Requirements to Avoid Current Taxation of SERP Benefits to the Executive

Kevin Wenke

Kevin Wenke

Owner at Decision Tree Financial. CFP. CLU

A business setting up a SERP may want to avoid current taxation of the SERP benefits to the executive. An important characteristic of SERPs is that they avoid current taxation of SERP benefits to the executive until the benefits are actually received by the him or her.

However, to ensure deferred (rather than current) taxation of the SERP benefit, certain requirements must be met:

  • A SERP plan must be “unfunded.”
  • It must meet the requirements of IRC § 409A.

Let’s briefly examine these requirements.

To Avoid Current Taxation of SERP Benefits To The Executive It Must Be Unfunded. A SERP is normally included in the category of nonqualified plans referred to as deferred compensation plans.

A deferred compensation plan may be a funded plan or an unfunded plan. Only an unfunded plan, however, will enable the participant to avoid current taxation of benefits.

funded plan is a plan to which specific assets are allocated to ensure that the promised benefit will be paid. The allocation of specific assets to guarantee payment of promised benefits will result in current taxation to the participating executive.

Although there may be cases in which assuring the benefit is of greater importance than tax-deferral, trying to avoid current taxation of SERP benefits to the executive is usually central to a SERPs success.

An unfunded plan is a plan whose benefits are supported by the general assets of the employer, rather than by a specific asset or assets that have been segregated from those general assets.

As such—because the assets supporting the plan are general assets—they are attachable by the employer’s creditors. Again, most SERPs are unfunded plans.

In most cases, unfunded deferred compensation plans, including SERPs, employ an informal funding approach under which a specific asset is acquired by the employer to support the benefits provided by the plan.

Although informal funding of a SERP may permit the use of virtually any type of investment to support the benefit—such as mutual funds, life insurance, etc.

Many organizations opt for life insurance as the informal funding vehicle for the reasons cited below and because the agreement may provide for benefits to be paid to survivors in the event of the executive’s death during the term of the agreement.

Informal funding simply means that an asset, attachable by the business’s creditors, has been purchased or acquired by the business to help it meet the future obligation of the plan’s promised benefits.

For many organizations, the best informal funding vehicle is life insurance. Life insurance offers two distinct advantages: favorable tax treatment and the opportunity for the employer to recover some or all of the costs of providing the promised SERP benefits.

Informal Funding of a SERP Using Life Insurance

Life insurance generally provides the most cost-effective method of informally funding a SERP, as long as the executive participant is insurable.

The life insurance policy used is a permanent policy owned by the employer who is also its premium payer and beneficiary. The executive participant in the plan has no policy rights.

A typical SERP provides benefits:

  • At the participant’s retirement from the employer’s service or at the end of a specified period
  • In the event of the participant’s disability occurring prior to retirement
  • To survivors upon the participant’s death occurring before retirement or before retirement benefits have been completely paid

During the period before the participant’s retirement, the employer normally makes regular premium payments for the life insurance policy that has been purchased to support the promised benefits.

The policy’s cash values grow on a tax-deferred basis, and the death benefits are immediately available upon the insured’s death income tax free to the business in order to provide any pre-retirement survivor benefits.

The survivor benefits could, of course, become payable almost immediately after the deferred compensation agreement is entered into.

The preretirement survivor benefits provided by deferred compensation plans may constitute a substantial financial obligation for the employer, and one that it might be reluctant to assume without the protection of life insurance coverage.

When the participant retires, the policy’s cash values can be accessed (but do not have to be) by the employer to provide the retirement payments.

At the executive’s eventual death, the life insurance policy’s death benefit is payable to the employer, enabling it to recover the costs for both the retirement benefits that were paid and the life insurance premiums in a tax favorable manor.

The life insurance policy selected by the employer as the informal funding vehicle should be a permanent policy for several reasons:

  • Permanent life insurance policies build cash values that can be accessed to help the employer pay retirement benefits or for any other purpose.
  • The cash value growth avoids current income taxation (i.e., the policy gain is tax-deferred unless and until it is distributed through a withdrawal that exceeds basis or upon surrender).
  • The permanent nature of the policy means that death benefits will be available to the employer to enable it to recover costs even if the executive lives for many years after retirement.

There is no requirement that any specific type of permanent policy be used. A SERP can be informally funded with traditional whole life, declared-rate universal life, indexed universal life, variable life, or variable universal life.

Many employers prefer universal life insurance policies, which permit flexible premium funding and enable the policyowner to withdraw funds from the policy’s cash value as well as take loans under the policy.

It is the unusual business whose cash flow doesn’t vary from time to time.

Because of that, the ability to make large premium payments when cash flow is high, smaller premium payments when it is low and no premium payments when cash flow is interrupted can be the critical component in selecting a universal life policy for SERP funding.

While it is true that a business may be able to fulfill its obligations under a SERP without purchasing a life insurance policy, the employer that buys a life policy to support its obligations actually satisfies several objectives. Its purchase guarantees that:

  • Funds will be available to meet the employer’s preretirement death benefit liability
  • Funds will be available to help provide retirement benefits
  • The employer can recover its costs

The purchase of a life insurance policy on the participant’s life also tends to provide a sense of security to the executive who is more assured of the business’s ability to meet its commitments under the plan.

Plan Must Meet IRC § 409A Requirements

To Avoid Current Taxation of SERP Benefits to the Executive. Federal tax law includes supplemental executive retirement plans in a broad category of plans referred to as “nonqualified deferred compensation plans.”

Under IRC § 409A, which became effective with respect to contributions and deferrals occurring on or after January 1, 2005, a SERP is considered a nonqualified deferred compensation plan that is an “employer non-account balance plan.”

The requirements imposed by IRC § 409A on SERPs in order to avoid current taxation of SERP benefits impact three principal areas:

  1. Plan documentation
  2. Permitted distributions
  3. Accelerations of payments

Plan Documentation

A plan subject to IRC § 409A must meet certain documentation requirements. Pursuant to those requirements and those of existing applicable law, the plan:

  • Must be in writing.
  • Must specify:
    • The amount of deferred compensation or the method for calculating it.
    • the time and form of payment.
  • Must contain the definitions from IRC § 409A that apply to the plan.
  • Must provide that participants have only the status of general unsecured creditors of the employer in bankruptcy.
  • Should specify that:
    • the employer contractually agrees to pay deferred amounts at a future date as additional compensation.
    • it is the intention of the parties that the plan be an unfunded plan for tax and ERISA purposes.

As is the case with respect to all legal documents, a SERP plan document should be drafted by appropriate legal counsel.

Permitted Distributions

Permitted distributions under the plan pursuant to IRC § 409A are distributions that are made upon the occurrence of one of the following:

  • The participant’s separation from service
  • The participant’s disability
  • The participant’s death
  • A fixed date or time specified in the plan
  • A change in the ownership or effective control of the company or its assets
  • An unforeseeable emergency15

Acceleration of Payments

Although plan distributions are normally permitted only as specified above, distributions from a SERP may be accelerated to:

  • Comply with a domestic relations order
  • Comply with a divestiture requirement in the case of a conflict of interest
  • Pay income taxes because a plan is not an eligible deferred compensation plan
  • Pay FICA or other employment taxes imposed on deferred compensation
  • Pay any amount included in income under IRC § 409A
  • Pay the amount due, based on an unforeseeable emergency
  • Terminate a participant’s entire interest in the plan or
  • Terminate the plan entirely

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