Individual life policies bought by employer...

[J Simmons]

Scenario: In 1993 the employer purchased individual insurance policies with a promise that each employee would get the policy when he or she retired. No plan documents, just policies and conversations. The employees expected to get the policy tax free on retirement and defer the income until they withdraw the cash from the policy.

Since there is no documentation, I am concerned that anything I do will be construed as a material modification that would trigger income and the 20% penalty. Any thoughts and suggestions will be greatly appreciated.

[Guest mjb]

How could the employees expect not to be taxed upon transfer of the policies when the tax law in effect in 1993 would treat the transfer of the LI as taxable under IRC 83. You need to see if the statute of frauds would require a written agreement signed by the employer to assign the policies in order to be a binding contract which would be subject to modification.

[Steelerfan]

A promise was made in 1993, a promise isn't a transfer of section 83 property. With no documentation other than the policies, isn't there an ERISA written plan issue (or is there an exception for life insurance)? What did the employees promise as consideration in return, any continued employment, etc.? If not, it may not be clear whether there is grandfathering if nothing has been earned and vested, or whether there is a contract, or whether a section 83 transfer would occur (what kind of an arrangement is this?).

As far as SOF, assuming there is a contract, from what I can remember, a contract that can be performed w/in one year is an exception, so depending on the meaning of "retirement', the lack of a writing may not be an issue, for example if retirement includes termination of employment for any reason then no writing is generally required, as with contracts of employment at will.

Sounds like you need either an army of lawyers or one very smart person

[jpod]

Forget about 409A; that is the least of the employer's worries here. The employer has been maintaining an ERISA pension plan, which probably is not a top hat plan, that is not in compliance with Title I of ERISA.

Best and simplest result: transfer the policies to the employees now and get rid of these compliance issues going forward. The employees can use the cash value to pay the withholding taxes. Shouldn't be an impermissible acceleration under 409A, because of the short-term deferral rule and the present existence of a substantial risk of forfeiture (i.e., the requirement that the employees remain until "retirement").

These are my off-the-cuff observations. ERISA counsel should be retained to study this carefully.

[Guest mjb]

1. There is a question of whether the purchase of a LI policy for an employee is a pension plan under ERISA. Also the plan may be exempted from ERISA as a Top Hat welfare plan. You need to review the case law and regs.

2. Under IRC 83 the employees will be taxed on the FMV of the LI policies when they are transferred to them regardless of what they thought the tax result would be.

3. my reference to the statute of frauds was only an example. As I noted many states require a written assignment of a LI policy in order to prevent fraud. If a written assignment is required then the employees have no rights to the policy until it is transferred.

[jpod]

mjb: Don't you think that an employer's promise to transfer cash or specific property to the employee upon termination of employment meets the ERISA definition of "pension plan?" In my view the fact that the property is LI is not relevant and does not convert the arrangement to a welfare plan, if that was your line of thinking.

[Steelerfan]

The more I thought about this strange arrangement, I thought the same thing jpod did. The employer created a plan that probably fits the definition of an ERISA pension plan--deferral of compensation to termination of employment, and should have satisfied the minimal ERISA filing requirement--statement to DOL, etc. There was clearly some kind of "promise" to make a payment in the future. But if I were the ER, I would argue there is no enforceable ERISA claim or contract. It's going to be the employer's word against the EEs. [see Gallione v. Flaherty [70 F 3d 724 (2d Cir 1995)] (The court concluded that the participants had no remedy under ERISA's enforcement provisions and then analyzed the top-hat plan under traditional contract theory. Finding no plan provision that vested the participants in their plan rights at any particular time, the court concluded that the employer had the right to terminate the top-hat plan at any time and that the participant's contract claim had no merit because the plan was terminated before the participant retired (the event that gave rise to benefit entitlements under the terms of the plan)).] But see Carr v. First Nationwide Bank [816 F Supp 1476 (ND Cal 1993)], a federal court ruled that participants in a top-hat plan have a federal ERISA common-law right to have their top-hat plan benefits protected. The court held that there exists under ERISA a "common law doctrine of unilateral contract" under which an employer-sponsor of a top-hat plan can unilaterally bind itself (as First Nationwide had) to provide a specific top-hat plan benefit and under which plan participants may sue under ERISA to enforce the employer-sponsor's unilateral promise.

There are alot of problems here so why not just sweep the 1993 promise under the rug and figure out how to come as close as possible to giving the employees what they "expected" to get by any means legal and possible to avoid potential ERISA issues? Obviously there was poor tax planning here and the employees will have to deal with any unintended tax consequences--it always comes down to careful communication when an ER messes up--or just gross them up--if they are executives they have a God given right to have their taxes paid for them.

[Mark Whitelaw]

A common "key-person" insurance sales idea was that in return for granting permission to be insured for the employer's benefit while employed, if the employee stayed to retirement, the company would bonus the policy to the person for post-retirement life insurance protection since their group coverage was going away. The policy would be minimum funded with just enough cash value at retirement to keep the policy alive to projected life expectancy wtih no addtional contributions. Often a "double bonus" was involved so the employee had no net costs of the bonus ... this double bonus was chosen as opposed to risking over-funding a policy on an employee that doesn't stay. They were portrayed as a bonus 162, not a serp, as the intent was extending life insurance protection, not cash. Up to the employer's attorney to determine the proper documentation. So, as Steelerfan suggested, bonus the contracts, pay an additional bonus for the taxes, and next time better document the arrangement.