Workshop Overview. Deferred Compensation for Closely Held and Family Businesses

Transcription

1 Deferred Compensation for Closely Held and Family Businesses Presented By John Gephart, J.D., CLU Second Vice Present Ameritas Life Insurance Co. 1 Workshop Overview Part I Income Tax Nonqualified Deferred Compensation History Income Tax Basics 409A Multiple SROF Comparison COLI Best Practices 2 Workshop Overview Part II ERISA ERISA Overview Top Hat Exception Unfunded Select Group High Comp Mgmt. 3 1

2 Workshop Overview Part III Drafting Issues Income Tax Magic Words 409A Magic Words ERISA Magic Words IRS Audits IRS Correction Program 4 Workshop Overview Part IV Closely Held & Family Business Market Psychology of the Entrepreneur Closely Held vs. Publically Traded Non Family Key Employees Golden Handcuffs SERP is King 5 Workshop Overview Controlling Shareholder Deferrals? Phantom Stock Plans Rabbi Trusts? DC or DB Balance Sheet Product or Retail Insurance 6 2

3 Workshop Overview Part V The Perfect Sale Find out what they want and give it to them 409A in Context Tax Policy and the Closely Held Business Owner An Editorial Why the Perfect Sale? 7 Deferred Compensation A Brief History 1960 s Income shifting Revenue Ruling ERISA Transition Employee Benefit The American Jobs Creation Act 10/24/04 I.R.C. Section 409A 8 Demographics Boomers Longevity Social Security Savings Retired Planning and the Rule of 75 The Retirement Gap Gen X Worry! 9 3

4 Income Tax Basics Constructive Receipt Doctrine Rev. Rul Reg. Sec (a) income included in gross income for the taxable year in which actually or constructively received Reg. Sec (b) (dating back to the Revenue Act of 1918) taxable receipt of income occurs when credited to his account or set aside 10 Income Tax Basics Constructive Receipt Doctrine Right to draw upon it at any time Constructive receipt is avoided if taxpayer s right to the compensation is subject to substantial limitations or restrictions Agreement to defer entered into before services are rendered Employer s promise to pay is not secured in any way 11 Income Tax Basics Constructive Receipt Doctrine Substantial Risk of Forfeiture (SROF) Any asset acquired by employer is held as a general asset of the employer subject to the claims of the employer s general creditors IRC Section 451 codifies the Constructive Receipt doctrine 12 4

5 Income Tax Basics Economic Benefit Doctrine Employee receives income when he or she receives something other than cash that has a determinable, present economic value IRC Section 83 codifies the Economic Benefit Doctrine Property transferred by employer to employee in connection with performance of services 13 Income Tax Basics Economic Benefit Doctrine & SROF In a Funded Plan. Property is subject to a SROF if full enjoyment of the property is conditioned upon the future performance of substantial services by the employee. Or refraining from performing substantial services Vested = no SROF 14 Income Tax Basics Economic Benefit Doctrine & SROF In an Unfunded Plan. A properly designed NQDC plan, in compliance with Rev. Rul , (unfunded) is not subject to Section 83 vesting ok 15 5

6 Section 409A Section 885 of American Jobs Creation Act of 2004 signed by President Bush 10/22/04 Notice , extended good faith compliance to 12/31/06 Proposed Regulations issued 10/04/05 16 Section 409A Notice , Extended Good Faith Compliance to 12/31/07 Final Regulations Issued 4/10/07 Notice , Split dollar and 409A Notice , 457 and 409A Notice , Operational Correction Notice , Document Correction 17 Section 409A Effective Date 12/31/04 Nonqualified Deferred Compensation Plan any agreement, method or program that provides a legally binding right to Future compensation for current services. Reg. Section 1.409A 1 Covered Plans Salary Deferred, Salary Continuation, SERPs, DBO, 457(F), SARs 18 6

7 Section 409A Excluded Plans Qualified Plans, TDA s, 457(b), SEPs, SIMPLE, vacation, sick leave, death benefit, disability Grandfathering Plan in existence on 5/1/04 Earned and vested benefits Plan itself not grandfathered but earned and vested benefits within the plan Material Modification New or enhanced benefits as of 10/3/04 19 Section 409A Service Provider generally employee Service Recipient generally employer Independent Contractors if 70% or less of annual compensation not from the same employer exempt 20 Section 409A Plan Failure Penalty IRC Sec. 409A(a)(1) Gross Income Inclusion If at any time in a taxable year a deferred compensation plan Fails to Meet the requirements of 409A Documentary Or Fails to Operate in Accordance with 409A Operational All deferrals Under the plan for the taxable year and all preceding taxable years Shall be includable in income if not subject to a 409A SROF 21 7

8 Section 409A Plan Failure Penalty Income tax on failed deferrals Plus 20% excise tax on the amount required to be included in Gross Income Plus interest at the Underpayment Rate plus 1% Penalty applies to the participant/employee to whom the failure relates! 22 Section 409A New Plan in writing by 12/31 of year preceding performance of services and deferral New hire in existing plan within 30 days of eligibility Performance Based 6 months before service period for bonus ends 23 Section 409A Permissible Distributions Specified Time, Age or Fixed Schedule before any deferrals are made Haircut Trigger Out Financial Trigger Out Offshore Rabbi Trusts Out 24 8

9 Section 409A Acceptable Distribution Triggers Death Disability Unforeseeable Emergency Separation from Service Change in Ownership Effective Control Change in Ownership of Substantial Portion 25 Section 409A Subsequent change in Time and/or form of Payments Lump sum to installment or vice versa Retire at 70 rather than 65 Request Employer 12 months prior Minimum of 5 years beyond original event A 1. Foundational SROF Essentially Adopts Section 83 Vesting Used to Determine Inclusion in Income when NQDC Plan Fails to Meet the Requirements of 409A Not a Repeal of Rev. Rul Coordination with pre existing law Additive 27 9

10 409A 2. Controlling Shareholder SROF Controlling Shareholder No Substantial Risk Possible old IRS control over right argument Reminder Controlling Shareholder Risk only applied in Plans that Fail to meet the Requirements of 409A Controlling shareholder can defer in 409A compliant plan Also remember asset protection should be considered with owner deferrals Also, remember C Corp firewall required NO Passthrough A 3. Short Term Deferral SROF Loophole to 409A Plan benefits paid at the later of 2 1/2 months after the year in which services provided OR SROF removed SROF Sec. 83 = vesting 29 Let s Look at Other SROFs 457(f) SROF Pre 409A Basic risk plus Section 83 No vesting risk Pre retirement SROF post retirement SROF 30 10

11 Let s Look at Other SROFs 457(f) SROF Post 409A 409 A essentially eliminates Rolling SROF Consulting services Non Compete Haircuts 31 Let s Look at Other SROFs Notice /SROF on Steroids! Absent tax considerations a rational 457(f) participant would not defer current compensation if there was real possibility of forfeiture Thus salary deferrals in a 457(f) cannot be made subject to a substantial risk of forfeiture 32 Let s Look at Other SROFs Notice /SROF on Steroids! Employer funded SEFPs still ok Radical tax theory presumed subjective intent trumps four corners of document Strict liability extension of 409A s controlling shareholder SROF 33 11

12 Let s Look at Other SROFs Section 3121 SROF FICA/FUTA Wages deferred in our NQDC plan are subject to FICA and FUTA under special timing rule 34 Let s Look at Other SROFs Section 3121 SROF Amount deferred is considered wages at the later of the date the services are performed, or the employee s rights to such amounts are no longer subject to a SROF SROF = Section Let s Look at Other SROFs Section 457A SROF Deferrals involving foreign corporation Hedge fund of shore deferrals SROF = Section 83 conditioned upon the future performance of substantial services 36 12

13 COLI Best Practices Pension Protection Act Section 863 Janitor Insurance IRC Section 101(j) COLI Death Benefit in Excess of Premiums and Amounts Paid Taxable Exceptions (L) Proper Notice and Consent Prior to Issue (2) Death Benefit to Heirs 37 COLI Best Practices Death Benefit on Individual more than 12 months after Separation Taxable rules Highly Compensated under 414q or 105(h)(5) IRC Section 6039 Annual Report and Record Keeping Form 8925 Impact on NQDC Cost Recovery Design 38 ERISA Employee Retirement Income Security Act of 1974 Employee Welfare Benefit Plan covered Accident, Sickness, Death, DI, Vacation, etc. Employee Pension Benefit Plan Covered Retirement benefits or results in income deferral until retirement NQDC plans usually both covered 39 13

14 ERISA ERISA Exempt Church Plans Government plans 457(b) Independent contractors Excess benefit plans 40 ERISA Excess Benefit Plans Maintained Solely for the purpose of providing benefits for employees in excess of the Section 415 limits on qualified plans Need plan Need maxed out 41 ERISA Top hat exception An employer plan that is unfunded and offered to a select group of highly compensated or management employees Not exempt from ERISA but excepted from majority of ERISA Title I participation, vesting, funding, and fiduciary requirements 42 14

15 Top Hat Plans Primarily Select Group Highly Compensated Management Unfunded 43 Top Hat Plans Reporting and Disclosure DOL Letter Participation, Vesting, Funding Plan Fiduciary Claims Procedure Also Good Business 44 Nonqualified Deferred Compensation ERISA Employee Benefit Plans INCOME TAX Deferred Compensation Pension Benefit Plans Welfare Benefit Plans Exempt Plans Quasi-Exempt Church Excess Benefit Top Hat Constructive Receipt Theory IRC 451 Unfunded IRC 409A Economic Benefit Theory IRC 83 Vested 45 15

16 Drafting & Tax Traps Income Tax Magic Words Employer shall have no obligation to set aside, earmark, or entrust any fund or money with which to pay its obligations under this Agreement. The Executive, his beneficiaries, or any successor in interest to him shall be and remain simply a general creditor of the Employer in the same manner as any other creditor having a general claim for matured and unpaid compensation. 46 Drafting & Tax Traps Income Tax Magic Words The Employer, in its sole and absolute discretion, reserves the absolute right to purchase life insurance, annuities, mutual funds, disability income insurance, or any other investment or property it deems suitable to allow it to recover the cost, in whole, or in part, of providing benefits under this plan. The Employer shall be the sole owner and beneficiary of any such policy or policies, mutual funds, investments or property so acquired and shall possess and may exercise any and all incidents of ownership therein. 47 Drafting & Tax Traps Income Tax Magic Words Neither the Executive, his beneficiary or beneficiaries, heirs or assigns not any other person shall have not acquire any lien, right, title, or interest whatsoever in any policy or policies, mutual funds, investments or property so acquired

17 Drafting & Tax Traps Income Tax Magic Words Neither Executive, the surviving spouse not any other beneficiary under this Agreement shall have any power or right to transfer, assign, anticipate, hypothecate, mortgage, commute, modify or otherwise encumber in advance any of the benefits payable hereunder nor shall any of said benefits be subject to seizure for the payment of any debts, judgments, alimony or separate maintenance owed by the Executive or his beneficiary, nor be transferable by operation of law in the event of bankruptcy, insolvency, or otherwise. In the event Executive or any beneficiary attempts assignment, commutation, hypothecation, transfer or disposal of the benefits hereunder, the Employer s liabilities shall forthwith cease and terminate. 49 Drafting & Tax Traps ERISA Magic Words It is the intent of the parties hereto that this Agreement be considered an arrangement maintained primarily to provide supplemental retirement benefits for the Executive, as a member of a select group of management or highlycompensated employees of Employer. Executive is fully advised of the Employer s financial status and has had substantial input in the design and operation of this benefit plan 50 Drafting & Tax Traps ERISA Magic Words The Fiduciary of this plan shall be. The Fiduciary shall be responsible for the management, control, and administration of this Agreement as established herein. The Fiduciary may delegate to others certain aspects of the management and operation responsibilities of the plan, including the employment of advisors and the delegation of ministerial duties to qualified individuals 51 17

18 Drafting & Tax Traps IRS Audits IRS stepped up enforcement of 409A in 2009 Service began issuing Information Document Requests (IDRs) from taxpayers under audit IDRs typically include requests fro the following information 52 Drafting & Tax Traps IRS Audits Provide a list of all plans and arrangements that provide an employee with a legally binding right to compensation in one year, but payment in a subsequent year Provide the basis for the position that the arrangement(s) is not subject to Section 409A, e.g., the short term deferral rule, if applicable Identify the terms of the nonqualified deferred compensation plan s elections, including the deadline for the elections If a payment was deferred beyond the originally scheduled payment date, identify the terms, including the payment date and the rescheduled payment date 53 Drafting & Tax Traps IRS Audits Identify any acceleration in payments, including transition relief elections and deadlines, the original payment and actual payment dates Identify specified employees and any payments of nonqualified compensation made to specified employees within six months after separation of service Provide a description of the plan and each modification made to comply with Section 409A Identify and describe Section 409A violations and if such amounts were reported on a W 2 or Form

19 Drafting & Tax Traps IRS Audits Identify participation in any correction programs Provide certain information on stock options and SARs that may be subject to Section 409A Provide a description of any nonqualified deferred compensation funding resulting from a decline in the company s financial condition 55 Correction Programs The requirements of 409A are complex and businesses can easily violate its terms inadvertently IRS has provided correction programs for violations of documentary requirements (impermissible provisions) and operational requirements (impermissible actions) 56 Correction Programs Notice Notice addresses documentary failures of the plan If a noncompliant payment provision is corrected, but the noncompliant payment provision happens within one year of the correction, the service provider generally treats 50% of vested compensation as taxable under 409A After one year period has elapsed, the corrected provision will not be taxed under 409A 57 19

20 Correction Programs Notice Notice is the IRS s program for correcting inadvertent operational failures with reduced penalties A failure correctable under Notice , tax and penalties apply only to failure amount and not the entire plan 58 Correction Programs Notice Acceleration Failures Six month/30 day rule failures Prohibited deferral failures Stock option and stock appreciation right failures 59 Closely Held & Family Business Market Fiercely independent Self starter Line of sight Loathes government, red tape, taxes Lives to be Boss! 60 20

21 Closely Held & Family Business Market Public Company Outside Board of Directors Decision maker Human Resources Executive Benefit Committee Salary Reduction Employee Money SROF is a major concern Balance Sheet COLI Product 61 Closely Held and Family Business Market Private Company Controlled Board of Directors Decision Maker Owner/Entrepreneur SERP Employer Money SROF v. Gift Horse Balance Sheet Typically Non Issue A Non Issue Written agreement by 12/31 of prior year Haircuts Financial Triggers Offshore Rabbi Trusts Closely Held Who cares? 63 21

22 Plan Design Participant Selection Top Hat Group Identify amount of employer investment Defined Contribution avoid DB Custom Design Vesting Performance Based and Phantom Stock 64 Tax Policy & Closely Held Business Owner An Editorial 65 Why the Perfect Sale? 409A is a non issue Plan Audits Marketing as an Expert Professional Advisors Top Hat gives Entrepreneur bang for the buck Top Hat lets the Boss be Boss Deferred Compensation the Perfect Sale 66 22