Bryant - Course 5. Retirement Planning & Employee Benefits. 3. Non-Qualified Plans Flashcards

Question

Describe Stock Appreciation Rights/Phantom Stock Formulas

Answer 1

**The benefit formula in the plan can be determined on the basis of the value of a specified number of shares of employer stock, or contributions to a salary-reduction formula can be stated in terms of shares of employer stock rather than cash**. 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. **Obviously, this type of formula provides a substantial incentive for the executive, and, from the employer viewpoint, matches the size of benefits with company success**. There is **no firm distinction between these two types of benefit formulas**. * **A stock appreciation right (SAR) formula provides that the employee's future benefits are to be determined by a formula based on the appreciation value of the company's stock over the period between adoption of the plan and the date of payment**. **The American Jobs Creation Act signed into law changes to the tax treatment of nonqualified deferred compensation plans under Section 409A.** * To be exempt from Section 409A, **the stock appreciation right (SAR) must not be less than the fair market value of the stock subject to the option at the time the option is granted**. * In addition, a stock appreciation right will not be subject to 409A under the following exceptions: * The stock appreciation right's exercise price is not less than the fair market value of the underlying stock on the date the stock appreciation right is granted and cannot become less than such amount; * 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.

Answer 2

**Nonqualified deferred compensation plans usually provide payments at retirement in a lump sum or a series of annual payments**. * Life annuities or joint and survivor annuities for the participant and spouse can also be provided. * Since the elaborate restrictions on qualified plan payouts do not apply, **considerable design flexibility is available**.

Answer 3

The questions that must be asked in a nonqualified deferred compensation plan is, "**When are the deferred amounts included in the employee's income and when is it deductible by the employer**?" The nonqualified deferred compensation **plan may either be funded or unfunded, though most are intended to be unfunded because of the tax advantages unfunded plans afford participants**. **An unfunded arrangement is one where the 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**. **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**. **In the unfunded plan, the tax consequence will be determined on the Doctrine of Constructive Receipt. The rules for Constructive Receipt are found in Section 451**. **Cash basis taxpayers must include gains, profits, and income in gross income for the taxable year in which they are actually or constructively received**. Under the constructive receipt doctrine, a cash-basis taxpayer will report income in the year in which it is actually or constructively received. **Constructive receipt means that the income is made available to the taxpayer so that he may draw upon it at any time**. **However, income is not constructively received if the taxpayer's control of its receipt is subject to substantial limitations or restrictions**. **Establishing constructive receipt requires a facts and circumstances determination regarding the taxpayer's control of the receipt of the deferred amounts**. * If there are **no substantial limitations or restrictions, the amount is not deferred and is currently taxable**. * Therefore **it is necessary to scrutinize all plan provisions relating to each type of distribution or access option to determine if the employee has unfettered control of the receipt of the deferred amounts**. **In an unfunded plan, amounts set-aside in trust for the employee are available to satisfy the general creditors of the corporation in the event of a bankruptcy**. In the **funded plan, the tax analysis is the understanding of Economic Benefit Doctrine found under Section 83**. 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. **When property is transferred to a person as compensation for services, the service provider will be taxed at the time of receipt of the property if the property is either transferable or not subject to a substantial risk of forfeiture**. If the property is not transferable and is subject to a substantial risk of forfeiture, no income tax is incurred until it is not subject to a substantial risk of forfeiture or the property becomes transferable. The analysis under Section 83 is to determine the definition of "property." **"Property" includes real and personal property other than money or an unfunded and unsecured promise to pay money in the future**. In addition, it includes a beneficial interest in assets, including money, that are transferred or set aside from claims of the creditors of the transferor, for example, in a trust or escrow account. **Therefore, the cash equivalency doctrine must also be considered when analyzing a nonqualified deferred compensation arrangement**. * Under the cash equivalency doctrine, if a promise to pay of a solvent obligor is unconditional and assignable, not subject to set-offs, and 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 considered to be the equivalent of cash and the value of the right is includible in gross income**. **The amounts are deductible by the employer when the amount is includible in the employee's income**. Interest or earnings credited to amounts deferred under nonqualified deferred compensation are added to the additional deferred compensation and are deductible when the employee is taxed on the distribution.

Answer 4

Employees recognize that any kind of deferred compensation plan holds money that they could have usually received earlier in cash. Thus, certainty of receipt is a very important consideration. Similarly, employees like plan provisions that permit them to use deferred funds when they need them. **However, if a deferred compensation plan simply allowed the participant to withdraw from the plan at any time without restriction, the plan would fail to defer income taxes under the doctrine of constructive receipt**. **Withdrawals must be subject to a restriction or limitation that prevents them from being currently available within the constructive receipt doctrine**. Some commonly used withdrawal provisions include: * **Penalty or haircut provisions are no longer permitted**: Provisions under Section 409A allow withdrawal for a wide range of reasons stated in the plan, or even upon the mere request of the participant, due to termination of employment, death, disability or retirement. Penalties that are based on a percentage of the withdrawal, known as haircut provisions, are not permitted. For example, if the participant requests $10,000, he receives $10,000, less a stated percentage penalty, such as 6%. * **Suspension of participation provision**: This is a typical withdrawal provision that **suspends the employee's participation in the plan for a period such as six months after withdrawing money from the plan**. * **Hardship withdrawal provision**: **Another way to avoid constructive receipt is to condition withdrawals upon events that are not within the employee's control**. In effect, death and disability provisions are examples of this approach. Withdrawals may also be conditioned on other specific hardships, such as financial emergencies, health matters, purchase of a house, educational costs for family members, and the like. **The specific hardship withdrawal rules for Section 401(k) plans need not be followed in a nonqualified plan**. * **The withdrawal provision can be quite broad, as long as it provides a significant limitation or restriction on the employee's ability to gain access to the plan funds**. It is very helpful if the plan gives the final decision concerning the withdrawal to a person or committee that is not controlled by the employee.

Answer 5

If the plan emphasizes employer objectives, termination provisions are designed to maximize incentive features and noncompetition and similar provisions. **At the extreme, an employer-instituted plan may even provide a complete forfeiture of nonqualified benefits if the employee terminates employment before retirement**. **Most employer-instituted plans will at least have a vesting schedule under which benefits do not become vested until a specified number of years of service have been attained**. Graduated vesting can also be used. If the plan is unfunded, the ERISA vesting provisions generally do not apply and any type of vesting schedule generally can be used. **If an executive's termination of employment results from disability, special benefits may be provided, particularly if the employee has some bargaining power in designing the plan**. * An employee will generally want benefits paid immediately upon disability. * For this purpose, the employee will also want to use a definition of disability that is somewhat less restrictive than the total and permanent disability required for Social Security disability benefits. **A typical disability provision based on employee objectives would provide for disability payments if the employee is no longer able to continue working in his specific profession or executive position**. Disability determinations can be shifted to a third party such as an insurer, or a physician chosen by the employer and employee, in order to minimize possible disputes.

Answer 6

In the employee benefit area, the term funded plan has a very specialized meaning. * **In the tax sense, a 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**. * For example, setting assets aside in an irrevocable trust for the exclusive benefit of employees covered under the plan. * For ERISA purposes, the Department of Labor (DOL) has not specifically endorsed this clear-cut definition of funding, but **for plans that benefit a select group of management or highly compensated employees, if the plan is unfunded for tax purposes, it probably will be regarded as unfunded for ERISA purposes**. Assets used to informally fund or finance the employer's obligation under a nonqualified plan can, and almost always should, be set aside, but **if this fund is accessible by the employer's creditors, providing no explicit security to the employee ahead of other employer creditors, the plan is deemed to be unfunded for tax purposes**. As indicated above, although the issue is not completely clear, such an arrangement is probably also an unfunded one for ERISA purposes. **Most nonqualified deferred compensation plans are unfunded because of significant tax and ERISA considerations**: * In a **funded plan, amounts in the fund are taxable to the employee at the time the employee's rights to the fund become substantially vested**. Under the rules of Code Section 83, substantial vesting can occur before funds are actually received by the employee. * **Funded plans are generally subject to the ERISA vesting and fiduciary requirements, which create design inflexibility**. Under the ERISA vesting rules, **the plan must have a vesting schedule at least as fast as either the three-year schedule, that is, no vesting up to three years of service, 100% vesting after three years, or the two-year to six-year schedule:** YEARS OF SERVICE VESTED PERCENTAGE 2 20% 3 40% 4 60% 5 80% 6 100% **The vesting and fiduciary rules for funded nonqualified and qualified plans are the same**.

Answer 7

**Because almost all nonqualified deferred compensation plans are unfunded in the formal sense, employees initiating deferred compensation arrangements are likely to seek ways to increase benefit security**. The following approaches are commonly used: * Reserve account maintained by employer * Employer reserve account with employee investment direction * Corporate-owned life insurance * Rabbi trust * Third-party guarantees

Answer 8

**The employer maintains an actual account, invested in securities of various types**. * There is no trust in this case. * **Funds are fully accessible to the employer and its creditors**. * The plan is **considered unfunded for tax and ERISA purposes**.

Answer 9

With this variation, **the employee obtains greater security by having the right to direct or select investments in the account**. * He or she must limit this right to a choice of broad types of investment such as equity, bonds and a family of mutual funds. * The ability to choose specific investments **may lead to constructive receipt by the employee**. * Also, the **investment direction by the participant must be advisory only and not binding**.

Answer 10

**Life insurance policies on the employee's life, owned by and payable to the employer corporation, can provide financing for the employer's obligation under nonqualified deferred compensation plans**. * With life insurance financing, **the plan can provide a substantial death benefit, even in the early years of the plan**. * This is of **significant value to younger employees**. **Exam Tip:** * **Informally funding a nonqualified deferred compensation plan with life insurance is common because the cash value buildup is tax-deferred**.

Answer 11

**A rabbi trust is a 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**. * These trusts are referred to as rabbi trusts because an early IRS letter ruling involved an arrangement between a rabbi and the employing congregation. * The IRS has ruled that **trusts designed this way do not constitute formal funding in the tax sense**. * The DOL has a working premise that rabbi trusts meeting with the approval of the IRS **will not cause excess benefit plans or top-hat plans to be funded for ERISA purposes**. * Establishing a Rabbi trust to hold funds does not provide the employer with a current tax deduction, however.

Answer 12

In these arrangements, there is a **guarantee from a third party to pay the employee if the employer defaults**. * The **guarantor could be an insurance company or some other entity**. * **On occasion, third-party guarantees have received favorable tax treatment**. * But the law in this area is not entirely clear. * **Employer involvement raises the possibility that the guarantee may cause the plan to be deemed formally funded for tax purposes**. * However, it appears that if the **employee, independently of the employer, obtains a third-party guarantee, the IRS would not necessarily view the plan as formally funded**.

Answer 13

**Nonqualified deferred compensation plans are subject to certain tax implications**. * These include **constructive receipt, economic benefit, taxation of benefits and contributions, Social Security taxes and federal estate taxes**. * In the case of **constructive receipt, an amount is considered for taxation if it is put aside or credited to the employee's account unless the employees control of the receipt is subject to a substantial limitation or restriction**. * According to the **economic benefit doctrine, a compensation agreement that provides a current economic benefit to an employee is taxed as soon as the employee is vested in contributions made to the fund, even when the employee does not have a right to withdraw cash at that time**.

Answer 14

**Under the constructive receipt doctrine, code Section 451, an amount is treated as received for income tax purposes, even if it is not actually 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. **A requirement of a passage of time until the employee can receive money is usually considered a substantial limitation or restriction**. In a typical deferred compensation plan, for example, if the plan provides that an amount is not payable for five years or not payable until the employee terminates employment or retires, it will not be constructively received before that time. **The view of the IRS is that an agreement to defer compensation generally must be made before the compensation is earned**. * **In order to defer compensation after services have already been performed, the IRS is of the opinion that the plan must have a substantial risk of forfeiture of the benefits**. **Plan distribution provisions must be designed to avoid constructive receipt**. * For example, assume that the plan provides for distribution in 10 equal annual installments. If the employee can elect, at any time, to accelerate payments, then, under the constructive receipt doctrine, the employee would have to include in income each year the amount that the employee could have elected to receive. Or, for instance, consider that the plan provides for a payout in 10 annual installments with an election at any time to spread payments out further. The constructive receipt doctrine may require taxation under the original 10-payment schedule, regardless of any election to further defer payments, unless the plan imposes a substantial risk of forfeiture. **A typical forfeiture provision found in nonqualified plan distribution provisions of this type is a requirement that the employee be available for consulting and refrain from competing with the employer**.

Answer 15

Credited to an employee’s account Set aside * An amount is treated as received for income tax purposes, even if it is not actually 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.

Answer 16

**A compensation arrangement that provides a current economic benefit to an employee can result in current taxation, even though the employee has no current right to receive cash or property**. * For example, suppose an employee is covered under a funded nonqualified deferred compensation plan that has an irrevocable trust for the benefit of the employee. * **Under the economic benefit doctrine, the employee will be taxed as soon as the employee is vested in contributions made to the fund, even though the employee does not, at that time, have a right to withdraw cash**. * **This factor makes funded plans extremely unattractive**. **The economic benefit doctrine does not generally affect unfunded plans, and almost all nonqualified deferred compensation plans are unfunded**. * It is possible that some incidental benefits in the plan could create an economic benefit. * **This issue has sometimes been raised in the case of a plan that includes an insured death benefit**. * Currently, however, the IRS does not claim that there is an economic benefit resulting from the insured death benefit in a properly designed nonqualified plan.

Answer 17

**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**. **Death benefits from nonqualified plans that are payable to a beneficiary are taxable as income in respect as a decedent to a recipient**.

Answer 18

**Amounts deferred under nonqualified deferred compensation plans are not subject to Social Security taxes until the year in which the employee no longer has any substantial risk of forfeiting the amount, provided the amounts are reasonably ascertainable**. * In other words, **as soon as the covered executive cannot lose his interest in the plan, he will be subject to Social Security taxes**. * Conceivably, this could be earlier than the year of actual receipt. For example, assume that the plan provides that benefits are payable at retirement, but the benefits become vested five years after they are earned. * **Then the amounts deferred will enter into the Social Security tax base five years after they are earned**. * Note that this is neither the year in which they are earned nor the year they are paid, **a circumstance that complicates tax compliance in this situation**. **Although part of the Social Security taxable wage base, the Old-Age, Survivors, and Disability Insurance (OASDI) part has an annual upper limit ($160,200 for 2023), the Medicare hospital insurance portion is unlimited**. * **The Medicare tax rate is 1.45% for the employer and for the employee**. * **A surtax of 3.8% is applied to Net Investment Income or the excess of modified adjusted gross income above $200,000 filing single and $250,000 married filing joint**. * Also, **an additional 0.9% on all earned income above the wage thresholds**. * For higher-paid executives, the inclusion of deferred compensation in the wage base during a year of active employment will not result in additional OASDI taxes if the executive's current, that is, non-deferred compensation, is more than the OASDI wage base, but additional Medicare taxes will be payable. * **This factor must be considered while designing nonqualified deferred compensation plans**.

Answer 19

**The amount of any death benefit payable to a beneficiary under a nonqualified deferred compensation plan is generally included in the deceased employee's estate for federal estate tax purposes, at its then present value**. * In other words, **the commuted value of payments made to the employee's beneficiary are included in the employee's gross estate**. * But **such payments are considered income in respect to a decedent, Code Section 691 income, and an income tax deduction is allocated to the recipient of that income for the additional estate tax the inclusion generated**. * **To the extent that payments are made to the employee's spouse in a qualifying manner, the unlimited marital deduction eliminates any federal estate tax**. You **can design a plan so that the decedent does not have a right to receive the benefit prior to death**. * **A plan designed to provide only death benefits is referred to as a death benefit only (DBO) plan**. * **For employees potentially liable for substantial federal estate taxes, the DBO plan may be an appropriate design**.

Answer 20

**For a nonqualified deferred compensation plan, the employer does not receive a tax deduction until its tax year, which includes the year in which the compensation is includable in the employee's taxable income**. * **If the plan is unfunded, the year of inclusion is the year in which the compensation is actually or constructively received**. * For a formally **funded plan, compensation is included in income in the year in which it becomes substantially vested**. Like other forms of compensation, **payments under a deferred compensation plan are not deductible unless the amounts meet the reasonableness test**. The same issues can arise with respect to deferred compensation as with regular cash compensation or bonus arrangements. **The IRS raises the reasonableness issue in the year in which an employer attempts to take a deduction**. * For nonqualified deferred compensation, this is **generally the year in which the employee includes the amount in income-that is, a year that is later than the year in which the services were rendered**. * Compensation can be deemed reasonable on the basis of prior service. However, it is possible that a combination of deferred compensation and current compensation received in a given year can raise reasonableness issues, particularly if the deferred amount is very large. **Publicly held corporations generally cannot deduct compensation in excess of $1 million per tax year to certain top-level executives**. * If assets are set aside in a reserve used to informally finance the employer's obligation under the plan, **income on these assets is currently taxable to the employer**. * **Consequently, the use of assets that provide a deferral of taxation can be advantageous**. * **Life insurance policies are often used because their cash value build-up from year to year is not currently taxed**. * Death proceeds from the policy are also free of tax, **except for a possible alternative minimum tax (AMT) liability**. **If assets used to finance the plan are held in a rabbi trust, the employer's tax consequences are much the same as if assets are held directly by the employer**. * **For tax purposes, the rabbi trust is a grantor trust**. * A grantor trust's income, deductions, and tax credits are attributed to the grantor, in this case the employer, for tax purposes.

Answer 21

Two types of nonqualified deferred compensation plans are eligible for at least partial exemptions from the ERISA requirements. 1. **Unfunded excess benefit plan**: This type of nonqualified deferred compensation plan, **designed solely to supplement the qualified retirement benefits limited in amount by Code Section 415, is not subject to any ERISA requirements**. 2. **Top-hat plan**: The top-hat plan **involves the most important ERISA exemption**. 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**. Top-hat plans can satisfy the reporting and disclosure requirements by **providing plan documents, upon request, to the Department of Labor, and by filing a simple, one-time statement about the arrangement with the Department of Labor**. The Department of Labor is responsible for interpreting this provision of ERISA, and it has not yet issued clear guidelines. The DOL's current position seems to be that the select group of management or highly compensated employees is limited to those employees who, by virtue of their position or compensation level, have the ability to affect or substantially influence the design and operation of their deferred compensation plan. However, a plan that covers only a few highly paid executives will probably meet this ERISA exemption. If a plan does not meet one of these ERISA exemptions, it must generally comply with most of the ERISA provisions applicable to qualified pension plans, including the vesting, fiduciary, minimum funding, and reporting and disclosure provisions. **As a result of these ERISA aspects, almost all nonqualified deferred compensation plans are limited to management or highly compensated employees and are formally unfunded, even though they may utilize some informal financing methods as discussed earlier**. Finally, the courts have sometimes held that a nonqualified deferred compensation plan was not subject to ERISA because it was not a plan within the meaning of ERISA. This ERISA exemption has been generally held to apply to plans covering one or only a few employees, where there was no ongoing administrative scheme to maintain the plan. Unless the situation is nearly identical to reported court cases, this exemption is not very practical to rely upon, because it is based on particular facts found by courts in each case, and the result of future court proceedings cannot be easily predicted.

Answer 22

* **Types of benefit and contribution formulas**: The benefit formula helps design or explain a nonqualified deferred compensation plan. **Benefit formula design is almost wide open** for nonqualified deferred compensation plans as great flexibility is possible and formulas can be designed for the specific needs of specific employees. **Some common benefit formula approaches include: salary contribution formula, salary reduction formula, excess benefit plan, and stock appreciation rights**. * **Withdrawals during employment**: Employees like plan provisions that permit them to use deferred funds when they need them. **Withdrawals must be subject to a restriction or limitation that prevents them from being currently available within the constructive receipt doctrine**. Some commonly used **withdrawal provisions include: Penalty or haircut provisions, the suspension of participation provision, and the hardship withdrawal provision**. * **Termination of employment**: Termination provisions can be used to maximize incentive features and noncompetition. **An employer-instituted plan may even provide a complete forfeiture of nonqualified benefits if the employee terminates employment before retirement**. If an executive's termination of employment results from disability, special benefits may be provided, particularly if the employee has some bargaining power in designing the plan. * **Funded versus unfunded plans**: **From the tax point of view, a 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**. * **Financing approaches**: **Since almost all nonqualified deferred compensation plans are unfunded in the formal sense, employees initiating deferred compensation arrangements might seek ways to increase benefit security.** The approaches commonly used include **reserve account maintained by employer, employer reserve account with employee investment direction, corporate-owned life insurance, rabbi trust, and third-party guarantees**. * **Tax implications**: The tax implications for nonqualified deferred compensation plans include **constructive receipt, economic benefit, taxation of benefits and contributions, Social Security taxes and federal estate taxes**. * **ERISA requirements**: Two types of nonqualified deferred compensation plans are eligible for at least partial exemptions from the ERISA requirements, **unfunded excess benefit plans and top-hat plans**.

Answer 23

Jennifer would like to provide Rob with the benefits and at the same time not overshoot the allocated budget. Jennifer would like to provide Rob a deferred compensation under conditions that are different from those applicable to the junior employees. Jennifer would be able to convey to Rob that his work in the company is appreciated. She would also be able to put to rest a fear that has troubled her regarding Rob not being content. * As an employer, Jennifer can use the deferred plan to her advantage, as she can provide additional benefits to Rob within the company’s budget. She need not use the same benefit program for all other employees, that is, the plan gives her the flexibility to decide whom to include for the benefit plan. Also, by using the deferred plan she can make sure that Rob is happy with the working conditions in the company. However, Jennifer will not receive a tax deduction in the year that Rob receives the compensation. The deduction will be deferred until the year that the income is taxable to Rob, and this could take up to 30 years or more.

Answer 24

Salary continuation formula

Answer 25

Salary reduction formula

Answer 26

Excess benefit plan

Answer 27

Stock appreciation rights

Answer 28

Penalty or haircut provision

Answer 29

Suspension of participation provision

Answer 30

Hardship withdrawal provision

Answer 31

Upon completion of this lesson, you should be able to: * Explain the uses of supplemental executive retirement plans, * Describe the advantages of a supplemental executive retirement plan, * Define the disadvantages of a supplemental executive retirement plan, * Identify the key components of the plan design for a supplemental executive retirement plan, and * Describe the tax implications of supplemental executive retirement plans.

Answer 32

Generally, **SERPs provide a flat amount per year to participating employees**. * **SERPs called excess SERPs seek to replace the retirement benefits that highly compensated employees lose because of IRC or ERISA limitations**. * Thus, the **employer would provide a benefit amount equal to the difference between**: * The full amount under its qualified retirement benefit formula, ignoring any IRC- or ERISA-imposed limits, and * The actual qualified plan and Social Security retirement benefits. Another popular SERP called a **target SERP** **seeks to replace retirement benefits lost by ERISA, such as imposed limits, and counteract the Social Security benefit bias in favor of low-income workers**. * Thus, the **employer may promise to provide selected executives with a total retirement benefit of a set percentage of their final pay, such as 75%**. The **employer would pay an amount equal to the difference between**: * The target retirement benefit that is the stated percentage times the final pay, and * The qualified plan and Social Security retirement benefits.

Answer 33

A supplemental executive retirement plan (SERP) provides many advantages to **employers**, such as: * An **attractive benefit for recruiting, retaining and rewarding key employees**. * **Flexibility in selecting individual benefit levels without restrictions**. * **Minimal reporting and filing** requirements for the plan. * The **option to selectively single out plan participants to participate in the plan**. * The **continuation of existing retirement plans without changing their plan documents**. A SERP also provides many **advantages to employees**, such as: * An increase in the retirement benefits they receive. * They do not have to change their current compensation. * The **plan design allows for survivor benefits during retirement and/or employment**. * The **plan provides the opportunity to receive additional or accelerated benefits upon a change in corporate control or ownership**.

Answer 34

A supplemental executive retirement plan (SERP) has disadvantages as well, such as: * The **employer is not entitled to an income tax deduction until the amounts are actually or constructively received by the employee**. * **Investments for a nonqualified plan cannot be separated from the employer's general assets without creating unfavorable current income tax consequences for SERP participants**, so **the assets set aside to informally fund the plan must remain subject to the claims of the employer's creditors**.

Answer 35

When creating a supplemental executive retirement plan (SERP), an **organization agrees to pay a chosen group of highly compensated or key employees a supplemental retirement benefit**. If the participant dies before reaching retirement age, usually the company will also pay a survivor benefit to a named beneficiary. To establish a SERP, **the employer signs a written agreement to pay certain participants an annual sum beginning at retirement**. * The **employer purchases a life insurance policy on each covered participant**. * The employer is the owner and beneficiary of the policy. **When the participant is ready to retire, the employer makes benefit payments to the participants, which are tax-deductible to the employer**. * These benefit payments are **taxed as ordinary income to the participant**. * The **employer usually surrenders, borrows or withdraws the funds from the insurance contract to pay the participant's retirement benefit**. * The **employer will recoup some or all of the plan costs at the participant's death**. * Additionally, **the corporation may recover the opportunity cost of funding the insurance contract**. **The employer will pay survivor benefits to the participant's designated beneficiary if the participant dies before retiring**. * This preretirement death benefit will be **taxable to the beneficiary and deductible by the employer when paid**. * **The after-tax cost of the survivor benefit from the policy's death proceeds are then reimbursed to the employer**.

Answer 36

There is a contractual agreement between a SERP plan participant and his or her employer regarding benefits that are promised to the participant. * **The IRS and DOL dictate that a SERP cannot be formally funded without triggering current taxation to the participant**. * However, **it is a good accounting practice for the employer to set aside funds for the accruing benefits in the plan**. * Setting funds aside provides for future cash flow needs and increases an executive's confidence in the plan's soundness. Investments created for a nonqualified plan cannot be separated from the employer's general assets without creating unfavorable current income tax consequences for SERP participants. * The assets set aside to informally fund the plan must remain subject to the claims of the employer's creditors to avoid current participant taxation of employer SERP contributions. **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**. * The appropriate face amount of insurance coverage is determined by the following factors: * Employer's after-tax costs of each participant's retirement benefits. * Premium funding requirements. * The present value of any survivor benefits and, if preferred. * The cost or time value of money.

Answer 37

**Nonqualified retirement plans have income tax implications for both employers and employees**. * Generally, **the employer is not entitled to an income tax deduction until such time as amounts are actually or constructively received by the employee**. * Thus, premium payments or other contributions to fund a nonqualified retirement plan informally are not deductible currently by the employer. * **When payments are made to the employee, upon retirement or otherwise, or to his or her heirs in the case of death, the employer may take a deduction for the payments to the extent that they are deemed reasonable compensation**. **A 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**. * Income is considered constructively received if it is made available to the employee or if he or she could have taken it but chose not to. * Income is not constructively received if it is subject to a substantial risk of forfeiture. * Moreover, even if the employee's rights are nonforfeitable, **there will be no constructive receipt**, provided: * **The agreement was entered into before the compensation was earned**, and * The **employer's promise to pay is unsecured**. **If the promise to pay is secured in any way, such as the employee being given an interest in assets or other media, for example, life insurance used to fund the agreement, the employee is taxed on the economic benefit of the security interest**. * To minimize the chance of taxation under the economic benefits doctrine, these agreements are **made with provisions that rights to payments will be nonassignable and nontransferable**. If an employee was receiving or was entitled to receive payments prior to his or her death, and if the agreement provided that these payments were to continue after death, **the present value of the remaining payments normally would be included in the decedent's gross estate**. If **payments were continued to the employee's spouse, they might qualify for the marital deduction**. If payments ceased on death, there obviously would be nothing to include in the gross estate. **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.

Answer 38

* **Plan Design**: To establish a SERP, the employer signs a written **agreement to pay certain participants an annual sum beginning at retirement**. The **employer purchases a life insurance policy on each covered participant**. The employer is the owner and beneficiary of the policy. **When the participant is ready to retire, the employer makes benefit payments to the participant, which are tax deductible to the employer at that time. These benefit payments are taxed as ordinary income to the participant**. * **Tax Implications**: **SERPS hold good for both employers and employees in the case of nonqualified retirement plans**. Premium payments or contributions made toward a nonqualified retirement plan informally are not deductible currently by the employer. **When payments are made to the employee, upon retirement or otherwise, or to his or her heirs in the case of death, the employer gets a deduction for the payments**. **There are no tax obligations to the employee during the deferral period. If the promise to pay is secured in any way, the employee is taxed on the economic benefit of the security interest. To minimize taxation under the economic benefits doctrine, these agreements have provisions that rights to payments will be nonassignable and nontransferable**.

Answer 39

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.

Answer 40

Employer's after-tax costs of each participant's retirement benefits Premium funding requirements The present value of any survivor benefits * The appropriate face amount of insurance coverage is determined by the following factors: employer's after-tax costs of each participant's retirement benefits, premium funding requirements, the present value of any survivor benefits and, if preferred, the cost or time value of money.

Answer 41

In a non-employment trust situation the same "loan regime" would apply but ultimately the loan would have to be repaid, or forgiven and treated as a gift. Under either scenario the most common approach would be for the non-owner to pay part or all of the premium and treat such payment as an interest free loan. Under the interest free loan rules (Section 7872 of the IRC) an economic benefit would be determined by imputing interest on the outstanding loan balance in any given year. The most common approach for determining the appropriate interest rate would be to use the short term Applicable Federal Rate (AFR) on a blended basis for the current tax year. In an employment situation the imputed income would be taxable income to the employee. The employer would be in a wash position with no tax consequence. In a non-employment or trust situation the imputed interest would most usually be treated as a gift. There are an almost infinite number of variations on the splitting of dollars theme, limited only by the needs and premium-paying abilities of the parties and the creativity of the planner. To ensure that you have a solid understanding of Split Dollar Life Insurance, the following topics will be covered in this lesson: * When Is It Used? * Advantages * Disadvantages * ERISA Requirements Upon completion of this lesson, you should be able to: * Identify the uses of split dollar insurance, * Define the advantages of this type of plan, * Describe the disadvantages of this plan, and * Describe the ERISA requirements for split dollar insurance. **Practitioner Advice:** * **After a series of interim notices, including Notice 2001-10, Notice 2002-8 and Notice 2002-59, the IRS issued final regulations regarding split dollar on September 11, 2003 for all transactions entered into after September 17, 2003**. * Notice 2002-8 will be the main source of guidance for split dollar arrangements entered into prior to September 17, 2003. * It should be noted that under transition rules prior arrangements for so called "equity split dollar" could be converted to a "loan regime" approach for periods after January 1, 2004 and expect to receive safe harbor treatment. * Existing arrangements before September 17th may also continue to consider themselves treated under the old rules but if they choose that approach there is no assurance that the IRS will agree upon audit. * **The final regulations, officially known as Split Dollar Life Insurance Arrangements, TD 9092, significantly revise the traditional treatment of split dollar**. * Under the new rules there are **two mutually exclusive regimes. They are an "economic benefit regime" where the only benefit being bestowed and therefore measured is a pure death benefit, and a "loan regime" where equity or cash value benefits are being enjoyed in addition to a pure death benefit**. The IRS says that the split dollar participants can, in effect, **select which regime will apply by determining who is the owner of the life insurance contract**.

Answer 42

**A split dollar plan can be used to provide cost-effective life insurance preretirement death benefits, fringe benefits and to help shareholder employees**. The conditions for using split dollar life insurance are: * When an **employer wishes to provide an executive with a life insurance benefit at low cost and low outlay to the executive**. Split dollar plans are **best suited for executives in their 30s, 40s, 50s and 60's, because Table 2001 cost can be excessive at later ages**. * When a preretirement death benefit for an employee is a major objective, split dollar **can be used as an alternative to an insurance-financed nonqualified deferred compensation plan**. * When an **employer is seeking a totally selective executive fringe benefit, the "loan regime" approach to split dollar can be an attractive option, particularly in a low interest rate environment. An employer can reward or provide incentives for employees on a pick and choose basis**. Neither the coverage, amounts, nor the terms of the split dollar arrangement need to meet nondiscrimination rules that add cost and complexity to many other benefit plans. * When an **employer wants to make it 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**. This helps establish a market for what otherwise might be unmarketable stock, while **providing an incentive for bright, creative, productive employees to remain with the company and increase profit**s.

Answer 43

A split dollar plan **allows an executive to receive a benefit of current value, namely life insurance coverage, using employer funds, with reduced cost to the executive**. In most types of split dollar plans, the **employer's outlay is at all times fully secured**. * **At the employee's death or termination of employment, the employer is reimbursed from policy proceeds for its premium outlay**. * The **net cost to the employer for the plan is merely the loss of the net after-tax income the funds could have earned while the plan was in effect.** Many types of split dollar design are possible so the plan can be customized to meet employer and employee objectives and premium paying abilities. 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**. * **A typical design would have the employee pick up income each year at the short term Applicable Federal Rate (AFR) as applied to the then current balance of the employee's cumulative premium advance account**. * The **employer is deemed to be in a "wash position" being entitled to a deduction for compensation paid the employee, in the form of forgiven interest and taxable income for the deemed interest received**.

Answer 44

**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**. * This cost can be **determined by using either one-year term rates provided by the federal government to measure the taxable economic benefit received by employees from the pure insurance protection provided by split dollar plans when the employer owns the policy or imputed income to the employee under the "loan regime" when the employee owns the policy**. The **plan must remain in effect for a reasonably long time, that is 10 to 20 years, in order for policy cash values to rise to a level sufficient to maximize plan benefits**. Plans that provide for an employee share in the policy's cash value-equity-type split dollar plans have been attractive in the past because they provide a savings or investment benefit for the employee. * **Under new regulations the employee tax cost of these plans is directly linked to the level of interest rates**. * The **tax consequences under the new regulations make this form of split dollar unattractive**. **Exam Tip:** * **If the employer relinquishes the rights to the policy, there will be a taxable event at that time to the employee**.

Answer 45

**A split dollar plan is considered an employee welfare benefit plan and is subject to the ERISA rules applicable to such plans**. * **A welfare plan can escape the ERISA reporting and disclosure requirements**. These include: * Form 5500 filing, and * The summary plan description (SPD) requirement, if it is an insured plan maintained for a select group of management or highly compensated employees. **Most split dollar plans qualify for this exception**. * I**f the plan covers more than a select group, it must provide SPDs to participants**. * **If the plan covers fewer than 100 participants, the SPD need not be filed with the DOL**. * ERISA further requires: * A written document, * A named fiduciary, and * A formal claims procedure for split dollar plans.

Answer 46

* **Disadvantages**:- One of the biggest disadvantages of the split dollar plan is that the **employer receives no tax deduction for its share of premium payments**. The **employee has to pay income taxes each year on the current cost of life insurance protection under the plan, or for an employee owned policy, the employee must pay taxes on the imputed income less any premiums paid by the employee**. Also, the plan must remain in effect for a reasonably long time, that is, 10 to 20 years, in order for policy cash values to rise to a level sufficient to maximize plan benefits. * **ERISA requirements**: As a split dollar plan is **considered an employee welfare benefit plan, it is subject to the ERISA rules applicable to such plans**. A welfare plan **can escape the ERISA reporting and disclosure requirements, which include Form 5500 filing and the summary plan description (SPD) requirement, if it is an insured plan maintained for a select group of management or highly compensated employees**. If the plan covers more than a select group, it has to provide SPDs to participants. If it covers fewer than 100 participants, the SPD need not be filed with the DOL. **ERISA also requires a written document, a named fiduciary, and a formal claims procedure for split dollar plans**.

Answer 47

If Bruce would like to provide Tom a life insurance benefit at low cost. If Tom is in his 30s, 40s, or early 50s. If a preretirement death benefit for Tom is a major objective, and if Bruce is looking out for an alternative to an insurance-financed nonqualified deferred compensation plan. If Bruce is seeking a totally selective executive fringe benefit. * Bruce could use the split dollar life insurance option if he wants to provide Tom retirement benefits without having to spend too much on it. * This option would be ideal if Tom is in his 30s, 40s or early 50’s, as the plan requires a reasonable duration so as to build up adequate policy cash values and because the cost to the executive, that is the P.S. 58 or Table 2001 cost, can be excessive at later ages. * He can also use it if a preretirement death benefit for Tom is a major objective. * He will use this option if he is looking for a totally selective executive fringe benefit. * The other situation where Bruce can use this option is when he wants to make it easier for shareholder-employees like Tom to finance a buyout of stock under a cross purchase buy-sell agreement, or to make it possible for non-stockholding employees to effect a one-way stock purchase at an existing shareholder’s death.

Answer 48

False * Normally, the life insurance policy is owned by the employer who also controls and owns the cash value as well as enough of the death benefit to cover expenses if the executive dies. The balance of the death benefit goes to the executive's beneficiary.

Answer 49

The policy premiums, cash values, and death benefits. * Split dollar life insurance is an arrangement between an employer and an employee which involves a sharing of the costs and benefits of the life insurance policy. Usually these plans involve a splitting of premiums, death benefits, and/or cash values.

Answer 50

There are **two main types of stock option plans used for compensating executives**: 1. **Incentive stock option (ISO) plans**, and 2. **Nonqualified (NQSO) stock options**. To ensure that you have a solid understanding of stock options, the following topics will be covered in this lesson: * Nonqualified Stock Options * Section 409A * Incentive Stock Options * Planning Strategies for ISO and NQSO * 83(b) Election of Gross Income * Cashless Exercise of Options Upon completion of this lesson, you should be able to: * Describe nonqualified stock options, * Explain the tax treatment of nonqualified stock options, * Explain incentive stock options, * Discuss planning strategies for ISO and NQSO, * Describe 83(b) election of gross income, and * Explain the cashless exercise of options.

Answer 51

**Nonqualified stock options provide a right to purchase shares of company stock at a stated price that is the option price for a given period of time, frequently ten years**. **The option exercise price normally equals 100% of the stock's fair market value on date of grant, but may be set below or above this level, that is, it may be a discount or premium**. * However, **recipients normally must wait a period of time, often of one to four years, called the vesting period, before they can exercise options, although vesting may be accelerated in certain circumstances**, for example, upon change in control. * The option term may be shortened if the recipient's employment terminates before exercise. **NQSOs may be exercised by cash payment or by tendering previously owned shares of stock, depending on plan terms**. NQSOs may be granted in tandem with stock appreciation rights or other devices. For example, Sally has the opportunity to participate in a nonqualified stock option plan. Sally has the right to buy 100 shares of stock at $15 per share for 10 years. After five years, the stock is at $24, and Sally could buy the $24 stock for $15. * **Under the NQSO plan, Sally will immediately pay tax on the $9 difference at ordinary income tax rates**. * The **company gets a corresponding tax deduction** on the amount on which Sally is taxed. * This remains true whether the employee keeps the shares or sells them. * **Subsequently, when Sally sells the stock, she pays capital gains on the difference between the sale price and the $24 value of the stock at the time of purchase**.

Answer 52

An employer can use nonqualified stock options **when it compensates employees with company shares**. It **can also be used in a situation where the employer wants to reward performance with equity-type compensation**. The details for the two uses are: * When an **employer is willing to compensate employees with shares of company stock**. **Many family corporations or other closely held corporations do not want to share ownership of the business in this manner. Corporations whose ownership is relatively broad most often use option plans**. Option plans are common in large corporations whose stock is publicly traded. * Where an **employer wishes to reward executive performance by providing equity-type compensation**, that is, compensation that increases in value as the employer stock increases in value.

Answer 53

**Nonqualified stock option plans can be designed so as to be suitable to an executive or to the employer**. There are **few tax or other government regulatory constraints**. For example, a stock option plan can be provided for any group of executives, or a single executive. * **Benefits can vary from one executive to another without restriction**. * There are **no nondiscrimination coverage or benefit rules**. Stock options are a **form of compensation with little or no out-of-pocket cost to the company**. * **The real cost of stock options is that the company forgoes the opportunity to sell the same stock on the market and realize its proceeds for company purposes**. Stock options are a form of compensation on which **tax to the employee is deferred**. * Tax is generally not payable at the time when a stock option is granted to the executive. * **Taxation to the employee generally occurs when the option is exercised**. * However, it **may be possible to further defer taxation by combining the option with a nonqualified deferred compensation agreement**. * Under this agreement, **the tax at exercise is further deferred by restricting or limiting access to the required stock or stock value for a period of time or until retirement**.

Answer 54

There are certain drawbacks to the nonqualified stock option plans. These could include **the price falling below the option price**. Fluctuation in the price could weaken the effectiveness of the plan as a performance incentive. The drawbacks are: * The **executive bears the market risk of this kind of compensation. If the market value of stock goes below the option price while the option is outstanding, the employee does not have any actual out-of-pocket loss**. However, since the executive would not purchase the stock, there is **no additional compensation received**. And, after an option is exercised, that is, the executive purchases company stock, the executive bears the full market risk of holding company stock. * The **executive must have a source of funds to purchase the stock and pay taxes due in the year of exercise in order to benefit from the plan**. Executives often borrow money with the anticipation that dividends from the stock purchased, plus immediate resale of some stock, will be sufficient to pay part or all of the interest on the borrowed funds. However, **investment interest expense in excess of investment income is not deductible**. * **Fluctuation in the market value of the stock may have little or no relation to executive performance**. This factor weakens the value of a stock option plan as a performance incentive. * The **employer's tax deduction is generally delayed until the executive exercises the option and purchases stock**. Furthermore, the **employer generally gets no further deduction, even if the executive realizes substantial capital gains thereafter**. CASE-IN-POINT During the **Internet Boom of the late 1990s**, many executives were lured to Dot Com positions by lucrative stock options. * **Those who exercised their options and sold their shares made millions of dollars**. * However, as the **Internet Bust took place in the early 2000s, many of these stock options were rendered nearly worthless**.

Answer 55

The nonqualified stock option plan has certain tax implications. * If the **option does not have an ascertainable fair market price, it is not considered taxable income**. * The **employee has taxable compensation income in the year of purchase of the stock**. * Also, there is **no tax deduction at the time when the option is granted**. **However, if the grant has an ascertainable value at grant, it will be a taxable event at that time**. The tax implication details are: * If an option has no readily ascertainable fair market value at the time it is granted, that is, transferred to the executive, there is no taxable income to the executive at the date of the grant. * The **employee has taxable compensation income, ordinary income and FICA, in the year when shares are actually purchased under the option**. The amount of taxable income to the employee is the **bargain element**. It is the **difference between the fair market value of the shares at the date of purchase and the option price that is the amount the executive actually pays for these shares**. The **employer must withhold and pay federal income tax with respect to this compensation income**. * The employer does not get a tax deduction at the time an option is granted. The **employer receives a tax deduction in the same year in which the employee has taxable income as a result of exercising the option and purchasing shares**. The amount of the deduction is the **same as the amount of income the employee must include**. For example, Lee, an executive, was given an option in 2015 to purchase 1,000 shares of Employer Company stock at $100 per share, the 2015 market price. Lee can exercise the option at any time over the next five years. In 2019, Lee purchased 400 shares for a total of $40,000. If the fair market value of the shares purchased in 2019 is $60,000, * **Lee has $20,000 of ordinary income and FICA income in 2019**. * **Employer Company gets a tax deduction of $20,000 in 2019 (assuming that Lee's total compensation meets the reasonableness test), which is the same amount as Lee's compensation income**. * **If Lee resells this stock at a gain in a later year, he has capital gain income.** Employer Company gets no further tax deduction, even though Lee realizes and reports capital gain income from selling the stock. **The executive's basis in shares acquired under a stock option plan is equal to the amount paid for the stock, plus the amount of taxable income reported by the executive at the time the option was exercised**. * In the example, Lee's basis for the 400 shares purchased in 2019 is **$60,000**, that is, the $40,000 that Lee paid, plus the $20,000 of ordinary income that he reported in 2019. * Therefore, if Lee sells the 400 shares in 2023 for **$90,000, he must report $30,000 of capital gain in 2023**, the selling price of $90,000, less his basis of $60,000. * Employer Company gets no additional tax deduction in 2023. The tax rules that apply are: * **If an option meets these rules, it is taxed at the time of the grant, and the employer receives a corresponding tax deduction at that time**. * The **employee has no further taxable compensation income when the option is later exercised**. **If the employer stock is expected to increase in value substantially, there is an advantage in designing an option plan so that it is taxed at the time of the grant**. * However, this approach can be used only where options can be traded on an established market. **If the option has a readily ascertainable fair market value at the time of the grant, all the implications mentioned above do not apply**. An option will be deemed to have a readily ascertainable fair market value if: * The option has a value that is determinable as of the time of the grant, and * The option can be traded on an established market.

Answer 56

Nonqualified stock options **may be transferred, during the life of the individual who owns the options, to certain members of their family or to a trust for their benefit**. * In addition, they can also transfer NQSOs to **charitable organizations**, as long as the NQSO permits for such a transfer. * When gifting NQSOs to a noncharitable beneficiary, **the individual owning the options should do the gifting as soon as possible to get the value of the transfer as low as possible**. * The outline for establishing a safe-harbor method for **valuing an NQSO for estate, gift, and generation-skipping tax purposes is listed in Revenue Procedure 98-34**.

Answer 57

In general, **an NQSO is considered vested if you have the ability to transfer the stock to another person without any restrictions, or you have the right to keep the stock if you are terminated or leave the company**. * Your NQSO is **considered unvested if you have what the IRS calls a "substantial risk of forfeiture." This means that if you terminate employment, you may lose some or all of the value of your NQSOs**. * **Tax consequences will vary depending on if the NQSO is unvested or vested**.

Answer 58

Exercised/Unexercised **The decision of when to exercise and sell NQSOs is based mainly on the anticipated performance of the stock, liquidity needs, and risk tolerance of the individual holding the NQSOs, and any requirements or policies required by the company**. * For executives who have a high risk tolerance, **postponing the exercise of the option may be to their advantage**. * This gives the executive the **opportunity to participate in any stock appreciation without a cash outlay**. * The downside with NQSOs is that **by waiting the appreciation will be taxed as ordinary income**. * **Due to this downside, many executives will exercise early and hold the shares to begin the holding period for long-term capital gain tax treatment**. * The success of this strategy is based on how the options are exercised and the performance of the stock. **Practitioner Advice:** * **Many companies, through a third party administrator, offer employees the opportunity for a "cashless exercise" of their options**. * For a nominal fee, the **administrator exercises the options and immediately sells sufficient shares to pay itself back for the purchase price and also to pay taxes and FICA**. * The **net profit is sent to the employee either as cash or stock**. * If an employee truly **believes that the value of the stock will increase in the future, and is willing to bet on that, it may be useful to exercise options early before there is much stock appreciation**. * The **tax treatment for gains after exercise is based on long term capital gains rates, rather than ordinary income plus FICA**.

Answer 59

**Stock options are formal nonqualified deferred compensation arrangements which allow an employee to purchase company stock at a specified price, within specified time limits**. This arrangement **provides for the deferral of additional employer compensation**. * The **purpose of Section 409A is to determine whether at the date of grant the fair market value of the underlying stock options is less than the exercise price**. * If so, the rules of Section 409A will apply. However, non-discounted grants of stock will not be subject to these rules. Under Internal Revenue Bulletin 2005-2 (dated January 10, 2005) and Bulletin 2006-3 (dated January 17, 2006), Section 409A provides: ". . . **that all amounts deferred under a nonqualified deferred compensation plan for all taxable years are currently includible in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income, unless certain requirements are met**."

Answer 60

To deal with this complex section of the Internal Revenue Code, an understanding of Section 409A and the application of the good faith standards in 1.422-2(e)(2) is a essential. Notice 2006-4 states the good faith standards of 1.422-2(e)(2) as follows: ". . . the option price of an incentive stock option must not be less than fair market value of the stock subject to the option at the time the option is granted. **Section 1.422-2(e)(2) generally provides that if a share of stock is transferred to an individual pursuant to the exercise of an option which fails as an incentive stock option merely because there was a failure of an attempt, made in good faith, to meet the option price requirements of 1.422-2(e)(1), those option price requirements are considered to have been met**." Until the IRS provides additional guidance on the application of Section 409A, **a facts and circumstances test will determine whether a good faith effort was made in setting an option price at not less than fair market value**. There are **important exceptions to the rules under Section 409A**. Here are some key excerpts taken from the Internal Revenue Code. * First, **a deferral of compensation will not be subject to Section 409A if at all times the terms of the plan require payment by, and an amount is actually or constructively received by the later of**: * The date that is 2½ months from the end of the service provider's first taxable year in which the amount is no longer subject to a substantial risk of forfeiture, or * The payment is made no later than the 15th day of the third month following the later of the end of the service provider’s taxable year or the end of the service recipient’s taxable year in which occurs the later of the time the legally binding right to the payment arises or the time such right first ceases to be subject to a substantial risk of forfeiture (subject to certain extensions for unforeseeable events). * Second, in addition to the exceptions above, **plan distributions are permitted under 409A(a)(2)(A) in the event of separation from service, disability, death, a specified time pursuant to a fixed schedule, a change in employer, or an unforeseeable emergency**. * Lastly, **Notice 2005-1 provides limited exceptions from coverage under Section 409A for certain stock appreciation rights that do not present potential for abuse or intentional circumvention of the purposes of 409A**. According to Notice 2005-1, **under this exception, a stock appreciation right will not constitute a deferral of compensation if**: * The value of the stock the excess over which the right provides for payment upon exercise (the SAR exercise price) may never be less than the fair market value of the underlying stock on the date the right is granted, * The stock of the service recipient subject to the right is traded on an established securities market, * Only such traded stock of the service recipient may be delivered in settlement of the right upon exercise, and * The right does not include any feature for the deferral of compensation other than the deferral of recognition of income until the exercise of the right.

Answer 61

There are **significant penalties that apply for noncompliance with Section 409A. If a deferral amount is required to be included in income under Section 409A, the amount is subject to both income tax and interest**. The **interest imposed is equal to the interest at the underpayment rate plus one percentage point. The additional tax is equal to 20 percent of the compensation required to be included in gross income**. In addition, in calendar years beginning after December 31, 2004, there are **new reporting rules that apply requiring the deferred amounts to be submitted to the IRS using Form W-2 (for employees) or Form 1099 (for non-employees)**. **Practitioner Advice:** * **As long as the non-discounted grant is greater than or equal to the fair market value at all times, the rules and penalties associated with Section 409A will not apply**. * However, **if the non-discounted grant is LESS than the fair market value you should review all of the specific rules that relate to 409A and outstanding stock rights. For more information about these rules, see Notice 2005-1 and Notice 2006-4 at www.irs.gov**

Answer 62

**An incentive stock option (ISO) plan is a tax-favored plan for compensating executives by granting options to buy company stock at specific exercise prices**. * Unlike regular stock options, **ISOs generally do not result in taxable income to executives either at the time of the grant or the time of the exercise of the option**. * If the ISO meets the requirements of Internal Revenue Code Section 422, the **executive is taxed only when stock purchased under the ISO is sold, except for the potential of Alternative Minimum Tax**. For example, in 2019, through an ISO Plan at Sally's work, she is given the right to buy 100 shares of stock at $15 per share for 10 years. After five years, in 2023, the stock is priced at $24, and Sally can buy the $24 stock for $15. Sally pays no tax when she exercises her options, and the company gets no tax deduction. **Subsequently, she sells the shares for $30 per share (the fair market value (FMV)) in 2026**. Sally has **met the minimum holding requirements of waiting two years after the options were granted and one year after exercising the options.** In this scenario, **Sally pays capital gains tax on $6, the difference between the market value when exercised ($24) and the sale price ($30) and the capital gains tax on $9, which was the difference between the exercise price ($15) and the market value ($24) at the time of exercise**. * **If the holding period is not met, the gain will be ordinary income and taxed as such**. * If the ISO rules are not met, then the options are taxed like a non-qualified option. **Practitioner Advice:** * Regarding the above example, **Sally could have a tax liability because of AMT**. * **The difference between the market price and the exercise price is a tax preference item and gets added back for the AMT calculation in the year the ISOs are exercised**.

Answer 63

**To compensate executives, larger corporations primarily use ISOs. They are generally not suitable for closely held corporations because**: * **ISOs are valuable to executives only when stock can be sold, and there is usually no ready market for closely held stock**, and * **Shareholders of closely held corporations often do not want unrelated outsiders to become shareholders of the company**.

Answer 64

**The ISO provides greater deferral of taxes to the executive than a nonqualified (nonstatutory) stock option. Income from the sale of the stock obtained through exercise of an ISO may be eligible for preferential capital gains treatment, enhancing the value of the tax deferral**. The ISO is a **form of compensation with little or no out-of-pocket cost to the company**. * The **real cost of stock options is that the company forgoes the opportunity to sell the same stock on the market and realize its proceeds** for company purposes.

Answer 65

There are certain drawbacks to the ISO plan. These are detailed below: * The **corporation granting an ISO does not ordinarily receive a tax deduction for it at any time**. * The plan **must meet complex technical requirements of Code Section 422** and related provisions. * The **exercise price of an ISO must be at least equal to the fair market value of the stock when the option is granted**. There is no similar restriction on nonstatutory options. * As with all stock option plans, the executive gets no benefit unless he is able to come up with enough cash to exercise the option. * An **executive may incur an alternative minimum tax (AMT) liability when an ISO option is exercised, thus increasing the executive's cash requirements in the year of exercise**. **Practitioner Advice**: * **Many people during the tech boom exercised their incentive stock options, which caused them to pay AMT**. * Unfortunately, in many circumstances, **stock prices have been drastically reduced**. * **In addition to paying AMT at exercise, these employees own stock that is worth much less than they paid for it**.

Answer 66

There are certain tax implications for incentive stock options. **Generally, the executive is not taxed either at the time of granting of the stock or when he buys the stock**. * Generally, the executive is not subject to federal income tax on an ISO, either at the time the option is granted or at the time he exercises the option, that is, when he buys the stock. **Tax consequences are deferred until the time of disposition of the stock**. * **In order to obtain this tax treatment for incentive stock options, Section 422 prescribes the following rules**: * The options must be **granted under a written plan specifying the number of shares to be issued and the class of employees covered under the plan**. There are no nondiscrimination rules, and the plan can cover key executives only. * **Only the first $100,000 worth of ISO stock granted to any one employee, which becomes exercisable for the first time during any one year, is entitled to the favorable ISO treatment. To the extent that the value of the stock exceeds $100,000, this amount is treated as a non-statutory or regular stock option**. * **No option, by its terms, may be exercisable more than 10 years from the date of the grant**. * The person receiving the option must be **employed** by the company granting the option **at all times between the grant of the option and three months before the date of exercise**. This period is **12 months in the case of permanent and total disability, with no limit in the event of death**. * Stock acquired by an employee under the ISO **must be held for at least two years after the grant of the option and one year from the date stock is transferred to the employee.** This requirement is **waived upon the employee's death**. * **No options may be issued more than 10 years from the date the ISO plan is adopted or approved**, whichever occurs first. * The **option must not be transferable, except by will or descent and distribution, and must be exercisable only by the person receiving it**. * Corporate **stockholders must approve the ISO plan within 12 months of the time it is adopted by the company's board of directors**. * The exercise price of the option must be at least equal to the fair market value of the stock on the date the option is granted. * **ISOs may not be granted to any employee who owns, directly or indirectly, more than 10% of the corporation, unless the term of the option is limited to not more than five years and the exercise price is at least 110% of the fair market value of the stock on the date of the grant**. * Although there is no regular income tax to the executive when an ISO is exercised, **the alternative minimum tax (AMT) may have an impact. The excess of the stock's fair market value over the option price at the time of exercise is included in the individual's alternative minimum taxable income**. However, if the individual is subject to the alternative minimum tax, his basis in the stock for alternative minimum tax purposes will be increased by the amount included in income. * If the **executive holds the stock for the periods specified above, two years after grant and one year after exercise, the gain on any sale is taxed at preferential long-term capital gain rates**. * If the stock is **sold before the two-year or one-year holding periods specified above, the excess of the fair market value of the shares at the time of exercise over the exercise price is treated as compensation income to the executive in the year the stock is sold,** depriving the executive of preferential capital gains treatment. * For example, Flo Smith, an executive, is covered under her company's ISO plan. Under the plan, Flo is granted an option in 2017 to purchase company stock for $100 per share. In January 2019, Flo exercises this option and purchases 100 shares for a total of $10,000. The fair market value of the 100 shares, in January 2019, is $14,000. In October 2019, Flo sells the 100 shares for $16,000. **Flo's taxable gain is $6,000, that is, the $16,000 amount realized less the $10,000 cost. Of this amount, $4,000, the fair market value of $14,000 less $10,000 exercise price, is treated as compensation income for the year 2019. The remaining $2,000 is capital gain**. * The corporation does not get a tax deduction for granting an ISO. Nor does it get a deduction when an executive exercises an option or sells stock acquired under an ISO plan. **However, the corporation does get a deduction for the compensation income element that an executive must recognize if stock is sold before the two-year/one-year holding period, as described in paragraph five above**.

Answer 67

**Although currently many people have ISOs that have no value (the fair market value is less than the exercise price), financial planners should track their clients' ISOs and** * **have a specific plan to exercise some of the options when they are in the money**. * This is **especially important from a diversification standpoint**.

Answer 68

Each client has a different situation, but **many people will benefit from exercising their ISOs and NQSOs and holding them until they can take advantage of the long-term capital gains treatment**.

Answer 69

**Section 83(b) of the Internal Revenue Code allows a taxpayer to 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 they want to avoid paying a large tax bill at the time of exercise. For example, on 1/1/20, if Jill exercises her option to purchase 50,000 shares of stock at $1/share, and the market value is $1/share, and Jill makes the 83(b) election, she will actually pay no taxes because there is no spread. The FMV is also $1/share. She will pay $50,000 to XYZ for the stock and will now have a basis of $50,000. * On 1/1/24, when the forfeiture provisions lapse, Jill can sell her stock for $1,000,000 and realize a gain of $950,000. * She will pay $142,500 in capital gains taxes-assuming a federal long-term capital gains rate of 15%. * **Without the Section 83(b) election, the gain is subject to ordinary income tax (top bracket is 37% in 2023) in the year the forfeiture provisions lapse**.

Answer 70

**A cashless exercise is often used by 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**. * **In the "sell-all" case, the executive has cash left over after paying all the applicable costs**. * **In the "sell-to-cover" case, the executive still retains the remaining shares**. * In either case, the sale of the stock and the exercise of options occur at the same time. * **These strategies are not typically used with ISOs because the sale of the shares would produce a disqualifying disposition**. * A disqualifying disposition refers to the sale of a stock from an ISO in the same year in which they are exercised. This means that the tax privileges inherent in an ISO are given up.

Answer 71

* **Incentive Stock Option is a tax-favored plan for compensating executives by granting options to buy company stock**. Unlike regular stock options, ISOs **generally do not result in taxable income to executives either at the time of the grant or the time of the exercise of the option**. If the stock option meets the Internal Revenue Code **Section 422 requirements, the executive is taxed when the purchased stock is sold**. * **Planning Strategies for ISO and NQSO**: Each client has a different situation, but 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**. * **83(b) Election of Gross Income allows a taxpayer to 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**. * **Cashless Exercise of Options** is often used by 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. In the "sell-all" case, the executive has cash left over after paying all the applicable costs. In the "sell-to-cover" case, the executive still retains the remaining shares**.

Answer 72

As there are few tax or other government regulatory constraints, these plans can be designed to suit the executive or the employer. Income from the sale of these stocks can be eligible for preferential capital gains treatment. These plans have little or no out-of-pocket cost to the company. In the case of nonqualified stock options, tax to the employee is usually deferred at the time of grant. * The employer has the flexibility to design the plan to suit both himself or herself and the employee. The company bears little or no out-of-pocket cost for these plans. For the employee, tax is generally not payable at the time when a stock option is granted. Taxation occurs when the option is exercised.

Answer 73

Denise must recognize ordinary income of $3,000. * 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.

Answer 74

There is no regular income tax recognition until the shares are subsequently sold. * There is no gain recognized for regular income tax purposes upon exercise of an incentive stock option. The tax treatment of any gain will be determined when the shares acquired are subsequently sold.

Answer 75

To ensure that you have a solid understanding of employee stock purchase plans, the following topics will be covered in this lesson: * Requirements * Tax Implications Upon completion of this lesson, you should be able to: * Define an employee stock purchase plan, and * Discuss the tax implications of an employee stock purchase plan.

Answer 76

**Qualified employee stock purchase plan is sometimes referred to as a 423 plan because the regulations that govern these plans are set forth in Section 423 of the Internal Revenue Code**. A "qualified employee stock purchase plan" must meet the following requirements: * Options are to be granted only to employees of the employer corporation or of its parent or subsidiary. * The plan is approved by the stockholders of the granting corporation within 12 months before or after the date that such plan is adopted. * **No employee can be granted an option if he or she owns 5% or more of the total combined voting power or value of all classes of stock of the employer corporation or of its subsidiary corporations**. * Options are to be **granted to all employees of the sponsoring employer**; however, employees who have been employed less than 2 years, employees whose customary employment is 20 hours of less per week, employees whose customary employment is for no more than 5 months in any calendar year, and **highly compensated employees outlined in Section 414(q) may be excluded from participation in the plan**. * All employees granted such options **shall have the same rights and privileges, except that the amount of stock which may be purchased by an employee under such option may bear a uniform relationship to the total compensation**, or the basic or regular rate of compensation, of employees, and the plan may provide that no employee may purchase more than a maximum amount of stock fixed under the plan. * **The option price is not less than the lesser of an amount equal to 85% of the fair market value of the stock at the time such option is granted**, or an amount which under the terms of the option may not be less than 85% of the fair market value of the stock at the time such option is exercised. * **Options cannot be exercised after the expiration of 5 years from the date such option is granted** if, under the terms of such plan, the option price is to be not less than 85% of the fair market value of such stock at the time or the exercise of the option; **or 27 months fro**m the date such option is granted, if the option price is not determinable in the manner described. * Under all such plans of a corporation, its parent and subsidiary corporations, **no employee may be granted an option which permits his right to purchase stock to accrue at a rate which exceeds $25,000 of fair market value of such stock (determined at the time the option is granted) for each calendar year in which such option is outstanding**. * **Such option is not transferable by such individual otherwise than by will or the laws of descent and distribution, and is exercisable, during his lifetime, only by him**.

Answer 77

The exercise price must not be less than 85% below FMV of the stock. Must be exercised within a specific time period. Must be an employee of the corporation, its parent, or subsidiary. Must be approved by stockholders. **Some of the following requirements of Employee Stock Purchase Plans include**: * Must be exercised within a specific time period. * Must be an employee of the corporation, its parent, or subsidiary. * Must be approved by stockholders. * The exercise price must not be less than 85% below FMV of the stock.

Answer 78

The exact tax consequences of a participant in an ESPP plan depends on **whether they meet the holding period requirements set forth by the Internal Revenue Code**. * However, a **participant is generally not taxed until the sale of the shares**. * The **participant will pay ordinary income tax on a portion or the entire purchase price discount and will recognize a capital gain or loss for the value difference between their basis in the stock and the proceeds from the sale**.

Answer 79

In this lesson, we have covered the following: * **Requirements**: The requirements of a qualified employee stock purchase plan are sometimes referred to as a **423 plan** because the regulations that govern these plans are set forth in Section 423 of the Internal Revenue Code. * **Tax Implications**: The exact tax consequences for a participant in an ESPP plan depend on **whether the participant meets the holding period requirements** set forth by the Internal Revenue Code. However, a participant is **generally not taxed until the sale of the shares**.

Answer 80

**Most programs provide for settlement in stock because of the more favorable fixed expensing treatment accorded settlements in actual shares**. To ensure that you have a solid understanding of employee phantom stock, the following topics will be covered in this lesson: * Benefit to Employees * Phantom Stock versus Stock Options * Tax Implications Upon completion of this lesson, you should be able to: * Describe phantom stock, * Identify the benefits to employees, * Discuss the tax implications, and * Compare and contrast phantom stock versus stock options.

Answer 81

A phantom stock plan is a **way to give key employees benefits that are measured by the value of company stock without actually giving them stock**. If the business grows and prospers, so will the benefit for the key employee. Some of the main benefits of phantom stock for the employee are listed below: * **No immediate income taxation**. **Employees will recognize taxable income when the benefit is paid or made available to them**. * Employee is **not required to make any cash contributions**. * Employee **receives "equity-type" interest in the business. If the company prospers, so will the employee's phantom stock benefit**. * **If the employer funds the phantom stock plan with life insurance, it can provide the employee with a death benefit**.

Answer 82

A phantom stock plan is a way to give key employees benefits that are measured by the value of company stock without actually giving them stock. **Phantom stock comprises units analogous to company shares, with a value generally equal to the full value of the underlying stock**. If the business grows and prospers, so will the benefit for the key employee. **A stock option is a contractual right given to the employee by his or her employer that gives the employee the right to purchase the underlying shares represented by the option for a future period of time at a pre-established price**.

Answer 83

Phantom stock follows the general tax rules that are applicable to nonqualified deferred compensation plans. * An **employee will have no tax consequences when they receive phantom stock units**. * They will **recognize the income when the phantom stock units are paid or made available to them**. * The **employer is allowed to take a deduction for the benefits in the year in which they are paid** or when they are made available to the employee.

Answer 84

* **Stock versus Stock Options**: The main difference between phantom stock and stock options is **ownership**. **Stock options offer an employee the opportunity to purchase actual shares of stock at a predetermined amount at a future date**. The taxation of a stock option will depend on if it is an ISO or NQSO. **Phantom stock does not give an employee the opportunity for ownership in the company unless the payout is in the form of company stock, and it follows the nonqualified deferred compensation rules for taxation**. * **Tax Implications**: An employee will have **no tax consequences when he or she receives phantom stock units**. Employees will **recognize the income when the phantom stock units are paid or made available to them**. The **employer is allowed to take a deduction** for the benefits in the year in which they are paid or made available to the employee.

Answer 85

Upon completion of this lesson, you should be able to: * Explain the uses of loans to executives, * Identify the advantages of loans, * Describe the disadvantages of loans, * Explain the tax rules, * Describe ERISA and other regulatory requirements, and * Identify the benefit alternatives.

Answer 86

Employers rarely act as an unrestricted bank for executives. However, loan programs can be extremely attractive as a **compensation supplement to help executives meet cash needs in special situations**. Loans are typically offered for the following: * **Mortgage or bridge loan to help in the purchase of a home**, where the employee is moving from one of the employer's business locations to another * **College or private school tuition for members of the executive's family** * **Purchase of the employer's stock** through a company stock purchase plan or otherwise * **Meeting extraordinary medical needs, tax bills or other personal or family emergencies, such as divorce settlement costs** * **Purchase of life insurance** * **Purchase of a car, vacation home or other expensive item**

Answer 87

Executive loans provide an extremely valuable employee benefit. There are **no nondiscrimination rules for executive loan programs**. The advantages of executive loans are: * Although the tax rules provide no tax advantage for executive loans, these loans still provide a valuable benefit by: * **Making cash available where regular bank loans might be difficult to obtain,** and * Providing **loans at a favorable rate of interest**. * The loans that are exempt from the complex tax rules for below-market loans are: * Mortgage and bridge loans made in connection with an **employment-connected relocation**, * De minimis loans aggregating **less than $10,000**, and * Low interest loans without significant tax effect on the lender or borrower. * There are no nondiscrimination rules for executive loan programs. Loans can be provided to selected groups of executives or even a single executive. **The terms, amounts, and conditions of executive loans can be varied from one executive to another as the employer wishes**. * **The cost of a loan program to the employer is only the administrative cost plus the loss of interest on the loan**, if any, as opposed to what the employer could have obtained by another type of investment or investment in the business itself.

Answer 88

There are several disadvantages to executive loans. **The tax rules are complicated and result in increased administrative costs**. The **employer has to bear the cost of administering the loan**. The disadvantages are detailed below: * The **tax rules for below-market loans are complicated and confusing. This increases the administrative cost of the loan program for both employer and employee**. * The **tax treatment of term loans, as opposed to demand loans, is unfavorable, that is, the employee has to include a substantial portion of the loan in income immediately in some cases.** * **The employer must bear the cost of administering the loan, which includes such things as determining whether the loan should be granted, monitoring the payback, and advising the executive as to the tax consequences**. The employer must **also bear the risk of default, which could involve either losing the money altogether, or the costs of foreclosure on a house or other asset used as collateral**.

Answer 89

The following tax rules apply if a loan is: * A below-market loan, * Compensation-related, and/or * A demand loan. **A demand loan is payable in full at any time upon demand of the lender**. A demand loan also includes any loan: * Where the interest arrangements are conditioned on the future services of the employee, and * Of which the interest benefits are not transferable by the employee. **Most executive loan programs involve loans that meet these definitions**. **Term loans are those that are payable at a specified time in the future**. **For federal income tax purposes, interest on a loan meeting all three conditions is treated as three transactions combined, the actual transaction plus two deemed transactions**: * 1. **Interest actually paid by the executive borrower is taxable income to the company (lender) and that interest payment may be deductible by the borrower, subject to the usual limitations on interest deductions**. For example, if the loan qualifies as a home mortgage loan, the interest is fully deductible, but if it is a personal loan not secured by a home mortgage it is generally nondeductible. **The employer is treated as if it paid additional compensation to the employee in the amount of the difference between the actual rate of interest and the applicable federal rate**. This additional compensation income is **deductible by the employer (within the usual reasonable compensation limits) and is taxable to the executive**. **The IRS publishes the applicable federal rate (AFR) monthly as a Revenue Ruling that appears in the Internal Revenue Bulletin**. * For **demand** loans, **the AFR is the short-term semiannual rate**. * For a **term** loan, **the AFR is the short-term, mid-term, or long-term rate in effect as of the day the loan was made, also compounded semiannually.** * If the loan is of a fixed principal amount that remains outstanding for the entire calendar year, the blended annual rate published in July of each year is the AFR. * **The executive is treated as if he paid the amount in the second deemed transaction to the employer**. This amount is **additional taxable income to the employer.** The **amount is deductible by the executive borrower, again under the usual limitations on interest deductibility**. For example, executive Flint borrows $100,000 from her employer. Assume that interest at the applicable federal rate for the first year would be $12,000, but actual interest under the loan agreement is only $5,000. * **This loan results in additional taxable compensation income of $7,000 to Flint for the first year ($12,000 less $5,000)**. * If interest is deductible, for example, if the loan qualifies as a home mortgage loan, **Flint can deduct $12,000 (the actual $5,000 plus the deemed $7,000) as an interest payment**. * **Flint's employer can deduct $7,000 as compensation paid to Flint for year 1, regardless of whether Flint can deduct any of the interest**. * **A total of $12,000 is taxable to the employer (the $5,000 actually received and the $7,000 deemed to have been received)**. **These loans are advantageous to the employee as with a low interest loan it still costs the employee less to borrow money, even if it results in additional taxable income.** For example, suppose that in the example above, executive Flint had not been able to deduct any interest on the loan. * Then, in this worst-case scenario, Flint would have had additional taxable income of $7,000, at a marginal rate of 31%. This would result in an additional tax of $2,170. * The total cost of borrowing for the first year would be the actual interest paid, that is, $5,000 plus the additional tax of $2,170, or $7,170. * By comparison, a loan at the applicable federal rate, which presumably is close to the actual market rate, would have cost Flint $12,000 in the first year.

Answer 90

Exceptions **The rules described above do not apply to certain mortgage and bridge loans used to help an employee purchase a house in connection with the employee's transfer to a new principal place of work**. In other words, the employer and employee **treat such loans for tax purposes just as they are actually negotiated, without any deemed transactions**. **The following requirements must be met in order to qualify for the mortgage loan exception**: * The loan is compensation-related and is a demand or a term loan, * * The new principal residence is acquired in connection with the transfer of the employee to a new principal place of work which meets the distance and time requirements for a moving expense deduction under Code Section 217, * The executive certifies to the employer that he or she reasonably expects to be entitled to and will itemize deductions while the loan is outstanding, * Under the loan agreement, loan proceeds may be used only to buy the executive's new principal residence, and * The loan is secured by a mortgage on the new principal residence of the employee. **A bridge loan must satisfy the requirements above, as well as the following additional requirements:** * The **loan must be payable in full in 15 days after the old principal residence is sold,** * The aggregate principal of all bridge loans must not exceed the employer's reasonable estimate of the equity of the executive and his spouse in the old residence, and * **The old residence must not be converted to business or investment use.** In the case of de minimis loans, the below-market rules do not apply to a compensation-related loan for any day on which aggregate loans outstanding between the company and the executive do not exceed $10,000, provided that tax avoidance is not one of the principal purposes of the interest arrangements. **A husband and wife are treated as one borrower for this purpose**. A loan is exempt from the below-market rules if the taxpayer can show that the interest arrangements will have no significant effect on any federal tax liability of the lender or borrower. In making this determination, the IRS would consider: * Whether items of income and deduction generated by the loan offset each other, * The amount of such items, * The cost to the taxpayer of complying with the below-market loan rules, and * Any non-tax reasons for structuring the transaction as a below-market loan.

Answer 91

$10,000 * The below-market loan rules between an executive and his company will not apply to a compensation-related loan for any day which the amount of all loans between the executive and his company do not exceed $10,000.

Answer 92

An executive loan program **does not appear to fall within the definition of either a welfare benefit plan or a pension plan for ERISA purposes**. Therefore, **ERISA requirements do not apply and a Form 5500 need not be filed**. **Federal Truth in Lending requirements may conceivably apply**. * Employers should investigate the Truth in Lending requirements **if they extend more than 25 loans, or more than five loans secured by dwellings, in a calendar year**. * The Truth in Lending requirements **primarily involve additional paperwork, but failure to meet them could result in penaltie**s.

Answer 93

**As a result of the administrative cost and complexity of loan programs, employers may wish to investigate alternatives that would provide substantially the same benefits to executives**. These could include: * **Loans by the employer at full market rates, but paying the interest cost to the executive as additional compensation**, and * **Guarantees by the employer of regular bank loans taken out by executives**. This **works best where the bank is one with which the employer has an established business relationship**.

Answer 94

* **Tax Rules**: **Below-market loans, compensation-related loans and demand loans are governed by certain tax rules**. A demand loan also includes any loan where the interest arrangements are conditioned on the future services of the employee, and of which the interest benefits are not transferable by the employee. For federal income tax purposes, **interest actually paid by the executive borrower is taxable income to the company or lender**. The **interest payment may be deductible by the borrower**, subject to the usual limitations on interest deductions. The **employer is treated as if he or she paid additional compensation to the employee in the amount equal to the difference between the actual rate of interest and the applicable federal rate**. This additional compensation **income is deductible by the employer** within the usual reasonable compensation limits and is taxable to the executive. **For demand loans, the applicable federal rate (AFR) is the short-term semiannual rate. For a term loan, the AFR is the short-term, mid-term, or long-term rate in effect as of the day the loan was made. It is also compounded semiannually**. If the loan is of a fixed principal amount that remains outstanding for the entire calendar year, the blended annual rate is the AFR. **The executive is treated as if he paid the amount in the second deemed transaction to the employer. This amount is additional taxable income to the employer**. The amount is deductible by the executive borrower, under the usual limitations on interest deductibility. * **ERISA and Other Regulatory Requirements**: For ERISA purposes, an executive loan program does not appear to fall within the definition of either a welfare benefit plan or a pension plan. Therefore, **ERISA requirements do not apply and a Form 5500 need not be filed**. However, **Federal Truth in Lending requirements may conceivably apply**. Employers should investigate these requirements if they extend more than 25 loans or more than five loans secured by dwellings in a calendar year. If not met, these requirements can result in penalties. * **Alternatives**: The administrative cost and complexity of loan programs may prompt employers to investigate alternatives that provide substantially the same benefits to executives. These could **include loans by the employer at full market rates, but paying the interest cost to the executive as additional compensation. It would also involve guarantees by the employer of regular bank loans taken out by executives**.

Answer 95

To pay for his son Michael's college tuition. To meet the medical expenses incurred during his mother's yearlong illness. To purchase life insurance. * The company will sanction a loan to pay for Michael's education and to clear the medical expenses that the family had to incur during Christopher's mother's yearlong battle against cancer. * It would also sanction a loan if he wanted to buy a life insurance policy. The company will, however, reject the loan for the house in Nevada and for settling credit card dues. According to the company policy, only if Christopher were to move from his current office to a different city would a loan be sanctioned for a new home.

Answer 96

$9,000 * The amount deductible by Audrey's employer is $9,000. This would be the difference between the applicable federal rate of interest less the actual interest under the loan agreement, that is, $16,000 less $ 7,000. * The employer is treated as if it paid the additional compensation to the employee.

Answer 97

The loan is secured by a mortgage on the new principal residence of the employee. The loan is compensation-related and is a demand or a term loan. The new principal residence is acquired in connection with the transfer of the employee to a new principal place of work and meets the distance and time requirements for a moving expense deduction under Code Section 217. * It is necessary for the loan to be secured by a mortgage on the employee’s new residence. * The loan has to be compensation-related. Also, it must be a demand or term loan. * The new residence has to be acquired in connection with the transfer of the employee to a new principal place of work. It must meet the distance and time requirements for a moving expense deduction under Code Section 217. * There is no obligation for the loan to be payable in full in 15 days after the old principal residence is sold. The rule that the old residence must not be converted to business or investment use does not apply here.

Answer 98

Nonqualified plans typically provide an immediate tax deduction for the sponsoring company upon the establishment of the plan. * Typically, **nonqualified plans do not provide an immediate tax deduction for the sponsoring company**. * The **company receives a deduction when the employees receive benefits, or otherwise when the funds are made available**.

Answer 99

Nonqualified plans must follow a specific format outlined under ERISA. * **Nonqualified plans are not subject to all the ERISA rules applicable to qualified plans**. * This **gives the employer much flexibility in plan design**.

Answer 100

In a funded plan, the deduction to the employer is deferred until the executive retires and receives the benefits promised. * 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**.

Answer 101

Generally, stock is issued to the executive upon meeting plan requirements. * 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.

Answer 102

The earnings of plan assets set aside in currently taxable investments to informally fund a nonqualified deferred compensation plan also provide the employer with an offsetting tax deduction. * The earnings of plan assets set aside in currently taxable investments to informally fund a nonqualified deferred compensation plan **do not provide the employer with an offsetting tax deduction**. * The **employer receives no tax deduction until the employee has constructive receipt of the benefits**.

Answer 103

Third-party guarantees * Employer involvement in securing a third-party guarantee raises the possibility that the guarantee will may the plan to be deemed formally funded for tax purposes.

Answer 104

Excess benefit plan * An excess benefit plan makes up the difference between the qualified plan benefits top executives are allowed under IRC Section 415 and the benefit permitted for rank and file employees. In other words, highly compensated employees receive the difference between the amounts payable under their qualified plan and the amount they would have received if there were no benefit limitations under IRC Section 415.

Answer 105

Salary continuation plan * 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.

Answer 106

Lack of security because of depending only on the employer's unsecured promise to pay. * From the executive's point of view, the principal problem is lack of security as a result of depending only on the employer's unsecured promise to pay. * In addition, most of the protections of federal tax and labor law (ERISA) that apply to qualified plans, for example, the vesting, fiduciary, and funding requirements, are not applicable to the typical nonqualified plan.

Answer 107

An unfunded plan has only the employer’s “mere promise to pay” the promised future benefits. * An unfunded arrangement is a nonqualified plan in which the 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.