ALTERNATIVE RETIREMENT BENEFITS FOR KEY EXECUTIVES OF NON-PROFITS
by Thomas J. Raffa

Non profit employers face a challenge in structuring compensation packages that can effectively compete with for profit companies that can offer various stock options and golden parachutes. Restrictions on available current and deferred compensation alternatives and the disclosure requirements affecting the key executives place the non profit at a disadvantage in their ability to attract and retain key executives.

To complicate the situation further, recent tax law changes have reduce the total annual contributions or benefit accruals that an employee can earn under a qualified retirement plan or tax-sheltered annuity program (tax-qualified plans) by limiting the annual compensation that can be taken into account to $150,000 (reduced from $235,840 in 1993) further reducing benefits to the highly compensated employee.

Many for profits have replaced the lost benefits with additional benefits under non-qualified deferred compensation arrangements. This solution may not be practical for our non profit clients due to the restrictions placed on such benefit by the current tax code.

To be competitive, or to simply keep the key executive whole, more of our non profit clients are increasing current compensation, redesigning qualified retirement plans and considering some other interesting alternatives to tradition employee retirement benefits.

Deferred Compensation Plan
Under the current tax codes, Section 457 allows a tax-exempt employer to establish a deferred compensation plan by which a portion of an employee's compensation can be deferred to some future date. In so doing, the organization will get no tax deduction for the compensation nor will the taxpayer have any tax effects for the amounts deferred until such time as the taxpayer has constructive receipt of the funds.

Under such a plan, there are relatively complex deferral limits as well as distribution and other rules if the benefits are not forfeitable. Generally, for a tax-exempt entity such deferred benefits can not exceed $7,500 annually however, limits within other qualified retirement plans have to be considered in conjunction with this deferral. To extend the amount of deferred compensation beyond these limitations and provide a more substantial benefit for key executives, such deferrals must be forfeitable.

Under Section 457(f), if en employee defers more than the allowable limit, the excess deferred amount is not necessarily taxed immediately. Instead, it is taxed in the first taxable year in which there is no substantial risk of forfeiture. In other words, if a deferred compensation plan has forfeiture provisions, amounts greater than the annual limit can be deferred until the year in which the forfeiture provision lapses.

For example, a provision that the executive will not receive the deferred amount if he or she dies before retirement or leaves employment before retirement or before the expiration of his or her contract is usually considered to provide a substantial risk of forfeiture. However, a forfeiture only as a result of some event that is relatively unlikely generally does not constitute a substantial risk of forfeiture. For example, a plan providing that the employee forfeits the benefits if he or she commits embezzlement would not qualify. Since the event is unlikely and is also within the employee's control, the Internal Revenue Service is not likely to recognize it as a substantial risk of forfeiture.

Any attempt to provide forfeiture provisions that are not clearly covered by the regulation under Section 83 leads inevitably to uncertainty regarding the results in the event of a future IRS audit. In some cases, it may be appropriate to apply for a letter ruling from the Service on the plan to be implemented.

Another problem arises from the taxation of benefits at retirement. Many executives would prefer to receive their deferred compensation payments in installments over several years and pay the taxes as those benefits are received. However, if the substantial risk of forfeiture provision expires when the executive retires, the benefits become taxable in that year, even if the plan provides for deferred installment payments and the executive has no access to future installments.

A workable provision to continue tax deferral beyond retirement might be to make each benefit installment contingent on the executive's continuing availability for consulting services to the employer, subject to forfeiture of the remaining installments.

Obviously, the success of such a provision passing the scrutiny of the Service will depend on whether the provision actually has economic reality; that is, whether it actually imposes a burden on the executive and whether there is any real likelihood of forfeiture.

Under such an arrangement, there is no requirement for the employer to actually fund the deferral. However, in many cases the non-profit will set aside funds to further ensure the employee that the amounts will be paid. The funds do remain an asset of the non-profit and are subject to the claims of creditors.

If the employer chooses to fund the plan, it will likely be subject to ERISA requirements. However, the complexity of the reporting and disclosure requirements are dependent upon the number of employees covered. For example, reporting could be reduced to a simple one-page notification to the Department of Labor (DOL) if the plan covers only one key employee.

Split Dollar Life Insurance
The purchase of whole life insurance under a split-dollar arrangement has also become a popular method for recruiting and retaining key employees. In many cases in which a key employee wants to have the tax advantages of a deferred compensation plan but does not want to rely on the employer's unsecured promise to pay the deferred compensation, split-dollar arrangements can be advantageous. A split dollar plan can provide an employee with substantial insurance at a low cost as well as be a supplement to other retirement benefits and a vehicle for estate tax and personal insurance planning.

The advantages to the employer include:

* The ability to select the employees who will participate, as the usual discrimination rules that apply to qualified benefit plans do not apply here.
* The employer can have control of the policies and in many cases have access to the policy values.
* The plan can provide for the recovery of all employer costs, including the cost of the use of the employer funds.


Although there are several variations to these plans, a basic plan would have the insured employee be the policy owner. In this way, the employee has the right to name and change the policy beneficiary. The employer pays the premiums due under the policy and under a collateral assignment of the policy which is recorded with the insurance carrier, the employee/policy owner is obligated to repay such amounts. As there is this obligation, the employee does not pay tax on the premium payments made by the employer. Instead, the employee must pay the tax only on the amount of the premium payments that represent the cost of equivalent term life insurance. As the cash surrender values grow, the liability of the employee to the employer is reduced as under the terms of the collateral agreement the employer holds the cash surrender value. If the split dollar arrangement is terminated prior to death (i.e., upon the employee's retirement), the collateral assignment can be released by the employer and the employee becomes the sole owner of the policy. At that time, the employee is responsible for taxes on the amount of the premium costs paid by the employer on the policy. Alternatively, the employer does not release the collateral until the employee pays off the debt to the employer by purchasing the policy. Even interest can be assessed. If the employee does not purchase the policy, the policy is simply cashed-in and the cash surrender value is used to recover the debt. Upon the death of the employee/insured, the employer receives its interest in the policy proceeds and the beneficiary receives any balance.

Severance Trust Executive Program (STEP)
The Tax Reform Act of 1984 restricted the prefunding of welfare benefit plans (IRC Section 419) by generally limiting the employer deductions to fund various employee benefits through these voluntary employee beneficiary associations (VEBAs) to an amount necessary to pay current benefits and costs plus a modest reserve. In so doing, an exemption from such restrictions was also provided (IRC: Section 419(f)(6)) that permits more liberal funding of severance benefits. To do so, the plan established must qualify as a welfare benefit plan and not a disguised plan of deferred compensation. This means meeting certain DOL and Treasury regulations.

DOL regulations limit benefits to twice the final 12 months of income and benefits must be paid within 24 months. The trust requirements attempt to prevent over funding as excess funds cannot revert to the employer. Operational abuses are minimized as the trustee is responsible for the benefit payment; it is beyond the control of any one employee as the plan must be a multiple employer trust of at least 10 employers

However, if these criteria are met, the employer is allowed a deduction for prefunded severance benefits. Tax exemption for the investment income earned by the trust are a bit more onerous (as an election for tax-exempt status as a VEBA under 501(c)(9) would need to be obtained). A taxable trust provides much greater flexibility because by choosing a taxable trust, the employer can still get the deduction for the payments into the trust but can avoid the discrimination and inurement rules of a VEBA. The trust could choose tax-favored investments such a municipal bonds or even investment grade insurance policies.

A key distinction between severance benefits and retirement benefits is that severance is paid on account of a contingency beyond the control of the employee. Although benefits can be paid at retirement, they can not be paid on account of retirement. Since benefits are beyond the control of the employee, they can not be assured.

Although it may appear that this type of benefit has very limited use, employers have looked favorably on such plans for cash accumulation while receiving current tax benefits as well as allowable fringe benefit charges under government contracts. Usually, this limitation is prevalent with the employer/employee that controls the organization in that severance benefits can not be paid for voluntary termination and retirement and, by definition, a controlling shareholder, for example, by definition, controls the condition of his or her employment.

However, for a non-profit whose executive does not exercise such control, this could be an excellent benefit program. Rather than expose employees to across-the-board salary cuts or layoffs, employees near retirement or long-term employees could be offered window programs. The severance benefit can serve as an inducement to elect retirement over layoff and age discrimination can be avoided by structuring these programs on a voluntary basis In this way, an employee who wishes to retire receives the severance benefit while the employee who waits until after the expiration of the window period will forfeit their benefits.

There are insurance providers that can establish and administer such plans at a minimal cost to the employer as they will receive their fees from the investment transactions of the trust.

Compensatory Options (ESOPs)
Compensatory options are the newcomers in the marketplace but have become a popular method for eliminating the "substantial forfeiture risk" and other limitations present in Section 457. Although considered by some to be a controversial reading of federal tax law, our Firm has employed a basic employee stock option plan (ESOP) as defined under Section 83 as an alternative arrangement for many of our clients' key executives. While most executives understand such ESOPs which distribute the employer's own stock, Section 83 does not prevent an organization from granting options on other assets, such as shares in mutual funds.

Under Section 83, if the options granted have no readily ascertainable fair market value at the time the option is granted, they are not taxed when they are given to an executive, but rather when they are exercised - an event the executive can delay for years in hopes that the options will increase in value. To enhance the benefits of such a plan, when an executive decides to exercise the options, he or she can do so over several years to avoid a large, one-time tax bill.

A plan of this type can be carried out in several ways. The non-profit organization could buy the stock or mutual funds and hold them until the executive exercises the options. Buying the shares when the options are granted can save the non-profit money in periods when stock values are rising. The other alternative is to wait until the options are exercised before acquiring the stock in the open market, thus, shifting the risk (and possible rewards) to the non-profit issuing the options.

For the executive, the options he or she receives to purchase third party securities are not taxed upon receipts and thus, the executive is essentially investing in the market with pretax dollars. Compare this to direct compensation or a bonus subject to tax upon receipt by the executive, which may only net the executive 60% of the value of the compensation/bonus for investing.

Additionally, the executive is completely vested in the property rights of the option at the time it is granted, eliminating the risk of forfeiture. In fact, such plans can be established to allow the executive the ability to give his options away or retain them even after he leaves the employ of the non-profit.

Promotional literature for an option program offers the following example: A hospital acquires shares of a mutual fund for $90. An employee who defers current income of $10 receives an option to buy the mutual fund for $80. If the fund drops by 10%, nine of the executive's ten dollars are lost. However, models using historical fund data show that over a period of ten or more years, a $10,000 annual deferral into an option plan can produce in excess of $1 million.

The concern then should involve intermediate sanctions. Rules recently issued by the Service, which clearly apply to executive compensation, impose a penalty on excessive benefits "enuring" to the benefit of an "insider". One point of view is that these sanctions apply when the option is issued. That is that the value of the option when it is issued is the difference between the spot price of the underlying asset (or $90 in the above example) and the strike price (i.e., $80). Since the executive defers $10 in compensation in connection with this plan, it can be said that compensation is not increased. If his or her compensation was reasonable before the option plan, it should be considered so after the option is issued. Many practitioners believe the key is to ensure the size of the options are not too large in relation to an executive's overall compensation and that any discounting of share prices is within acceptable bounds.

As for the Service, it has approved compensation methods that include plans and arrangements other than simple salary. However, the Service could certainly evaluate any option plan adopted by a non-profit using several criteria, including whether the arrangements met these new rules of compensation and benefits. Marc Owens, the director of the Service's Exempt Organizations Division, was quoted in a recent article as saying that the tax rules on stock-compensation plans "have not been thoroughly sorted" by the Service. In "egregious cases" of abuse, an organizations tax-exempt status could be placed in jeopardy.

Summary

There are many other alternative strategies available to the non profit employer in the design of competitive compensation packages. Our Firm can assist your organization in exploring all such possibilities. In so doing, our analysis not only considers the complex interaction between the statutory requirements and the restrictions affecting tax-qualified plans but also the effects on employer costs, participant benefits and, perhaps, most important of all, employee morale. For more information, please contact Tom Raffa at (202) 955-6700 or tjr@raffa.com.