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Deferred compensation alternatives to sec. 457(f).

Large tax-exempt organizations (such as universities and hospitals) must address complex administrative and financial problems, triggering a need for top executive talent. The ability to offer an attractive total compensation package, including a deferred compensation plan, is a valuable recruiting tool for both for-profit and nonprofit organizations. However, for-profit organizations generally have substantially greater flexibility in offering deferred compensation plans to employees, in large part because of the Sec. 457 limits on tax-exempt organizations.

Sec. 457 provides rules for two types of nonqualified deferred compensation plans--an "eligible" plan under Sec. 457(b) and an "ineligible" plan under Sec. 457(f). Under an eligible Sec. 457(b) plan, an employee may elect to defer a portion of compensation; the plan functions much like a Sec. 403(b) or 401(k) plan, in that deferred amounts and the earnings thereon are not subject to Federal income tax until distribution. Like Sec. 401(a) qualified plans and Sec. 403(b) plans, Sec. 457(b) plans are subject to limits under the Code and generally cannot provide significant deferred compensation value to executives. Notwithstanding these limits, recent tax legislation removes the coordination requirement (with Secs. 403(b) and 401(k)) under Sec. 457(c), thus providing better opportunities for deferral under a Sec. 457(b) plan.

Certain employees of tax-exempt organizations may be able to receive deferred compensation under an ineligible Sec. 457(f) plan. However, benefits under such a plan must be subject to a "substantial risk of forfeiture" to avoid taxation at deferral. Typically, vesting in a deferred compensation amount is conditioned on future performance of substantial services for the employer. This condition creates a "catch-22" situation for an executive. On the one hand, the executive will not realize a meaningful benefit from tax deferral unless he can defer tax for a reasonably long period of time; on the other hand, the longer the deferral period, the greater the risk that the executive may forfeit his right to the compensation altogether by terminating employment before the vesting date. There are, however, potential alternatives for deferral of compensation by executives that may fall outside of Sec. 457(f).

Private Stock Option Plans

Private stock option plans offer flexibility in designing a compensation package, provided the plan can be crafted to fall under the rules of Sec. 83 rather than the rules of Sec. 457. Sec. 83 spells out the rules for taxation of property transferred to an employee in connection with the employee's performance of services; in general, taxation is triggered when the employee's rights in the property are no longer subject to a substantial risk of forfeiture.

Under a basic private stock option plan, an executive is granted "private options" to purchase shares of a mutual fund at a specified exercise price. If these options are granted at a discount, the amount of the discount equates to deferred compensation. One important issue is the degree of discount an employer may offer through the exercise price, as compared to the market price at the time of the option grant. Offering too great a discount might change the substance of the transaction, from an option not taxed until exercise to a taxable transfer of property.

Assuming that a private stock option plan falls under the favorable option rules of Sec. 83, the executive will be taxed on the spread between the market price and the exercise price on the date he exercises the option. Additional gains after the exercise date will be subject to tax at capital gain rates at the time of the sale of the mutual fund shares. It should be noted that the IRS has not yet issued guidance on the tax rules applicable to private stock option plans established for a tax-exempt employer; therefore, it is not clear whether the Service would consider such plans to fall outside Sec. 457(f).

Split-Dollar Life Insurance

A split-dollar life insurance plan may provide an alternative to a Sec. 457 plan. A properly structured split-dollar life insurance plan may be exempt from Sec. 457 restrictions if it falls under the exception for a bona fide death benefit plan (Sec. 457(e)(11)(A)(i)). To date, the IRS has not issued a definition of a "bona fide death benefit" that excludes split-dollar insurance.

Under a collateral assignment split-dollar plan, an executive owns a life insurance policy. The exempt organization pays the premiums on the policy and holds an interest in the policy to the extent of the premiums. The executive has a right to the inside build-up on the policy and death benefits to the extent that amount exceeds the employer's right to its premium return.

Notice 2001-10, providing interim guidance on certain split-dollar arrangements, permits the split-dollar arrangement to be characterized in several ways for tax purposes, provided (1) the method used reflects the economic substance of the transaction and (2) the method has been consistently applied since the policy's inception. Under Notice 2001-10, the payment of the premiums by the exempt organization may be characterized as a below-market-loan to the executive, subject to the rules of Sec. 7872. Alternatively, the arrangement may be characterized so that the executive may realize income currently to the extent of the life-insurance protection provided, and may recognize additional compensation for inside build-up if the policy is terminated prior to his death. Either approach raises additional tax issues that must be considered carefully prior to implementing a split-dollar plan.

Severance Plans

Under Sec. 457(e)(11), a bona fide severance plan is not subject to Sec. 457(f). Thus, severance plans that would provide benefits on termination of employment for any reason were used as a substitute for a deferred compensation plan. However, Letter Ruling (TAM) 9903032 and Ann. 2000-1 limit the use of a severance plan as an alternative to establishing a Sec. 457(f) plan. According to the TAM, severance payments would be viewed as made under a bona fide severance plan only when the payments are made because employment has been terminated and not simply when employment terminates. In Ann. 2000-1, the IRS indicated that bona fide severance plans should provide payments only on termination triggered by unanticipated circumstances (such as layoff) rather than on any termination event (such as retirement).

Tax-exempt organizations considering adoption of one of these Sec. 457(f) alternatives should seek advice from a practitioner specializing in executive compensation for tax-exempt organizations. Besides income tax consequences, the specialist should consider additional issues applicable to the organization. Among other things, plans should be designed to avoid intermediate sanctions, penalties or the excise taxes imposed on a compensation plan perceived to be a self-dealing arrangement. Issues of public perception also should be considered prior to implementing any compensation plan for an executive of an exempt organization. Finally, the practitioner should examine the issues that arise with reporting compensation on Form 990, Return of Organization Exempt from Income Tax, or 990-PF, Return of Private Foundation or Section 4947(a)(1) Nonexempt Charitable Trust Treated as a Private Foundation, for the exempt organization.

Robert Zarzar, CPA
Washington National Rax Service
Washington, DC
COPYRIGHT 2001 American Institute of CPA's
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Title Annotation:large tax-exempt organizations
Author:Zarzar, Robert
Publication:The Tax Adviser
Geographic Code:1USA
Date:Jul 1, 2001
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