3. Non-Qualified Plans

Question 1

When are nonqualified plans used

Answer 1

-Key employees to avoid cost of covering broad group of employees
- executives beyond limits allowed in qualified plans
- customized benefits for executives

Question 2

When does corporation receive deduction

Answer 2

when the employees receive benefits, or otherwise when the funds are made available

Question 3

When are Benefits Forfeitable?

Answer 3

If the plan covers only independent contractors or a select group of management or highly compensated employees, benefits must be forfeitable in full at all times or subject to current taxation to the employee.

Question 4

Who must be covered in a nonqualified plan

Answer 4

may cover only independent contractors/ members of management/ highly compensated employees/ whoever corporation sees fit

Question 5

When are deferred compensation benefits used?

Answer 5

Provide supplemental retirement benefits to select group of executives: same reasons as above, plus a forced, automatic, and relatively painless investment program uses the employer’s tax savings to leverage future benefits.
-helps with 4 Rs: Recruit, retain, reward, retire
-when closely held corporation wants to attract and hold non shareholder employees

Question 6

Pros of deferred compensation benefits

Answer 6

• much more flexible, serves as golden handcuffs, can provide security to the executive through informal financing arrangements such as COLI/rabbi trust, deferral of employee taxes

Question 7

CONS of deferred compensation benefits

Answer 7

-employer’s tax deduction deferred until income is taxable to employee
- lack of security since unsecured promise to pay
-may not be confidential
-not all employers can benefit: eg S Corporations and partnerships., must last long enough, and tax-exempt/governmental orgs have more problems

Question 8

Types of Benefit and Contribution Formulas

Answer 8

Salary continuation formula,
Salary reduction formula,
Excess benefit plan, and
Stock appreciation rights.

Question 9

Salary Continuation Formula

Answer 9

type of non-elective nonqualified deferred compensation plan that provides a specified deferred amount payable in the future.

A nonqualified salary continuation plan for a selected group of executives with similar formulas for the entire group is sometimes referred to as a SERP, for supplemental executive retirement plans.

Question 10

Salary Reduction Formula

Answer 10

The amount deferred each year under a salary reduction formula is generally credited to the employee’s account under the plan. When benefits are due, the amount accumulated in this account determines the amount of payments, generally lump sum.
Can be purely accounting, so when benefits are due, employer can pay from current assets

Question 11

Excess Benefit Plan

Answer 11

makes up the difference between the percentage pay that top executives are allowed under Section 415 and that which rank, and file employees are allowed.
The maximum annual benefit a company can provide in a qualified defined benefit plan is the lesser of $265,000 (2023) or 100% of the participant’s compensation averaged over his three highest-earning consecutive years. For an employee who makes significantly more than this limit, an excess benefit plan can provide a greater percentage of pre-retirement income during retirement.

Question 12

Stock Appreciation Rights/Phantom Stock Formulas

Answer 12

A stock appreciation right (SAR) formula = company’s stock appreciation between plan adoption and payment:
-must not be <FMV of stock subject to the option at the time it’s granted
-The stock of the service recipient subject to the stock appreciation right is traded on an established securities market;
-Only such traded stock of the service recipient may be delivered in settlement of the stock appreciation right upon exercise; and
-The stock appreciation right does not include any feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the stock appreciation right.

Question 13

Taxation Considerations of a Funded or an Unfunded Plan

Answer 13

An unfunded plan is based on the employer’s promise to pay deferred benefits in the future and is not secured tax consequence is based on Doctrine of Constructive receipt
Funded plan falls under Economic Benefit Doctrine under Section 83 and is taxable when transferable or not at risk of being forfeited.

Question 14

Withdrawal provisions to avoid income taxes under doctrine of constructive receipt

Answer 14

-No haircut provisions: wide reasons due to termination of employment, death, disability or retirement at a percentage penalty
-Suspension of participation provision: suspends participation for 6 months after withdrawal of money
- Hardship withdrawal provision: withdrawals upon events that are not within the employee’s control, can be broad as long as it provides a significant limitation or restriction on the employee’s ability to gain access to the plan funds

Question 15

Funded versus Unfunded Plans

Answer 15

plan is formally funded if the employer has set aside money or property to pay plan benefits through some means that restricts access to the fund by the employer’s creditors. => taxable to employee at time employee’s rights become substantially invested. subject to ERISA vesting and fiduciary requirements (at least 3 yrs/2-6 yr schedule)

If the fund is accessible to creditors, then deemed unfunded for tax purposes

Question 16

Financing approaches to increase benefit security

Answer 16

Reserve account maintained by employer
Employer reserve account with employee investment direction
Corporate-owned life insurance: Informally funding a nonqualified deferred compensation plan with life insurance is common because the cash value buildup is tax-deferred.
Rabbi trust
Third-party guarantees

Question 17

Rabbi Trust

Answer 17

trust set up to hold property used for financing a deferred compensation plan, where the funds set aside are subject to the employer’s creditors and does not constitute formal funding for tax purposes

Question 18

Third-party Guarantees

Answer 18

if the employee, independently of the employer, obtains a third-party guarantee, then not considered funded

Question 19

Constructive Receipt tax implications

Answer 19

an amount is treated as received if it is credited to the employee’s account, set aside, or otherwise made available.

Constructive receipt does not occur if the employee’s control over the receipt is subject to a substantial limitation or restriction.

Question 20

Economic Benefit tax implications

Answer 20

current economic benefit to an employee can result in current taxation
Does not usually affect affect unfunded plans, and almost all nonqualified deferred compensation plans are unfunded.

Question 21

Income Taxation of Benefits and Contributions

Answer 21

Employees must pay ordinary income tax on benefits from unfunded nonqualified deferred compensation plans in the first year in which the benefit is actually or constructively received.

Question 22

Social Security (FICA) Taxes

Answer 22

-OASDI capped at $160,200
-Medicare tax of 1.45% has no limit
- Net investment income tax of 3.8% + additional .9%Medicare applied to MAGI >$200,000/$250,000MFJ

Question 23

Federal Estate tax treatment of death payment

Answer 23

commuted value of payments made to the employee’s beneficiary are included in the employee’s gross estate, but income tax deduction is allocated to the recipient of that income for the additional estate tax the inclusion generated; and in the case of spouse, unlimited marital deduction eliminates federal estate tax

Death Benefit Only (DBO) plans where decedent does not have a right to benefit before death, may be appropriate for employees with substantial federal estate taxes

Question 24

Taxation of Employer

Answer 24

For NQ deferred comp plan, employer does not receive tax deduction until its tax year/when includable in employee’s taxable income:
-for unfunded, taxed when constructively received
-for funded, year when substantially vested

Question 25

ERISA requirements

Answer 25

Two types of nonqualified deferred compensation plans are eligible for at least partial exemptions from the ERISA requirements.

Unfunded excess benefit plan: designed solely to supplement the qualified retirement benefits limited in amount by Code Section 415, is not subject to any ERISA requirements.

Top-hat plan: Under ERISA, if a nonqualified plan is unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees, the plan is exempt from all provisions of ERISA except for the reporting and disclosure requirements, and ERISA’s administrative and enforcement provisions

Question 26

Supplemental Executive Retirement Plans (SERPS)

Answer 26

nonqualified retirement plan that provides retirement benefits to selected employees only, with benefits that can be set at any level and can be paid for life/set years

-provides flat amount per year to participating employees, equal to the difference between full amount under qualified retirement benefit formula and actual qualified plan + Social Security retirement benefits

Question 27

Target SERP

Answer 27

seeks to replace retirement benefits lost by ERISA, such as imposed limits, and counteract the Social Security benefit bias, and employer would pay the difference between target retirement benefit (percentage x final pay) and qualified plan + Social Security retirement benefits

Question 28

Disadvantages of SERP

Answer 28

-employer can’t take income tax deductions until the amounts are constructively received and assets aren’t secure/are subject to creditors

Question 29

SERP plan design

Answer 29

• Employer signs written agreement to pay annual amounts beginning at retirement and buys a life insurance policy on covered participant
  -Employer makes benefit payments to employees at retirement, which are tax deductible to employer, but ordinary income for employee
  -Employer surrenders/borrows/withdraws funds from insurance to pay for benefits and will recoup some/all of plan costs @ participant’s death, as well as the opportunity cost of funding the contract
  -Survivor benefits would be paid to the participant’s designated beneficiary if the participant dies before retiring

Question 30

SERP funding

Answer 30

Although it can’t be formally funded, it’s good accounting practice to set aside funds for accruing benefits in the plan that are subject to creditors

Face amount of insurance coverage is determined by:
- employer’s after-tax costs of each participant’s retirement benefits
-premium funding requirements
-PV of survivor benefits if preferred
-Cost/Time value of money

Question 31

Tax implications

Answer 31

properly drafted deferred compensation, SERP or incentive compensation agreement should result in no income tax obligations to the employee during the deferral period.
Payments are treated as ordinary income to the employee when the employee actually or constructively receives them
If the promise to pay is secured, eg interest in assets/other media like life insurance used to fund the agreement, then the employee is taxed on economic benefit of the security interest

• Income is not constructively received if it is subject to a substantial risk of forfeiture
• The agreement was entered into before the compensation was earned, and
  The employer’s promise to pay is unsecured.

If death occurred during the deferral period, the present value of the future payments would be included in the decedent’s gross estate if the deceased employee had an enforceable right in the future to receive post-employment benefits. If the plan did not provide such post-employment benefits, any payments made to the named beneficiary may not be included in the gross estate. Also, if the payment of survivor benefits is optional on the part of the employer, they escape inclusion in the gross estate.

Question 32

The employer is the owner and beneficiary of the life insurance policies it purchases for participants in the SERP plan. T/F

Answer 32

True, An employer purchases life insurance for each plan participant to informally fund the plan. The employer policies are purchased, owned, and payable to the employer.

Question 33

Split Dollar Life Insurance

Answer 33

Arrangement between employer and employee to split costs and benefits of a life insurance policy (premiums, death benefits and/or cash values); based on Endorsement method:
-Split Dollar Endorsement: employer own policy and cash value (gets enough death benefit to pay back costs with balance going to the employee)
-Equity Split Dollar Method: rarely viable as any payments by employee towards premiums will be taxable even for employee

Relationship between owner and non-owner will dictate whether economic benefit is compensation, dividend or gift. Employees report as compensation and trusts report on federal gift tax return

Under “loan regime” employee is the owner of contract from inception and would enjoy normal tax benefits. Employer is deemed making loan to employee where loan must be repaid or forgiven and treated as compensation or dividend, assuming policy is not a MEC (treated as ordinary income and subject to 10% penalty if employee <59)
To determine economic benefit, interest may be imputed on outstanding loan balances using Applicable Federal Rate (AFR)

Question 34

When to use Split Dollar Plan

Answer 34

Cost effective life insurance preretirement death benefits, fringe benefits and to help shareholder employees:
-life insurance benefit at low cost and low outlay to the executive 30-60s
-a preretirement death benefit for an employee is a major objective/used as an alternative to an insurance-financed nonqualified deferred compensation plan.
-selective executive fringe benefit, the “loan regime” approach to split dollar can be an attractive option in a low interest rate environment
-easier for shareholder-employees to finance a buyout of stock under a cross purchase buy-sell agreement, or make it possible for non-stockholding employees to effect a one-way stock purchase at an existing shareholder’s death

Question 35

Pros of Split Dollar Plans

Answer 35

allows an executive to receive a benefit of current value, (life insurance coverage) using employer funds, with reduced cost to the executive.
Under the new regulations, most employee owned split dollar life policies would have the employer pay some or all of the premiums under an “interest-free” loan approach

Question 36

Cons of Split Dollar Plans

Answer 36

If the employer relinquishes the rights to the policy, there will be a taxable event at that time to the employee.

The employer receives no current tax deduction for its share of premium payments under the split dollar plan
The employee must pay income taxes each year on the current cost of life insurance protection under the plan, less any premiums paid by the employee.

must remain in effect for a reasonably long time, that is 10 to 20 years

Question 37

ERISA Requirements

Answer 37

considered an employee welfare benefit plan and is subject to the ERISA rules applicable to such plans; but most qualify for exception using summary plan description (SPD) requirement, if it is an insured plan maintained for a select group of management or highly compensated employees and file form 5500

Question 38

Stock Options

Answer 38

formal, written offers to sell stock at a specified price, within specified time limits, usually 10 years, whereby tax is deferred until stock is purchased later

Question 39

NQ Stock Option

Answer 39

purchase shares @ stated option price for a given time (10) years and normally equals 100% of stock’s FMV on grant date, but there could be discount or premium. Vest 1-4 years, though may be shortened if terminated before exercise. NQSO can be exercised by cash payment or tendering previously owned shares, depending on plan terms

If option does not have ascertainable FMV, not considered taxable income. Year stock is purchased = taxable compensation

If grant has value, then there’s taxable compensation income/ Amount=bargain element

May be gifted/transferred, gifter should do so asap to keep value as low as possible

Considered vested if able to transfer stock without restrictions or can keep in the event of termination/leaving company

Appreciation taxed as ordinary income + FICA, so many exercise early and hold for LTCG treatment

Question 40

Section 409A

Answer 40

regulations regarding nonqualified deferred compensation plans, such as ISO and NQSO- determines whether @ grant date FMV<exercise price and is considered taxable income

Exceptions to deferrals not subject to 409A:
- 2.5 months from end of 1st taxable yr when there’s no longer substantial risk of forfeiture
-payment no later than 15th day of 3rd month following later of end of service provider OR service recipient’s taxable year

-plan distributions permitted in event of separation from service, disability, death, specified time pursuant to a fixed schedule, a change in employer, or an unforeseeable emergency

Stock appreciation right will not constitute deferral if:
-SAR exercise price must never be <FMV on grant date / not discounted
- stock is traded on an established securities market and is received at settlement
-does not include feature allowing deferral other than deferral of recognition of income until the exercise of the right.

Penalties for non compliance= interest @underpayment rate + 1%
and additional tax = 20% compensation to be included in gross income

Question 41

Incentive Stock Option

Answer 41

tax-favored plan for compensating executives by granting options to buy company stock. If it meets Revenue Code Section 422 requirements, the executive is taxed when purchased stock is sold

PROS:
Provides greater deferral of taxes than NQSO. Income from sale may be eligible for preferential cap gains treatment.
Little/no out of pocket cost to company

CONS:
-Corporation does not receive tax deduction
-must meet Code Section 422 and related provisions
-exercised price must be at least FMV of when granted
-may incur AMT liability

Section 422 stipulates:
-Only first $100,000 worth of ISO stock granted is entitled to favorable ISO treatment
-exercised w/in 10 years
-employee
-held for at least 2 years after grant and one year from date of transfer (except in case of death)
-not transferable (except by will/disposition) and only exercisable by recipient
-Corp stockholders must approve ISO plan within 12 months time of adoption by board of directors
-Exercise price must be >/= FMX on date granted
- May not be granted to anyone who owns >10% unless the term is limited to get more than 5%

In case of AMT, basis will be increased by amount included in income

Question 42

Planning Strategies for ISO and NQSO

Answer 42

many people will benefit from exercising their ISOs and NQSOs and holding for at least a year to take advantage of the long-term capital gain treatment.

Question 43

83(b) Election of Gross Income

Answer 43

elect to pay the tax upon the exercise of stock options in which they are not yet vested. The major risk with an 83(b) election is that if the stock becomes valueless, the exercise cost and any tax paid is lost. The money at risk in an 83(b) election is equal to the exercise price times the number of shares. An individual may use the 83(b) election because he or she wants to avoid paying a large tax bill at the time of exercise.

Question 44

Cashless Exercise of Options

Answer 44

executives who have NQSOs and want to sell and exercise all or enough of the shares to cover the exercise costs, which include any transaction fees or commissions, taxes, and the strike price.
-“sell-all” case, the executive has cash left over after paying all the applicable costs
- “sell-to-cover” case, the executive still retains the remaining shares.

Since sale and exercise occurs at the same time, this would result in a disqualifying disposition for ISO, which would negate tax privileges

Question 45

Chairman and owner of Winger Corporation, Jack Winger, would like to reward Denise for her hard work and perseverance. In 2020, she was granted non-qualified stock options of 1,000 shares of the company stock at $20 per share, the market value for the shares that year. In 2021, Denise purchases 500 shares for a total of $10,000. If the fair market value of the shares at exercise is $13,000, what is the regular income tax treatment of Denise’s purchase for 2021?

Answer 45

Upon exercise of nonqualified stock options the “bargain element,” the difference between the exercise price and the fair market value, is recognized as ordinary income: Denise must recognize ordinary income of $3,000.

Question 46

Employee Stock Purchase Plan (ESPP) / 423 Plan

Answer 46

-Deductions in salary between 3-27 months, usually 15% less than market price
Tax-qualified under Section 423
Requirements:
-must be written plan approved by stockholders
-granted only to employees >2yrs, not HCE/KE, not part time/seasonal
- must be held for at least 2 yrs from grant and one yr exercise
- option price must not be less than 85% of FMV on grant or exercise date
- if option price >=85%, then have 5 years from grant date to exercise; otherwise 27 months
-max of $25,000 calendar year

Question 47

Tax treatment of ESPP

Answer 47

-No AMT
-ordinary income on discounted amount (15%), balance is taxed at capital gain

Question 48

Phantom stock

Answer 48

-allows employer to offer “equity” in the business to the employee without any cash outlay
-value=full value of underlying stock and settled in cash and/or stock with SD/termination/event fixed in advance (beyond employee’s control)
-No taxation until benefit is available/units are paid. Employer can take deduction

Question 49

Loans to Executives

Answer 49

Cash needs in case of mortgage/bridge loan/college tuition/purchase of employer’s stock through purchase plan/medical needs for family, divorce settlement, LI/car/vacation home

PROS:
-Favorable loan rates, only need to pay admin+int

CONS:
-increased admin costs for employer (determining whether loan should be granted, monitoring and advising) and bears risk of default
- AFR compounded semiannually, taxable to employer
-Truth in Lending requirements
https://learn.bostonifi.com/content/course/203/lesson/1196/content/28894

Question 50

Which nonqualified plan typically uses generally uses a non-elective defined benefit type of formula to calculate the benefit amount?

Answer 50

Salary continuation generally refers to a type of non-elective nonqualified deferred compensation plan that provides a specified deferred amount payable in the future. A salary continuation formula generally uses a defined benefit type of formula to calculate the benefit amount

Question 51

Tax Treatment of Earnings

Answer 51

Earnings of plan assets to informally fund NQ deferred comp plan are taxed to the employer unless the use of assets that provide a deferral of taxation is used.

Question 52

funded nonqualified deferred compensation

Answer 52

-assets are set aside from the claims of the employer’s creditors, for example in a trust or escrow account
-Under the economic benefit doctrine, if an individual receives any economic or financial benefit or property as compensation for services, the value of the benefit or property is currently includible in the individual’s gross income
-If the right to receive a payment in the future is reduced to writing and is transferable, such as in the case of a note or a bond, the right is the equivalent of cash and the value of the right is includible in gross income.

Question 53

Each of the following statements is correct regarding a funded nonqualified deferred compensation:

Answer 53

-The amounts are deductible by the employer when the amount is includible in the employee’s income, that is when the employee has constructive receipt of the funds.
-Under the economic benefit doctrine, if an individual receives any economic or financial benefit or property as compensation for services, the value of the benefit or property is currently includible in the individual’s gross income
-A funded arrangement generally exists if assets are set aside from the claims of the employer’s creditors, for example in a trust or escrow account.
-If the right to receive a payment in the future is reduced to writing and is transferable, such as in the case of a note or a bond, the right is the equivalent of cash and the value of the right is includible in gross income.

Question 54

stock appreciation rights

Answer 54

Generally, no actual shares are set aside, nor are shares of stock necessarily actually distributed. The value of employer stock simply is the measure by which the benefits are valued.
The stock appreciation right’s exercise price cannot be less than the fair market value of the underlying stock on the date the stock appreciation right is granted.
The stock appreciation right does not include any feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the stock appreciation right.
The stock of the service recipient subject to the stock appreciation right is traded on an established securities market.

Question 55

unfunded nonqualified plan

Answer 55

employee has only the employer’s “mere promise to pay” the deferred compensation benefits in the future, and the promise is not secured in any way.

Question 56

On January 1, Olivia is granted a nonqualified stock option for 100 shares of her employer’s stock with an exercise price of $120 per share. Six months later, Olivia exercises the option when the fair market value of the stock is $145 per share. She subsequently sells the stock 18 months later at $160 per share.

Which of the following is correct?

Answer 56

At the time of sale, Olivia recognizes long term capital gain of $1,500, as she held the stock after exercise for 18 months. At exercise, she recognizes compensation income for the difference between the FMV at exercise and the exercise price. The income recognized at exercise is added to the exercise price to determine her basis in the stock acquired at exercised, making her basis $145 per share. At sale, she has a long-term capital gain of $15 per share ($160 - $145).

Question 57

Alicia, age 59, is transferring several retirement accounts to a new firm. She is transferring the IRAs using the direct transfer method and she is transferring the 401(k) account using the traditional rollover method as she may temporarily use some of the funds before depositing them into an IRA within 60 days. Alicia is in a 22% marginal federal tax bracket and a 15% average tax bracket.

Traditional IRA with a balance of $50,000
Rollover IRA holding her previous Section 401(k) funds with an account balance of $100,000
Roth IRA with an account balance of $20,000
Section 401(k) account still held at a previous employer with an account balance of $75,000
What total amount Alicia will take possession of in executing these transfers?

Answer 57

A traditional rollover from the Section 401(k) account still held at a previous employer will require a mandatory 20% withholding. This reduces the amount she will receive by $15,000 and she will take possession of $60,000. The IRAs do not require mandatory withholding.

Question 58

Whom among the following is not considered an eligible designated beneficiary of an IRA inherited from a decedent who was age 45?

A child of the decedent, age 15
The surviving spouse of the decedent, age 45
A child of the decedent, age 21 and a junior in college
A brother of the decedent, age 36.

Answer 58

A child of the decedent must be a minor to be considered an eligible designated beneficiary.

Question 59

Identify the correct treatment for Non-Qualified Distributions from Roth IRAs that are applied to Account Earnings. (Select all that apply)

Answer 59

Roth Account Earnings receive the following Non-Qualified Distribution treatment:

Regular Income Tax
10% Penalty

Question 60

Bill received 300 shares of YOLO stock when the FMV was $20/share. After 2.5 years he exercised 150 ISOs; at that time YOLO stock was priced at $40/share. One year and three months following the exercise, Bill sold 150 shares for $50/share.

Calculate the amount and tax character of the gains on Bill’s sale.

Answer 60

Because Bill’s sale of YOLO stock occurred over two years from grant (4 years from grant to sale) AND over one year from exercise (1 year, 3 months from exercise to sale), the transaction is considered a qualifying disposition. As a result, the entire spread of gains, from grant to sale, multiplied by the number of shares is treated as a long-term capital gain.

(Sale Price – Grant Price) x # of shares = LTCG of a Qualifying Disposition

($50 - $20) x 150 = $4,500 LTCG

Question 61

Pete was granted 500 ISOs of OBFU stock in May 2022 when the FMV was $28/share. In May of 2023, OBFU stock had increased to $44/share and Pete elected to exercise 250 of his ISOs. Identify which of the following will occur at Pete’s ISO exercise.

Answer 61

A positive AMT adjustment in the amount of the bargain element occurs with the exercise of ISOs. The bargain element = [(Exercise Price – Strike Price) x # of shares].

Here the bargain element = ($44 - $28) x 250 = $4,000 positive AMT adjustment.

Question 62

Each of the following are characteristics of a SIMPLE 401(k) that are shared with a SIMPLE IRA EXCEPT:
No other plan may be maintained by the employer.
The employee may defer up to $15,500 (2023) per year, pre-tax.
The employer match cannot go below 3%.
Deferrals are subject to FICA and FUTA.

Answer 62

SIMPLE 401(k) are similar to SIMPLE IRAs in each of the characteristics listed except for employer matching. In a SIMPLE 401(k), the employer match cannot go below 3%.

Question 63

Jacque, age 50, is self-employed with net earnings from self-employment of $500,000 in 2023. If Jacque contributes the maximum allowable to a traditional IRA for 2023, how much of the contribution is deductible?

Answer 63

Jacque may contribute and deduct up to $7,500 for 2023. Because she is not an active participant in an employer-sponsored retirement plan the full contribution is deductible without regard to her net earnings from self-employment.