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Supplemental Retirement Benefits Part II: Options for Deferred Compensation From Other Sources.

In last months column, Kurt Lawson outlined retirement benefit programs available through the use of Section 457(a) and 457(f) plans. Here he reviews deferred compensation from taxable subsidiaries, enhanced tax-qualified plans, severance benefits, and consulting contracts-additional options that may be available depending on the situation of the individual executive. Alternatives described in this two-part column are not mutually exclusive and can sometimes be used in combination.

Due to the limits placed on a highly paid executive's contribution to a 401(k) plan or pension plan, supplemental retirement benefits are often offered. Additional benefits take a number of forms and include those that follow. Note the changes in rules called for by the Economic Growth and Tax Relief Reconciliation Act of 2001.

Deferred compensation from a taxable subsidiary

Some associations maintain taxable subsidiaries to separate taxable activities from the main tax-exempt organization, to isolate higher-risk programs, or to accomplish other purposes. If executives of the association have responsibilities for management of--and derive part of their income from--the taxable subsidiary, they might be able to supplement their retirement income by receiving deferred compensation from the subsidiary. Since deferred compensation paid by a taxable entity outside of a tax-qualified plan is not subject to Section 457, income tax can be deferred until the compensation is paid even if the executive's rights to the benefits are fully vested-as long as the benefits are unfunded (i.e., the executive's rights to the benefits are no better secured than those of a general creditor of the association). If the services that the executive provides directly to the taxable subsidiary are not substantial enough to have earned all of the deferred compensation promised from the taxable subsidiary, th e Internal Revenue Service (IRS) is likely to question the arrangement.

Enhanced tax-qualified plans

Many associations have room in existing profit-sharing or other tax-qualified plans to enhance the proportion of contributions and benefits for senior executives. The existing formula may provide for a flat contribution, such as a percentage of salary, for all employees. Such a formula can be revised so that contributions are greater for older or longer-service employees, including senior executives. To do so, of course, raises concern about discrimination since such employees tend to be more highly compensated. However, as long as the differences in allocation rates between highly compensated and non-highly compensated employees are not too great, the Internal Revenue Code's nondiscrimination requirements generally can be satisfied.

The advantage of this approach is that additional retirement income provided in this way will be subject to tax only when it is paid and, unlike a Section 457(a) or (f) plan, will be secure from the claims of the organization's general creditors. The disadvantage is that the plan will have to be amended and might need to be tested regularly by an actuary to verify that it satisfies the Internal Revenue Code's nondiscrimination requirements, a process resulting in additional expense. Also, the aggregate annual contributions on behalf of any employee can never exceed certain contribution limits. Those limits currently are the lesser of $35,000 and 25 percent compensation, but will be increased by the Economic Growth and Tax Relief Reconciliation Act of 2001 effective in 2002 to the lesser of $40,000 (indexed for inflation) and 100 percent of compensation. Finally, the amount of compensation on which benefits can be based also is limited. This limit is $170,000 in 2001, but will be increased to $200,000 (indexe d for inflation) in 2002.

Severance benefits

Additional retirement income can be provided as a severance benefit via a simple written agreement with the executive. Bona fide severance benefits are not subject to Section 457. They generally are subject to tax when received by an executive, even if rights to the benefits are fully vested.

However, the IRS has taken a clear position that it will not consider benefits to be severance benefits if they are payable upon termination for any reason and are not limited to types of termination normally associated with severance pay, such as early or otherwise unexpected termination. The IRS has generally had success in litigating this issue, although no litigation so far has involved Section 457 plans. This approach, while simple, is risky, possibly to the point of subjecting an association or executive to penalties if no conditions whatsoever are placed on benefit receipt.

Consulting contracts

Finally, additional retirement income could be provided in the form of payments under a post-retirement consulting contract. When it encounters these arrangements, the IRS asks two questions: (1) Are the consulting services substantial enough to warrant the payments earned by providing the services? (2) If they are not, and it is more accurate to say that all or most of the payments were earned in a prior year, are the post-retirement consulting services nevertheless substantial enough that the requirement to provide them subjects the payments to a "substantial risk of forfeiture?" If either condition is satisfied, the executive will not be subject to tax until the post-retirement consulting services are performed and the executive has an unconditional right to the payments.

To satisfy the second condition, it is important that the post-retirement consulting services be substantial enough that there is a real chance that the executive will not perform them. The regulations defining a "substantial risk of forfeiture" explain that "[t]he regularity of the performance of services and the time spent in performing such services tend to indicate whether services required by a condition are substantial. The fact that the person performing services has the right to decline to perform such services without forfeiture may tend to establish that services are insubstantial." Thus, a benefit that is provided "to a retiring employee subject to the sole requirement that it be returned unless he renders consulting services upon the request of his former employer will not be considered subject to a substantial risk of forfeiture unless he is in fact expected to perform substantial services."

Keep in mind that there is no single deferred compensation arrangement that is best for every association executive. Often the best arrangement is a combination of several plans closely coordinated with the association's current base and incentive compensation policies.

Kurt L. P. Lawson and Jerald A. Jacobs are partners at the law firm of Shaw Pittman, Washington, D.C. Jacobs edits this column and is general counsel to ASAE.
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Publication:Association Management
Article Type:Brief Article
Geographic Code:1USA
Date:Oct 1, 2001
Previous Article:Reaching Out With Recovery Efforts.

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