Image Credit: https://en.wikipedia.org/wiki/Shavasana (It's a Yoga Death Pose)
The nonprofit sector has a significant presence and employs a surprising number of workers in many communities. Here is an opportunity that you may not have considered in serving that sector of the economy.
The death benefit-only (DBO) plan for nonprofits is an arrangement in which a 501(c) nonprofit organization agrees to pay the actuarially determined cost of the current death benefit on a permanent life insurance policy owned by the employee or the employer. The employer and employee enter into a written agreement that usually requires the employer to make premium payments as long as the employee works there. This arrangement can be part of a compensation plan for the organization’s executive leadership.
In this agreement, the employee also is required to execute a “co-ownership” or “restrictive endorsement” at the time the policy is purchased. The co-ownership agreement establishes the terms of the restrictive endorsement and the timing of its release. The employee will own the policy, and the co-ownership agreement provides the employee with access to the policy.
In addition, the actuarial cost of the current death benefit will be tax-deductible for the employer but not taxable to the employee. The economic benefit of the death benefit coverage also will be taxable to the employee. Any funds contributed by the employee or otherwise taxable to the employee will be a credit against the taxes levied against the employee’s economic benefit.
The employee’s nonprofit executive bonus is in the form of permanent life insurance that is owned by that employee. The policy can be continued after the employee retires or becomes disabled. The employee’s named beneficiary may receive the life insurance proceeds income tax-free.
Because the co-ownership agreement will lapse when the employee retires, the employee will have access to the policy’s cash value during retirement. Unlike most forms of traditional nonqualified deferred compensation, the employee receives immediate benefits under the DBO plan. The employee can immediately name the beneficiary of the death benefit.
In addition, the policy’s cash value usually is immediately vested in the employee — although subject to the restrictive endorsement. The DBO plan requires the employee to reimburse the employer for some or all of the premiums paid if the employee terminates their employment early.
Qualified retirement plans are subject to restrictions on the amount of money that can be contributed by (or on behalf of) an employee. When distributions are taken from a qualified plan, they may be subject to penalties, such as the 10 percent penalty tax on early (prior to age 59½) withdrawals. But the DBO plan is not a qualified plan. Once a participant is no longer in the plan, access to the policy’s cash value (by withdrawal up to basis or by loan) is not ordinarily subject to income tax or penalty taxes.
The DBO plan can play an important role in a compensation package by combining the advantages of current death benefit protection and immediate vesting of the policy’s cash value. Immediate vesting of the policy’s cash value differentiates the DBO plan from traditional nonqualified deferred compensation plans with which the employee usually receives little more than the employer’s promise to pay future benefits.
What’s more, the tax-favorable growth of policy cash values makes permanent insurance an attractive source of supplemental retirement dollars. One major disadvantage of qualified plans is the strict rules pertaining to participation that require an employer to make the plan available to most (or all) employees.
Because the DBO plan is not a qualified plan, the employer can select which employee, or group of employees, to cover. The DBO plan can be tailored to fit each employee’s needs and can reflect each employee’s value to the employer.
Unlike qualified plans and some types of traditional nonqualified deferred compensation plans, once the DBO plan is established, minimal annual reports and administration should be required. As long as the employee’s total compensation package is “reasonable” (according to IRS “reasonable compensation” limitations), the employer’s premium payments providing the current death benefit should constitute compensation and be a currently deductible expense. This differs from traditional nonqualified deferred compensation arrangements in which benefits are not deductible to the employer until they are paid to the employee.
Tax Consequences of the DBO Plan for Nonprofits
Taxation. Premium payments made by the employer are generally believed to be compensation to the employee under IRS Section 61. Therefore, subject to reasonable compensation limitations, the likely tax treatment should be current income for the employee equal to the premium paid, and a corresponding current deduction for the employer. When a “double bonus” arrangement is used, the employer also will “bonus” the employee an amount necessary to cover the employee’s income tax liability. This additional bonus also should be subject to current income taxation.
The DBO plan complies with the rules dealing with deferred compensation as set forth in IRC Section 457. As a death benefit plan as described in Section 457 (e)11, the DBO plan is not required to have a risk of forfeiture contingency as required under Section 457(f). Additionally, when the plan is integrated into a group carve-out arrangement, IRS regulations permit treatment of the plan as an employee benefit under IRC Section 79.
Tax shelter issues. The DBO plan is not a “listed transaction” under Treasury regulations, a “tax shelter” under the IRC, a “potentially abusive tax shelter” or a “reportable transaction” under Treasury regulations.
Tax Circular 230 issues. Because the DBO plan is not a listed transaction and there are no conditions of confidentiality or contractual protection, the covered opinion requirements of IRC Section 10.35 do not apply. Because the employer is not subject to income tax as a nonprofit employer, the principal purpose of tax avoidance or tax evasion does not apply.
Title 1 of the Employee Retirement Income Security Act (ERISA) covers all employee benefit plans. ERISA divides these plans into welfare plans and pension plans. To be covered under ERISA, there must be a “plan.” If the DBO plan is a negotiated arrangement between an employer and an individual employee, there is a strong argument that there is no plan and ERISA does not govern the arrangement. However, if there are multiple employees covered by the DBO plan, it is more likely that there is a plan for ERISA purposes.
In the event the DBO plan is considered a plan, it may qualify as a “top hat” plan if it covers only select management or “highly compensated” employees. ERISA reporting requirements for “top hat” plans are limited. Whether the DBO plan is subject to ERISA must be determined on a case-by-case basis. In any event, if the plan is determined to be subject to ERISA, it is subject only to the reporting and disclosure requirements, and it is not an ERISA plan for income tax purposes.
For nonprofit employers looking for a relatively simple way to reward key employees and recruit prospective employees, the DBO plan may be an answer. The DBO plan offers many of the best features of a Section 162 bonus plan with fewer costs (for example, current death benefit, current employer tax deduction and immediate employee vesting), while serving as a “golden handcuff” that encourages employee loyalty. In addition to providing an employee with current death benefit protection, the insurance policy’s cash value may be available as a source of supplemental retirement income.