Why is this Topic Important to Wealth Managers? Discusses particulars of Section 419 plans.  Presents a situation where deduction may be limited due to non-current liabilities.

Company is an accrual basis fiscal year taxpayer.  Company pays severance benefits in its discretion on an ad hoc basis, and vacation benefits pursuant to its established policy.

Historically, Company has paid both severance and vacation pay from its general assets.  Due to a decline in the Market over the past few years, Company has paid significant severance and expects to continue to pay additional severance over the next few years.  Effective Jan 1, 2009 Company established Trust to pay this anticipated severance and vacation pay.  Trust intends to submit an application for recognition of exempt status in 2010.  On 1/1/2009 Company contributed over $1,000,000 to the Trust and deducted that amount on its tax return for 2009.  Company indicates that beginning in 2010, Company will make payments for vacation and severance and will seek reimbursement from the Trust.

Company computed the amount deducted based on the limitation set forth in the Code.

Company has not provided any information documenting any severance claims incurred in 2009 that it expects to pay in 2010.  Company indicates that because the Trust was established “to pay severance that they anticipate they will have to pay over the next few years …”, and because the amount deducted is within the limit set forth in the Code that the deduction is proper.

Assuming the addition to the reserve is within the limit for severance benefits as a “safe harbor”, Company is not required to have actuarial certification of the amount.  This amount does not provide an alternative for determining the account limit, but rather the 75% limit is an upper limit on the amount that an employer may treat as an addition to a reserve for severance pay benefits without actuarial certification.

Thus, to deduct the amount contributed under section 419 in 2009, Company must demonstrate that the amount contributed and deducted in 2009 for severance benefits is not greater than the sum of qualified direct costs plus permitted additions to the qualified asset account, minus after-tax income of the fund.  Accordingly, the amounts either had to be used for benefits paid in 2009 (qualified direct costs), or be within the general limit for severance pay benefits of an amount reasonably and actuarially necessary to pay the claims incurred but unpaid as of the end of 2009.

Whether an amount is reasonably and actuarially necessary to pay the claims incurred but unpaid as of the end of 2009 is a determination that should be made based upon the particular facts and circumstances.

Among factors to take into consideration is whether there is an established obligation to make severance payments for a fixed amount of time, or whether continuation of any severance payments is in the Company’s discretion.  In this example, Company “pays severance benefits in its discretion and on an ad hoc basis”.

Accordingly, Company’s employees do not have an automatic right to severance benefits if they are terminated.  To establish that the severance benefits were “incurred” by the end of 2009, at minimum, Company would need to demonstrate that as of the end of 2009, some of its employees had been terminated, and also demonstrate that it reasonably expected to pay severance benefits to those employees beyond 2009.  In any event, the amount of the deduction in 2009 should not exceed amounts paid in severance benefits in 2009 plus the amount that Company can demonstrate it reasonably expected, as of the end of 2009, to pay beyond 2009 in severance benefits for those terminated employees.

This “reserve for incurred but unpaid claims” as of the end of 2009 would not take into account benefits expected to be paid to employees who as of the end of 2009 were still employed by Company.  The reserve should not take into account any benefits for employees that were expected to be severed in 2010 and beyond, because any severance claims for such employees were not “incurred” by the end of 2009.

Lastly, the reserve must be intended to pay severance benefits, and use for vacation or other benefits particularly within a short period of time, would tend to negate Company’s demonstration of intent, which is generally a consideration with regards to formation of a trust.

Next week’s blogticles will discuss important planning consideration for wealth managers.

We invite your opinions and comments by posting them below, or by calling the Panel of Experts

A recent Tax Court case demonstrates the severe tax consequences for an employee when a welfare-benefit plan ceases to qualify under section 419A of the Tax Code.  Section 419A governs “qualified asset accounts,” which are employer provided welfare-benefits plans that set aside funds for (1) disability benefits, (2) medical benefits, (3) severance benefits, or (4) life insurance benefits. In general, contributions by an employer to a welfare-benefit plan are tax deductible by the employer if they are ordinary and necessary business expenses. In the case, part of the funds contributed to the plan were used to buy life insurance coverage for the principal and other employees, with the rest of the funds constituting excess contributions. 

Read this complete analysis of the impact at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

The Department of Labor is looking to significantly broaden the definition of who is a fiduciary when giving investment advice to employee benefit plans and plan participants. Many plan consultants who previously escaped classification as fiduciaries will soon be subject to the conflict of interest and self-dealing rules that are applied to plan fiduciaries, creating a compliance nightmare for those advisors.

The Employee Benefits Security Administration (EBSA)—the agency of the U.S. Department of Labor responsible for administering ERISA—released proposed regulations on October 22, 2010, that will expand the reach of the plan fiduciary rules, even applying the rules to some advisors who do not advise a plan or its participants on a regular basis.  Read this complete article at AdvisorFX (sign up for a free trial subscription with full access to all of the planning libraries and client presentations if you are not already a subscriber).

For in-depth analysis of employee benefit plans, see Advisor’s Main Library: Employee and Government Benefits.

We invite your questions and comments by posting them below or by calling the Panel of Experts.

Why is this Topic Important to Wealth Managers? Provides information on one additional planning tool that many wealth managers find useful for affluent clients who own a small business.  Gives an overview of the nonqualified plans as well as proving a common use of life insurance to fund plan obligations well into the future.    

Simply a nonqualified pension plan is a retirement plan that does not meet the requirements under the tax code and federal employment law to be considered qualified, and therefore the nonqualified plan is treated differently for tax purposes. [1]

What are some of the advantages of using a nonqualified plan over a qualified retirement plan? [2] 

• Flexibility and selectivity—because the plan is not subject to requirements under the qualified plan rules, employers have much more control in terms of who may be included and the varying terms of each individual participant. 
• Vesting and contingencies—nonqualified plans allow for the employer to exclude all amounts not met by vesting conditions or contingencies that the employee must achieve to obtain the benefit.  Say for example, that the retirement funds become available to the employee after 10 years of faithful service to the company.  If the employee does not work for 10 years, no benefits have thus accrued and the employee has no benefit under the plan. 
• Cost savings through minimal reporting requirements—since nonqualified plans do not usually fall within major regulatory scope of qualified plans, the cost to administer these plans is generally less than some alternatives.

How are nonqualified plans treated for tax purposes?

Employees are generally not taxed on the benefits received under a nonqualified plan until they actually receive the compensation. [3]  Accordingly, the deduction for employee benefits is generally not taken by the employer until the benefits are paid to the plan participant. [4]

In addition, many nonqualified plans include the purchase of life insurance.  Since the value of the policy may grow at a tax-free rate inside the insurance policy, when the time comes for the payment of benefits, the deduction taken by the employer will generally be much larger than a qualified defined contribution plan.  However, the event causing the payment of benefits may not occur until some time long into the future, therefore significantly delaying the deduction in time. 

One consideration that is essential to the creation of a proper nonqualified plan is a carefulness in avoiding constructive receipt—If the plan benefits are actually realized by the taxpayer, i.e., the participant has a present right to withdrawal from the pension, the amount will be taxable to the employee when the employee is said to have constructively received the income. One such instance can occur when an insurance policy is purchased to fund plan obligations, but the beneficiary is listed as the insured and not the business.  Since the employee realizes a current benefit it is a taxable event.  For a detailed discussion of the constructive receipt doctrine, see AdvisorFYI: All Together Now: Gross Income, Increase in Wealth, Realization, Barter, and Constructive Receipt, as well as Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit.

Tomorrow’s blogticle will discuss Section 1035 exchanges in today’s marketplace.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Leimberg, Doyle.  Tools and Techniques of Life Insurance Planning, 4^th Ed.  493.  2007.  The National Underwriter Company.  Cincinnati, Ohio. (A Summit Business Media Co.) 

[2] Leimberg, Doyle.  Tools and Techniques of Life Insurance Planning, 4^th Ed.  At 494. 

[3] See generally 26 U.S.C. § 404. 

[4] 26 U.S.C. § 404 (a). 

Why is this Topic Important to Wealth Managers?  Discusses a basic deferred compensation plan available to many small businesses seeking to retain key personnel.  Provides discussion on common transactions as well as expected tax consequences.

Key employee insurance generally means “a life insurance policy owned by and payable to a business that insures the lives…of employees whose deaths would cause a significant economic loss to the business, upon whose skills talents, experience or business or personal contacts the business is dependent, and who would be difficult to replace.” [1]

Generally, life insurance premiums payable by a business are not deductible. [2]  Which means the income received (whether in a single sum or otherwise) by the business, under the life insurance contract by reason of the death of the insured, is not included in gross income.  [3] 

If a key employee policy is transferred for valuable consideration, just as with other life insurance policies, the income tax benefit normally afforded to life contract proceeds payable at death may be extinguished. [4]

As was discussed a few weeks back in our blogticle: AdvisorFYI- Treatment Life Insurance Contracts—Part II: Secondary Market Participants, “[i[n the case of a transfer for valuable consideration…the amount excluded from gross income shall not exceed an amount equal to the sum of the actual value of the consideration paid and the premiums and other amounts subsequently paid by the transferee.” [5]   In other words, the transferee must include the death benefits as gross income over the amount of consideration and any additional premiums paid. 

Nevertheless, there are exceptions to the transfer for value rule.  If one of the exceptions applies, the proceeds of the policy payable by death of the insured, can retain its income tax benefits, and be excluded from gross income. [6]

One exception to the transfer for value rule is when the policy is transferred to the insured directly. [7]

Let’s look at an example and the general tax consequences caused by the event; an insurance policy is paid to the insured as compensation when the employee retires. 

When the business pays the premiums it will not take a deduction from gross income.  The company will then either collect the insurance benefits or will not during the tenure of the employee.  Assuming the employee is planning to retire in the near future, the company may consider transferring the policy as an employment benefit upon retirement.  This is a usually a very common transaction, since there is no longer an insurable interest in the employee, the company no longer has a need for the policy.  Since further, the policy will has value in the hands of the insured, it makes for a simple deferred compensation plan to transfer the policy upon retirement to the employee. 

If the policy is given to the employee as compensation, the value of the policy may be deductible by the business as employment compensation. [8]  If this is the case, the employee will recognize gross income on the value of the policy. [9]  This amount is determined by the fair market value of the policy. [10]  Notwithstanding, the employee’s assigned beneficiary will still collect the proceeds payable at death tax-free. [11]

Tomorrow’s blog will discuss life insurance in qualified plans. 

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Leimberg, Doyle.  Tools and Techniques of Life Insurance Planning, 4^th Ed.  471.  2007.  The National Underwriter Company.  Cincinnati, Ohio. (A Summit Business Media Co.) 

[2] 26 U.S.C. § 264 (a)(1). 

[3] 26 U.S.C. § 101(a).

[4] 26 U.S.C. § 101(a)(2). 

[5] 26 U.S.C. § 101(a)(2). 

[6] 26 U.S.C. § 101 (a)(2)(B). 

[7] 26 U.S.C. § 101 (a)(2)(B). 

[8] 26 U.S.C. § 83 (h). 

[9] 26 U.S.C. § 83(a)(1).

[10] 26 U.S.C. § 83(a)(1).

[11] 26 U.S.C. § 101 (a)(2)(B). 

Why is this Topic Important to Wealth Managers? Discusses additional events and situations that may or may not trigger specific tax consequences related to common transactions.  Also provides distinctions common to these theories as well as methods to recognize particular fact patterns in relation to such.

The economic benefit doctrine is at issue when the taxpayer receives some benefit in connection with a business or contractual relationship with a current, real and measurable value. [1] One instance when an individual receives an economic or financial benefit or property is for compensation for services, whereby the value of the benefit or property is currently includible in the individual’s gross income. [2] This instance will be examined in further detail below.

Another common example is a promise to pay, which also provides a good illustration of how the doctrine applies.  A mere promise to pay, unsupported by notes or other evidences of indebtedness which by and large is unsecured, is not income to a cash method taxpayer. [3]

On the other hand, there is the cash equivalency doctrine, which states, where a promise to pay that is supported by notes or otherwise secured by a solvent obligor, which is unconditional and assignable, not subject to sett-offs, and issued at a reasonable discount, is therefore considered a cash equivalent.  Since, such notes are considered cash equivalents the notes are taxable in a like manner as cash, i.e., if cash instead of the note was received by the taxpayer the taxpayer would be taxed on the cash received.  “More simply, the cash equivalency doctrine provides that, 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.” [4]

Two additional examples of the economic benefit doctrine to further illustrate:

A football player entered into a two-year standard player’s contract with the Giants in 2009. In addition to salary, he received a signing bonus that was to be paid to an escrow agent designated by him. Under the agreement, the bonus plus interest were payable to the player over five years. The football player is taxed in full in 2009 when the payment was made to the escrow agent, because in that year, “the employer’s part in the transaction ended, and the amount of the compensation was fixed and irrevocably set aside for the player’s sole benefit” [5]

At the other end of the spectrum, consider ABC, a cash-basis taxpayer, who shares the top floor of an office building with the landlord. On December 31, 2009, a tenant from another floor mistakenly leaves cash rent in ABC’s office lobby, and ABC inadvertently deposits it. ABC discovers the error on January 5, 2010, and promptly issues a check to the landlord. The fact that ABC had dominion and control over the cash rent is irrelevant since it did not represent economic income to ABC. Therefore, ABC is not required to pay tax on the rent. [6]

Additionally, as briefly mentioned above, 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.” [7] Furthermore, an employee is required to include in his gross income, the value of assets that have been vested unconditionally and irrevocably, and transferred into a fund for the employee’s sole benefit, so long as the employee’s interest is not subject to financial forfeiture or transferable.  [8] A common example of this situation occurs when employee retirement programs are funded with employer stock options.

Tomorrow’s blogticle will discuss the ever popular economic substance doctrine.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] See generally, Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit.

[2] Internal Revenue Service—Department of the Treasury.  “Nonqualified Deferred Compensation Audit Techniques Guide”.  02-2005.  http://www.irs.gov/businesses/corporations/article/0,,id=134878,00.html. Page Last Reviewed or Updated: March 31, 2010.  Last Accessed 10/23/10.

[3] Tax Management Federal Income Portfolio. “Economic Benefit, Cash Equivalency, and Assignment of Income”.  No. 385 s V, (BNA), 20XX WL 4742238 (FEDERAL).  Compensation Planning Series– 385-4th: Deferred Compensation Arrangements.  Westlaw.  Citing Rev. Rul. 60-31

[4] Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.

[5] Tax Management Federal Income Portfolio. “Economic Benefit, Cash Equivalency, and Assignment of Income”.  Citing Ex. 4 of Rev. Rul. 60-31, Rev. Rul. 55-727, [other citations omitted]; Rev. Rul. Rul. 60-31.

[6] CCH Federal Taxation Comprehensive Topics. Chapter 13, Exhibit 17b.  35 of 70.  blue.utb.edu/…/2006%20CCH%20Comp%20Topics%20Ch%2013.ppt.  Last accessed 10/23/10.

[7] Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.

[8] 26 U.S.C § 83; Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit. ([09-36] 09/01/2009); Internal Revenue Service.  “Nonqualified Deferred Compensation Audit Techniques Guide”.