Business owners frequently use nonqualified deferred compensation (“NQDC”) plans to attract, retain and incentivize key employees. An NQDC plan, unlike a 401(k) plan or other qualified plan, cannot be funded by dedicated accounts owned by plan participants, so NQDC plan sponsors must find other ways to pay the promised benefits. In some cases, life insurance may be used. This article will describe some (but not all) of the federal income tax considerations of which attorneys should be aware when setting up an NQDC plan that uses life insurance as a funding method.
An NQDC plan is a plan under which an employee or other service provider has a legally binding right in one year to compensation that is, or may be payable, in a later taxable year, and which is not described by any of the qualified plan rules that allow for special tax treatment (e.g., Code Section 401(k) or 403(b)). There are different types of arrangements, but common to all is that the employee is paid a future amount taxable as ordinary income based on a formula or criteria set forth in a written plan.
Life Insurance for Informal Funding of Deferred Compensation Plans
Life insurance with an investment component (or “cash value”) can be a good fit for funding NQDC plan benefits due where benefit is payable (i) at the participant’s retirement from the employer’s service after a certain age; (ii) during the participant’s disability prior to retirement, and (iii) to survivors upon the participant’s death before retirement. These are plans where typically the ultimate benefit is based on a formula either as a set amount payable at a specific date in the future or as an amount determined by a formula (e.g., a percentage of compensation multiplied by the years of service at the payment date). When the benefit becomes payable, the policy cash value can be accessed by the employer to make the payments. Life insurance can also be used in an account balance type plan where the ultimate benefit is based on the value of the life insurance investment account at the payment date.
NQDC plans must be “unfunded” in order to prevent immediate taxation and application of most ERISA reporting and disclosure requirements, Thus, one drawback of any NQDC plan is that the employee participants are unsecured creditors of the employer, subject not only to its solvency and credit risks, but also to the employer’s willingness to fulfill its obligations. One way to assure plan participants that there is funding behind the promised benefit is for the employer to purchase and pay premiums for a life insurance policy on the life of the participant. The life insurance policy typically used is a permanent life insurance policy owned by the employer who is also the beneficiary. The employee has no rights in the policy.
Although an employer’s premium payments are not tax deductible, as long as certain conditions are met, life insurance has several federal income tax advantages (i) deferral of income taxation of deposits into policies and earnings thereon; (ii) a tax-free policy death benefit (assuming no transfer “for value” issue or state law insurable interest problem); (iii) deductible plan benefit payments; and (iv) tax-free withdrawal of policy value (as a return of basis or loans) to pay the benefit. Depending on the design of the NQDC plan and the performance of the investment portion of the policy, the employer may be able to recover the costs of the plan upon payment of the policy death benefit.
A life insurance policy funding an NQDC plan will typically be an “employer-owned life insurance contract” (“EOLI”) as defined in Code Section 101(j). In order for an employer to receive the life insurance death benefit proceeds free of federal income tax, the notice and consent requirements of Section 101(j)(4) must be met. The requirements of Code Section 101(j)(4) are that the insured (i) was an employee any time within 12 months of death, or, at the time the policy was issued, was a director, “highly compensated employee” or “highly compensated individual;” (ii) receives notice of the contract before it is issued and of the maximum face amount for which the employee could be insured; (iii) provides written consent to being insured and that the coverage may continue after the insured terminates employment; and (iv) provides written consent to the employer being designated as the beneficiary of policy death proceeds. Annual reporting of EOLI policies to the IRS is also required.
The death benefit is not tax-free to the employer if the policy in question is transferred “for value” as provided in Code Section 101(a)(2). In such case, a portion of the death benefit will be included in the employer’s taxable income. Treasury Regulation § 1.101-1(c) should be consulted in connection with the purchase of an employer with an EOLI and upon any sale or other transfer of a policy.
The advantageous tax treatment of policy withdrawals is lost if the EOLI is treated as a modified endowment contract (“MEC”) under Code Section 7702A. A policy will be treated as a MEC if premiums paid during the first seven contract years exceed certain standards. In addition, an additional 10% income tax is imposed on certain distributions from a MEC to the extent that the amounts received are includible in gross income.
If the employee has any ownership rights in the insurance policy (e.g. a right under the policy itself to designate a beneficiary), Treasury Regulations § 1.61-22(j) must be consulted to determine whether the arrangement is a split dollar arrangement. If so, the taxation of the employer and employee are determined under these regulations rather than under the rules described above. The definition of a split dollar arrangement is surprisingly broad and includes many premium sharing or lending arrangements.
State “insurable interest” laws should always be carefully considered prior to the use of life insurance. Generally, such laws require that the party purchasing a life insurance policy have an economic interest in the life of the insured. Many states have enacted legislation or have a body of case law specifying the circumstances and conditions under which an insurable interest will and will not be deemed to exist.
In summary, life insurance can be a valuable funding mechanism for a nonqualified deferred compensation plan but there are important federal income tax requirements that must be met in order to ensure that the taxation of the policy is consistent with the employer’s expectations.
 All references to the Code herein are to the Internal Revenue Code of 1986, as amended, and regulations thereunder.