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taxation of LI proceeds used to fund NQ plan


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It is my understanding that LI proceeds used to fund a NQ plan are exempt from income tax when paid to the employer and the proceeds are taxed as wages when paid to the beneficiary under the terms of the plan. Is there any way to avoid taxation, e.g. can the proceeds be paid to the employee's beneficiary or paid to an irrevocable life ins. trust for the employees beneficaries if the employer owns the contract?

mjb

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Guest EAKarno

Yes, have the employer endorse the death benefit to the employee allowing him or her to name the beneficiary. The death proceeds will then be tax-free to the beneficiary, however, the annual value of the term cost of the insurance protection will be taxable to the employee based upon IRS Table 2001. Moreover, if a trust is involved, there will be gift tax implications.

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Guest EAKarno

It is nothing more than endorsement split-dollar, which does not require that the employer retain any share of the proceeds. Still, in most cases there is more than enough COLI to fund the employee's promised death benefit so the employer would generally retain the balance.

The new split dollar regulations make it clear that any arrangement between an owner and non-owner of a life insurance contract is to be treated as a split-dollar arrangement if:

1. It is entered into in connection with performance of services and is not part of a Section 79 group-term arrangement;

2. The employer (or service recipient) pays, directly or indirectly, all or any portion of the premiums; and

3. Either the employee (or service provider) can designate the death benefit beneficiary, or has any interest in the cash value.

See Treasury Regulations Section 1.61-22(b)(2)

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EAKarno:

The original posting was how do you get insurance proceeds out tax-free from a nonqualified deferred compenstion plan?

Please explain how you can do that without changing the facts so that it involves a split dollar arrangement.

Also, please cite any authority that you are aware of that supports your position.

Kirk Maldonado

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A precise (but narrow) response to mbozek's post would be "no."

I would then go on to suggest that if the goal is to get the death benefit to the beneficiary tax-free, you can amend the NQ plan to eliminate the the death benefit and in its place set up a split-dollar endorsement.

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I think that the payment of the life ins proceeds by the employer to the ee's beneficiary is considered to be the payment of taxable income under IRC 61.

However, I dont understand how the payment of LI premiums by the employer under an endorsement split dollar policy where the employer has no interest in recovering any portion of the proceeds is not taxable to the employee. Reg. 1.61-2(d)(2)(ii)(a) provides that life insurance premiums paid by an employer on the life of an employee where the proceeds are payable to the employee's beneficiary are part of the gross income of the employee. Under the proposed SD regs under the above citation the employee is taxed on the payments by the employer to a SD policy where the employee is the owner to the extent vested, if the payments are not SD loans, but I have not reviewed the final regs.

mjb

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Guest EAKarno

Nonqualified plans are unfunded.

The fact that an insurance policy is held by a rabbi trust covering a nonqualified deferred compensation plan does not preclude use of the policy for other benefits if the trust is so amended.

The insurance policy is not a nonqualified plan asset -- there is no such thing, it is an asset of the employer that may be used to provide a death benefit payable by the carrier. Because the benefit is payable by the carrier rather than the employer, it will be tax-free under Section 101(a).

While this all may create a funded death benefit, so what?

Since the employee is not owner of the policy, he or she is only taxed on the economic benefit of current term protection based on Table 2001.

I don't know why this needs any citation of authority beyond the split dollar regulations, nevertheless, there is a ruling from the 1980's I believe that sanctioned the use of split-dollar policies in a rabbi trust to simultaneously, informally finance a nonqualified plan without triggering any economic benefit or constructive receipt.

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EAKarno:

This is how I understand the rules apply to LI which is paid to the bene of the employee:

1. If the employer owns the LI and is beneficiary under the NQDC, the proceeds paid to the employer are exempt from income taxation. The payment by the employer is taxes as income to the beneficary and the emplyer claims a deduction. This includes LI held in a Rabbi trust since the employer is the owner of the trust.

2. If the employer owns the LI policy outside of a SD plan and the employee designates the beneficary then the premiums will be taxed as income to the participant and the proceeds will not be taxed to the beneificiary.

3. If the employee owns the LI policy in a SD plan and the employer contributions to the LI policy are not SD loans then the employee is taxed on the premiums to the extent the employee is vested in the premiums and the proceeds will be exempt from income tax to the beneficary.

Cite: Final and prop. Reg. 1.61-2(d)(2)(a)(ii); IRC 101(a)

I dont see any authority in the regs to support your statement that the employee is taxed only on the economic value of the coverage if the employee is not the owner of the policy.

If the final SD regs have a different answer please let me know.

mjb

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Guest EAKarno

This is my last attempt at explaining a very widely accepted practice amongst executive benefits practitioners. For starters forget the rabbi trust, for tax purposes it is of no consequence.

The insurance policy is owned by the trust, and hence the employer. However, the employer may endorse ownership of some or all of the policy's death benefit to an employee and retain all other incidents of ownership. This is VERY COMMON, and widely referred to as non-equity endorsement split-dollar. The tax result of endorsing the death benefit is to tax the employee on the economic benefit of the one year term protection under Table 2001 -- the employer gets no deduction, however. By doing so the death benefit is tax-free to the beneficiary under Section 101(a). This has always been the case since RR 64-328 and remains so today under the new Regs.

The split-dollar arrangement has NOTHING to do with the deferred compensation because the deferred compensation plan is unfunded by definition. The COLI cash value in the split-dollar policy is a corporate asset and not a deferred compensation plan asset - notwithstanding the rabbi trust.

The fact that the death benefit is promised under the deferred compensation arrangement doesn't matter. Just think of the death benefit obligation as being settled by the split-dollar promise. The death benefit is now funded, but the deferred compensation element remains unchanged. Although covered by a single document, the deferral of compensation and any related welfare benefits such as a disability or death benefit are treated under separate regimes for both tax and ERISA purposes -- witness the application of new DOL welfare benefit regulations to disability provisions within a deferred compensation plan.

Another way to view this is to imagine that the disability provision under a deferral plan is covered by a disability insurance contract the cost of which is imputed into the income of the participant. Would there be ANY question that this benefit is tax-free to the participant upon his or her disability? It follows then that the exact same result must apply to a death benefit when the value of the death benefit coverage is imputed into income of the participant.

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  • 1 month later...

Not to beat a dead horse. The discussion have been very helpful- If in fact an endorsement of the death benefit is made to the employee who in turn may assign it to a trust(a transfer taxable event) Is the subsequesnt termination or lapsing of the endorement a taxable event to either the owner or non owner?. I have not seen any basis for it being a taxable event.

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This is my last attempt to explain a concept that is widely know and universally accepted in the employee benefits community.

A nonqualified deferred compensation plan is not the same thing as a split dollar life insurance policy. They are completely different arrangements and the terms for the two cannot be used interchangeably.

The topic of this thread relates to nonqualified deferred compensatio plans. Any references to split dollar life insurance are off the point and only serve to confuse the less-sophisticated readers.

If people want to change the topic of discussion to something that more suits their interests, they start a new thread, and not try to commandeer the discussion for their purposes.

Kirk Maldonado

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As Moderator, I'll simply point out that the poster asked, "...is there any way to avoid taxation.." which we should expect to broaden the scope of the replies.

This is a lively thread, I suspect readers have benefited by the different interpretations of what's in question here and whether you should view the facts as presenting NQDC issues, LI issues, or potentially both.

Good replies all.

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Guest hwhans

In response to the original question, the answer is "no" for practical reasons. First, a typical NQDC plan pays out for reasons other than death. In order to exempt the death benefit proceeds of LI from tax, the executive, at the very least would have to recognize current income on imputed premiums. Who would agree to that, especially if one plans on collecting at retirement. The tax cost of the premiums may never be recouped. Second, why should the death benefit under the LI policy offset the liability under the NQDC when the employee is paying for the LI coverage? If the executive dies, the beneficiaries would argue notwithstanding the insurer's payment that they are still entitled to a benefit under the NQDC plan. Who needs to go there.

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Guest wmacdonaldrcg

The responses on split dollar have been good, I would just add one additional concept. As many of you know, we have the patent on the ISOP concept. The ISOP would have the entire policy owned by a third party trust, which in turn would allow the death benefits to be paid tax free. The liability for the plan would be off the balance sheet of the company, and the participant would also have ERISA protection etc. See www.retirementcapital.com for more information on the concept.

William L. MacDonald

President & CEO

Retirement Capital Group

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