The Use of Deferred Compensation Funds – Part 1

During the years when part of Mr. Key’s salary is being deferred, the corporation has use of these funds. By all rights they should be used by it for the benefit of Mr. Key and not the corporation. After all, if he hadn’t chosen to have it deferred, the money would have been paid out and therefore wouldn’t be available to the corporation. A common method of using these funds for the employee is to use the funds to buy insurance on the executive’s life.

Key Person Insurance. When a company takes out insurance on a key person, it is, in effect, indemnifying itself in the event he dies and his services are lost. When key person insurance is used in conjunction with a deferred compensation agreement, however, it is also a way for the company to finance the deferred compensation. Should Mr. Key die, the proceeds from the insurance policy can be used by the company to meet the obligations of his family. If he retires, the cash surrender value can be used to meet its responsibility to him.

This insurance will often completely finance the company’s obligation to Mr. Key and his family at no, or little, cost to the company. This is so because: (a) the premiums are paid for out of the after-tax amount that the salary increase would have cost the company; (b) the insurance proceeds are received tax-free; and (c) the benefits paid to Mr. Key or family are tax-deductible.

Thus the cost to Corporation Americana of, say, a $13,000 raise to Mr. Key would have been $8,710 after taxes. This amount more than pays the annual premium on a $200,000 paid-up-at-65 policy on him. If Mr. Key should die before retirement, let us say, at age 60, the company would get $241,400 (including dividend additions) of tax-free proceeds, or $157,920 more than it paid in premiums.

On that basis it would be possible for the corporation to pay out as much as $300,000 to Mr. Key’s family over an extended period without dipping into any reserves. The $300,000 that is paid out is tax-deductible at a 34 percent rate, so the actual cost to the corporation is only $198,000- just $43,400 less than the company got in insurance proceeds.

On the other hand, if Mr. Key does not die but retires at age 65, the cash surrender value of the policy, including the dividend additions, is about $182,000. This is enough for the company to fund a deferred payout of $20,000 a year for fifteen years after its tax deductions, at a cost of $16,000 more than it received when it cashed in the policy. Thus Mr. Key has guaranteed a total of $300,000 to himself or his family whether he lives to retirement or dies anytime prior to it.

These are figures that Mr. Key should certainly have well in mind when he sits down at the bargaining table.

Split Dollar Life Insurance. For over forty years, split dollar life insurance plans have been a commonly used executive benefit. Put simply, they are an arrangement wherein the employer and the employee split the cost of paying premiums, and split cash or death proceeds. Literally speaking, if the employee is the owner of the policy, the employer "loans" the bulk of the premium cost to the employee. In the past, this operated like an interest-free loan, and no interest was deemed to be paid by the employee. A collateral assignment creates an obligation that the policy cash values or death benefit be used to reimburse the employer for any premiums it has paid. If the employer is the owner of the policy, the employer endorses a portion of the death benefit to the employee for his control. With deferred compensation plans, these arrangements have been used to help fill in any gaps in the plan. They have also been used in Supplemental Executive Retirement Programs (SERPs) to provide supplemental retirement income.

There has been a sea change in the use of this technique for providing selective benefits for key employees and owners of businesses. For plans entered into after September 17, 2003, there are new regulations governing split dollar plans. For those established prior to September 18, 2003, material modifications of the plan will trigger the application of portions of the new rules. These are very complex rules, but we will try to offer an overview of their effect.