dollars that are not taxed to the employee. The employee/executive has a lower cost basis than if they had paid all premiums themselves, but when the corporate assignment expires the executive owns all cash values with no need of repayment to the corporation. At that point the executive could access a tax free flow of retirement income from the policy. Relating this option to our introductory examples, our generic Variable Life policy (same 10% gross return assumption) would generate a twenty year tax free retirement income of $185,213/year with residual cash values and death benefit at age 86 of $880,000 and $1,078,000 respectively. In this circumstance, the Reverse Split Dollar technique would generate a higher net retirement income for the executive than traditional deferred compensation while still providing valuable key person life insurance protection for the corporation. The primary trade-off for the executive has been minimal preretirement death benefit due to the corporate assignment. One possible remedy for this dilemma is to use part of the corporate key person coverage to fund a taxable, death benefit only, salary continuation plan for the executive's family. It should be noted that the death benefit received by the corporation under a Reverse Split Dollar assignment may be taxable income to the corporation if the insured is not an officer or shareholder. This apparent problem may be of minimal consequence, if, in fact, the taxable death benefit is washed through as deductible salary under a death benefit only salary continuation plan.

Section 162 Plan

A Section 162 Plan may be called for when the employer insists on an income tax deduction for plan funding. This approach also maximizes the executive's security since he or she owns all cash values, without vesting or restriction, from inception.

Under a Section 162 Plan the corporation pays the premium and deducts same. The executive pays the income tax due on the premium payment and has full, immediate control of the policy, including cash values and death benefit.

This approach enjoys the benefit of tax deferred growth in the cash value accounts but loses the advantage of tax leverage on the premium deposit amount unless the employer grosses up the contribution due to the income tax deduction.

Group Term Carve Out

Group Term Carve Out is a common perk for intermediate and large size companies with a significant group life insurance plan. The first $50,000 of group term cost are deductible to the corporation and not taxable to the executive. Coverage amounts in excess of $50,000 not only generate corporate cost but also create taxable income for the executive (IRS Table I). Alternatively, the executive may be paying the actual premium for excess amounts of group life coverage. Either way, a significant, probably increasing cost is being paid for term coverage that, statistically speaking, is unlikely to pay off before retirement and generally will expire without value at retirement.

There are several varieties of Group Term Carve Out. One way or another, since term costs are being paid anyway, Group Term Carve Out would replace the excess term coverage with a permanent policy. Through levelizing the term premium equivalent into a permanent policy it may be possible to carry the same coverage and create some residual value at retirement with an option for post retirement coverage. Alternatively, one party or the other could make additional premium advances to further fund the investment or cash value component of the policy without increasing the insurance.

401(k) Look-a-Like Plans

401(k) Look-a-Like Plans can be designed using any combination of the above techniques. The precise design would depend on a number of variables including age, risk tolerance, goals, time horizon, business type and form, cash flow, volatility, control issues, vesting, death benefit needs, tax brackets and more.

The name 401(k) Look-a-Like comes from the fact that, through the use of modern Variable Life insurance products, the executive can enjoy investment flexibility and choices similar to a true 401(k) plan. The combination of tax deferred growth of sub-accounts, possible tax free policy withdrawals and wash loans, and tax bracket leverage between individuals and businesses allows for similar, and in some cases, superior tax advantages as compared to a true 401(k) plan. From a practical standpoint, there is no dollar limit on what can be contributed to these plans as they are generally considered to be nonqualified.