hen Congress enacted legislation restricting qualified retirement benefits, employers responded by creating nonqualified supplemental executive retirement plans (SERPs). These plans provide a tax-efficient way to restore benefits lost due to the restrictions in IRC sections 415 and 401(a)(17).
As Congress has continued to lower qualified plan limits, SERPs have become an increasingly important part of a corporate executive’s wealth accumulation strategy. Today, it’s common for more than 80% of an executive’s retirement benefits to be delivered through nonqualified plans.
Despite the benefits, many executives with sufficient retirement income are concerned about the tax inefficiency of SERPs as a wealth transfer vehicle. Multiple taxation and lost earnings can erode up to 85 cents of every dollar of SERP income transferred to an executive’s descendants. These taxes often include:
Many companies are implementing programs to help executives with this tax planning problem. One approach to maximize wealth for future generations and create liquidity to pay estate taxes is called a “SERP swap.” Also known as a preservation of wealth plan, a benefit exchange or an excess benefit swap, the arrangement allows participants to exchange heavily taxed retirement benefits for employer-funded life insurance contracts. The favorable tax treatment of life insurance can help produce significantly more wealth for future generations.
A SERP swap is a complicated financial, tax and accounting strategy. Experienced practitioners must help clients determine what benefits to exchange, plan mechanics and the optimal life insurance arrangement. It’s also important for financial managers to understand how these arrangements work so they can help their employers assess the consequences of offering SERP swaps to the company’s key executives.
THE PLAN MECHANICS
An executive’s financial position will determine the advisibility of his or her participation in a swap. A participant must be able to maintain a comfortable retirement without the entire SERP, since the decision to forfeit benefits is irrevocable. Companies often designate these income sources as eligible for a possible exchange:
To execute a swap, the company would structure a plan whereby a participant agrees—in any year before retirement—to forfeit all or a portion of future benefits. The company can spend its subsequent cost savings on annual insurance premiums, creating a cost-neutral transaction. A split-dollar agreement between the two parties divides ownership of the policy’s cash value and death proceeds. (Under most split-dollar insurance arrangements, when the employee dies the company receives an amount equal to the premiums it advanced; the employee’s beneficiary receives the remaining death benefit.) Participants generally assign their policy interest to an irrevocable trust to isolate death proceeds from estate taxes. Exhibit 1 shows the steps in a sample SERP swap.
Benefits to executive. A SERP swap facilitates the participant’s exchange of otherwise taxable income for tax-free insurance proceeds. The split-dollar arrangement with a trust minimizes gift and GST taxes, providing considerable leverage in transferring assets to future generations. Beneficiaries will get between 2 and 10 times more inheritance from the insurance proceeds than from the SERP. Exhibit 2 shows the results of a swap from the participant’s perspective.
Benefits to company. A SERP swap is structured to create no additional net present value cost to the company. The exchange also eliminates accrued and future compensation expenses, boosting net income, sometimes considerably, in the first and subsequent years. The reduction in compensation can also reduce proxy disclosures for corporate officers. Finally, the company should enjoy increased retention of top managers by offering a highly regarded benefit. Exhibit 3 shows the swap results from the company’s perspective.
Example. Mary Smith is a 50-year-old executive with a large company. After doing some retirement planning with her CPA, Mary decides she has accumulated enough deferred compensation that she probably will not need all of it for retirement income. She arranges with her company to swap $500,000 of her deferred compensation as well as $50,000 of her annual bonuses for the next five years.
After calculating its future cost savings and discounting it to a net present value, Mary’s company buys $9.5 million of survivorship life insurance on the lives of Mary and her husband. The company pays five annual premiums of $378,000 and retains the right to an equivalent share of the policy proceeds until Mary’s retirement. At retirement, Mary’s trust (the policy owner) withdraws money from the policy to reimburse the company for the premiums it paid. The entire transaction is projected to cost the same as the benefits Mary forfeited.
Before retirement, Mary makes an annual contribution to the plan, via a gift to the trust, equal to the pure insurance cost of her death benefit coverage. After Mary’s trust reimburses her employer upon her retirement, the trust holds the policy until both she and her spouse pass away. Assuming the policy cash values earn 8% annually and Mary and her spouse die at their life expectancy, the trust will receive—free of income and estate taxes—$20.6 million of death proceeds for Mary’s children. The deferred compensation would have provided only $3.1 million to Mary’s heirs after payment of all income, capital gains and transfer taxes (using the same 8% growth rate). As a result, the transaction will create an additional $17.5 million in wealth from tax savings.
Exhibit 4 summarizes the advantages and disadvantages of a SERP swap to both the participant and the company.
THE OPTIMAL INSURANCE ARRANGEMENT
Participants can choose from among many different types of insurance policies for a SERP swap, including general and separate account, single life and second-to-die (survivorship) and “street” and proprietary products.
General and separate account. General account life insurance invests policyholder cash values in the insurance carrier’s general asset portfolio. Policyholders earn a relatively safe, bond-like return and are general creditors of the insurance company. Many carriers also maintain a segregated asset account for variable, or “separate account,” policyholder cash values. The separate account includes numerous subaccounts, or investment portfolios run by professional money managers. While the cash values are insulated from the carrier’s general creditors, policyholders assume the investment risk of their chosen asset allocation. SERP swaps are typically funded with variable life insurance, since executives tend to want more control over the investment risk and asset allocation.
Single life and survivorship. A married SERP swap participant may choose to insure his or her spouse’s life as well, to reduce the policy’s insurance costs. In addition, death proceeds at the second death will coincide with the largest estate transfer costs, providing funds to help beneficiaries pay estate taxes on other assets.
Proprietary insurance products. When buying life insurance, executive and corporate insurance buyers generally have superior purchasing power. A SERP swap participant should be eligible for institutionally priced products designed specifically for this market. These products have lower insurance charges and lower loads than off-the-shelf products sold to the mass market.
Funding strategy. Funding the insurance contract at the maximum (seven-pay) premium level enhances performance by minimizing annual mortality costs. Depending on the participant’s age, this strategy usually produces higher death proceeds at life expectancy. Maximum funding also reduces (or eliminates) the company’s initial accounting expense from the insurance purchase. An appropriate insurance contract should have very high first-year cash values and no surrender charge.
A SERP swap offers the potential for significant tax savings. Likewise, the parties should carefully consider the risks of adverse taxation. Proper design can mitigate—and often eliminate—some of the tax risks.
A participant’s economic advantage in a SERP swap is predicated on two assumptions.
Taxation of exchange. The IRS could consider the benefit exchange a taxable event if it violates the doctrines of constructive receipt, economic benefit or assignment of income.
Constructive receipt. Under Treasury regulations section 1.451-1(a), constructive receipt is triggered if the SERP benefit is set aside for the employee or otherwise made available for withdrawal at any time. Most practitioners agree that an exchange does not give the executive the option of “cashing out” the SERP. Case law supports the tax-free exchange of one nonqualified benefit for another, although the IRS has not ruled specifically on a SERP swap exchange. [See Oates, 18 T.C. 570 (1952); Veit, 8 T.C. M919 (1949) and Martin, 96 T.C. 814 (1991).]
Economic benefit. The IRS might argue that the exchange confers an economic benefit on the executive if he or she subsequently enjoys non-forfeitable rights to a secured benefit. [See Minor, 772 f.2d 1472 (9th Cir. 1985) and revenue ruling 60-31.] It would seem, however, that an unsecured promise to pay premiums would not confer economic benefit.
The executive does recognize a separate, annual economic benefit from the company-paid insurance coverage until the agreement terminates. This amount is measured using the lower of the Treasury Department’s PS58 rates (US38 rates for a survivorship policy) or the carrier’s published one-year term insurance cost for standard risks.
Assignment of income. The executive would recognize taxable income if the exchange directed the SERP income to a third party. [See Hicks, 314 F.2d 180 (4th Cir. 1963).] It would appear, however, that the assignment-of-income theory does not apply to a swap because the SERP benefit is never paid to the executive or to his or her trust. The participant can choose to pay tax on the economic benefit or contribute it to the plan.
Taxation of split-dollar life insurance. The benefits of some SERP swaps depend in part on the IRS’s current position on the taxation of “equity” split-dollar arrangements. The IRS established its position in revenue ruling 64-328. Since this ruling almost 40 years ago, the general tax treatment of split-dollar has not changed, except in a few situations.
Equity split-dollar. The IRS issued technical advice memorandum (TAM) 9604001 concerning the taxation of equity split-dollar arrangements in 1996. “Equity” refers to policy cash value growth owned by the employee (or a trust). The TAM advised that the employee’s cash value represented taxable income under IRC section 83. The specific facts of this case led most practitioners to conclude that the TAM’s reasoning would not apply to a properly drafted split-dollar agreement.
Gift taxes. The annual economic benefit of insurance coverage held in trust is a taxable gift from the insured’s estate. Each donor may exclude the first $10,000 of every gift from tax annually and use an additional lifetime exemption ($675,000 in 2000, increasing to $1 million by 2006). An employee may use the annual exclusion provided the gifts are of a “present interest,” achieved by the grantor giving trust beneficiaries so-called Crummey rights of withdrawal. Thus it is often possible to exclude from gift tax all economic benefit amounts in a SERP swap. This is achieved only through proper plan and trust design, administration and documentation.
GST taxes. A SERP swap participant may establish an irrevocable trust for the sole benefit of grandchildren and subsequent generations. In addition to gift tax, annual economic benefit amounts are subject to an additional 55% GST tax on amounts in excess of each transferor’s $1,030,000 GST exemption. Like the gift tax, the first $10,000 of GST amounts are excluded before the transferor must use his or her lifetime exemption (subject to additional restrictions).
Interest deduction proration rule. A company owning cash value life insurance on the life of a “non-exempt” person loses part of its annual interest deduction based on the ratio of cash value to total interest expense under IRC section 264(f). Since an executive’s spouse is non-exempt, the proration rule applies to survivorship split-dollar contracts. Although it is generally minimal, financial managers should estimate the long-term impact of the disallowance so the company remains cost-neutral.
Companies should be aware of certain financial reporting consequences to offering SERP swaps to employees.
Settlement and curtailment of benefits. When a SERP swap participant forfeits a defined benefit pension, the employer is irrevocably released from its obligation. Under FASB Statement no. 88, Employers’ Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits, the swap should result in a net gain or loss associated with the obligation. The net gain or loss at settlement or surrender will be based on the employer’s specific situation. The settlement may require the company to immediately recognize or annually amortize the net gain or loss.
Reversal of deferred compensation liability. When a swap participant forfeits an existing deferred compensation balance, the company makes adjustments to reverse the accrued deferred compensation liability under APB Opinion no. 12, Omnibus Opinion—1967. Additionally, the company reverses the corresponding deferred tax asset carried on its books under FASB Statement no. 109, Accounting for Income Taxes.
Eliminating a defined benefit or defined contribution pension obligation generally creates net income (gain) at the time of swap. The company will also enjoy a reduction in future accrual expenses associated with the benefits that are exchanged.
Insurance value. FASB Technical Bulletin no. 85-4, Accounting for Purchases of Life Insurance, says the company should report as an asset the amount that can be realized under the insurance contract as of the financial statement date. Further, changes in the surrender value of the insurance contract are netted against premiums paid for the period to determine the net expense or income. The provisions of the split-dollar arrangement could affect application of the bulletin.
Postretirement benefits. A SERP swap plan design may include a postretirement annual bonus to the employee to alleviate the economic benefit cost as well as postretirement premium payments. Under FASB Statement no. 106, Employers’ Accounting for Postretirement Benefits Other Than Pensions, the company must accrue for the present value of both obligations before retirement.
A GOOD DEAL
A properly structured SERP swap can provide a tax-efficient alternative to nonqualified benefits to accommodate an executive’s wealth transfer strategy. The swap introduces important financial, tax and accounting considerations the company, potential participants and outside advisers must evaluate. Practitioners must help their clients evaluate the risks and design alternatives to separate attractive SERP swaps from risky arrangements. Financial managers must help their employers offer swaps that will benefit employees without costing the company additional money.