Recent IRS ruling could reduce tax on deferred compensation and unexercised options.

Notice 2001-10 created tax-planning opportunities for holders of nonqualified stock options (NQSOs) and for balances of unpaid compensation. Under the notice, an employee can exchange unrealized gain on the options and deferred compensation for cash-value benefits under a life insurance policy. The employee would treat premiums paid by the company as loans, relinquishing (1) the options to the company prior to their exercise date or (2) the right to deferred compensation before the due date. In exchange, the company would fund an insurance policy in the same amount as the spread in the options or the total amount of deferred compensation.

Tax Minimization

An exchange helps to minimize taxes an employee would pay in comparison to exercising NQSOs or receiving deferred compensation. Normally, on payment of deferred compensation, the employee would be taxed on the payment amount at the ordinary rate. When the employee exercises NQSOs, the spread between the exercise price and the option price would also be taxed at this rate. The employee can eliminate this tax by exchanging deferred compensation or unrealized gains in stock options for an insurance policy. The exchange is not taxable. In addition, an increase in the value of a policy's investments inures to the employee without tax consequence. Death benefits payable under the policy are not subject to income tax.

Further, by making the policy's death benefits payable to an irrevocable life insurance trust, an employee can also eliminate estate taxes on those benefits.

The employer pays the premiums under a plan. Therefore, for tax purposes, the premiums are treated as a loan to an employee, meaning that the employee must pay tax on the imputed interest on the total premiums paid on the policy.

Currently, the imputed rate on short-term loans is 5.5%. Therefore, for a $1 million premium, the deemed imputed interest is $55,000, with a resulting tax of $23,100 at the 42% Federal rate. The employee pays the tax annually, based on the new Federal rate. If the employer pays the premiums in installments (i.e., through a nonmodified endowment contract), the taxpayer can borrow the amount payable on the imputed interest tax-free.

Employers' Concerns

Because employers realize a tax deduction equal to the amount of any deferred compensation paid, it would seem that an exchange might be to their disadvantage. However, under a split-dollar arrangement, the employer receives reimbursement for its share of premiums paid. Those premiums equal the amount of deferred compensation accrued, so the employer has no deduction and no expenses.

The employer can contribute a cash premium to the policy. In an exchange stemming from a stock option program, however, it can contribute the stock to which those options relate. Employers must address complex tax issues (such as asset diversification rules) when premiums are paid with stock. Before pursuing such a plan, employers should obtain a legal opinion on the tax consequences of an exchange, such as whether the employer would receive any economic benefit, the effect of the assignment-of-income doctrine on the exchange for a split-dollar premium, and whether there is any constructive receipt.

FROM ISRAEL PRESS, NEW YORK, NY