Nonprofit and tax-exempt organizations are faced with the same challenges as their counterparts in finding ways to recruit, reward, retain, and provide supplemental retirement income to key executives. Offering nonqualified benefits above salary, bonus, and traditional qualified plans is a popular way to meet these objectives. While for-profit businesses must adhere to the rules and regulations of IRC Section 409A (§409A) inherent to nonqualified plans, most nonprofit nonqualified plans (IRC Section 457(f) plans) are governed by IRC Section 457 (§457) in addition to §409A. Disadvantages of a §457(f) plan are:
Subject to "Substantial risk of forfeiture"
Benefits are subject to income tax upon vesting and upon retirement
Death benefits paid to executive’s heirs are taxable as ordinary income
Fortunately, there are solutions designed to address these added challenges. Nonprofit organizations have alternative executive benefit plan options that fall outside the regulatory statutes of §457 and §409A and, when structured properly, meet the goals of the organization and executive alike. These plan types include:
Executive Bonus (§162) Plans
Restrictive Executive Bonus Agreements (REBAs)
Split-Dollar Loan Arrangements
Executive Bonus (§162) Plans
An executive bonus plan allows a nonprofit or tax-exempt organization to provide permanent life insurance coverage to key executives using after-tax dollars. Insurance policies are owned by the executives and are paid for through cash bonuses by the organization. The executive has all of the ownership rights of the policy, including the right to name beneficiary(ies) and to access the cash values of the policy.
Benefits of an executive bonus plan include:
A potential source of supplemental retirement income through tax-free policy loans and withdrawals
Income tax-free death benefit
Full executive control of the policy and policy cash values
Not subject to administration costs, IRS approval, §457, or §409A compliance
Not subject to substantial risks of forfeiture
Ease of administration
Disadvantages of an executive bonus plan include:
Immediate income taxation on premiums paid by the organization
No golden handcuffs (i.e., financial incentive for executive to stay with the organization)
No cost recovery for the organization
Restrictive Executive Bonus Arrangements
A Restrictive Executive Bonus Arrangement, or REBA, is an executive bonus (§162) plan that incorporates golden handcuffs, which tie the executive to the organization. The REBA may prevent the executive from accessing the policy’s cash values without the consent of the organization. The agreement may also require the executive to repay some or all of the organization’s contributions to the insurance policy if the executive leaves. The written agreement with the executive will define specific qualifying events that will trigger the release of the executive from the agreement. REBAs typically terminate upon death, disability, retirement, or after a specified number of years.
Benefits of the REBA include:
A potential source of supplemental retirement income through tax-free policy loans and withdrawals
Income tax-free death benefit
Golden handcuffs
Not subject to administrative costs, IRS approval, or §457 or §409A compliance
Not subject to substantial risk of forfeiture
Ease of administration
Disadvantages of a REBA include:
Immediate income taxation on premiums paid by the organization
Limited cost recovery for the organization
Split-Dollar Loan Arrangements
Split-dollar loan arrangements provide death, and potentially retirement, benefits to an executive through the organization’s sponsorship of a permanent life insurance policy. Similar to an executive bonus plan, the executive maintains control; however, there is an added benefit of potential cost recovery to the organization through the split-dollar loan arrangement.
In this arrangement, the organization pays the premiums on a life insurance policy owned by the executive and receives a collateral assignment interest in the policy equal to the total premiums paid. The premium payments are treated as loans by the IRS and the executive is taxed, under §7872, on the imputed interest on the loans. Typically, at the executive’s retirement, the split-dollar collateral assignment arrangement is terminated and the loan, plus interest, is repaid to the organization.
Benefits of the split-dollar loan arrangement include:
A potential source of supplemental retirement income for the executive through tax-free policy withdrawals
Income tax-free death benefit
Not subject to administration costs, IRS approval, or §457 or §409A compliance
Not subject to substantial risks of forfeiture
Potential cost recovery for the organization
Disadvantages of the split-dollar loan arrangement include:
Executive will be taxed on the imputed interest annually
Distributions from the policy to repay the organization reduce policy values and death benefits
No golden handcuffs
Summary
Like for-profit companies, nonprofit organizations are faced with recruiting, retaining, and rewarding key executives. Fortunately, executive benefit plan options exist outside the regulatory statutes of §457 and §409A and when structured properly, meet the goals of the organization and executive alike.
Objective | Plan(s) |
Executive Tax Deferral | §457(f) |
Avoid Substantial Risk of Forfeiture | Split-Dollar Loans Executive Bonus REBA |
Flexibility | Split-Dollar Loans Executive Bonus REBA |
Golden Handcuffs | §457(f) REBA |
Organization Cost Recovery | §457(f) Split-Dollar Loans |
Estate Planning | Split-Dollar Loans |
Simplicity | Executive Bonus REBA |
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