Nonqualified Plans Credit Default Insurance

[austin3515]

The assets held in a nonqualified plan are subject to the claims of creditors in the event of a liquidation/bankruptcy. Do you know if there is a particular kind of insurance a company can acquire to protect the participants against the risk of default?

In this particular case, the participant has several hundred thousand dollars.

Note that we have a rabbi trust but of course that does not help alleviate the risk presented by the insolvency/bankruptcy of the plan sponsor.

[Mike Preston]

Not saying it can't be done, but care is required. I'd be worried about eliminating the risk of forfeiture and causing early taxation. Need a tax lawyer for this one.

[austin3515]

I don't see why that would be an issue? If they leave before meeting the service requirement they still forfeit? Does there also have to be a risk of losing all of your money if they go bankrupt?

[jpod]

It's not a "risk of forfeiture" issue. It is a question of whether the insurance creates an "economic benefit" that results in immediate taxation. I believe there was a lot of discussion years ago (probably when the TRA 86 comp limit when into effect for all qualified plans) leaning towards the conclusion that it was safe as long as the executive procured the insurance himself or herself with very little employer involvement, but (a) I may be "misremembering," and (b) I have no idea what the market is like for these products.

[Peter Gulia]

The Internal Revenue Service has recognized some carefully arranged purchases of insurance against an employer’s inability or failure to pay an obligation as not funding a deferred compensation plan’s promise. IRS Letter Rulings 93-44-038 (Aug. 2, 1993), 84-06-012 (Nov. 5, 1983). Among the described facts, the participant paid for the insurance. Also, the participant negotiated the insurance, and did so without involving the employer.

Because a letter ruling is not precedent, each taxpayer should get his, her, or its lawyer’s advice. Among other methods, a lawyer might evaluate changes in relevant law.

I remember this insurance being available in the 1980s from Bermuda-based insurers. The underwriting tightened in the 1990s.

[EBECatty]

I second (third?) the thought of treading very carefully here. In some limited cases the IRS will let this slide without resulting in a "funded" nonqualified deferred compensation plan, which results in taxation as soon as the money is funded and vested.

From what I recall, the IRS has approved the use of a corporate parent guarantee where a participant's plan is with a subsidiary. The employer buying insurance, a letter of credit, bond, funding an irrevocable trust (a "secular" trust), etc. would all result in the plan becoming "funded" and losing its tax-deferred status.

[Peter Gulia]

Again, a key to avoiding funding of the employer's unsecured promise and avoiding an economic benefit provided by the employer is that the participant buys the insurer's obligation.

There is a dance to how the participant's lawyer approaches the insurer and sets up the participant's insurance purchase.