Tax-exempt organizations, such as colleges, hospitals, and other nonprofits, have traditionally struggled to attract and retain key talent due to their inability to compete with the executive retirement benefits offered by for-profit companies.
For-profits can, for example, offer phantom stock, stock options, and restricted stock units while tax-exempts cannot. Tax-exempts are also subjected to additional IRS codes. While both for-profits and tax-exempts must follow IRC Section 409A, which regulates any arrangement that defers compensation, only tax-exempts must adhere to IRC Section 457 as well. This code defines non-qualified, tax-advantaged deferred compensation retirement plans and applies additional restrictions.
IRC 457 does, however, have one bright spot in that it allows tax-exempts the ability to establish two additional options: 457(b) and 457(f) plans.
BENEFITS AND LIMITATIONS OF 457 PLANS
457(b) plans can be offered in addition to 401(k) or 403(b) plans and allow for the same contribution limits as traditional defined contribution plans, thus allowing employees to double their annual contributions (currently $20,500 for 2022 into each plan). Contributions to 457(b) plans can also be employer-paid. Tax-exempts can utilize these plans in combination, but they still don’t come close to providing the retirement packages necessary to recruit highly-paid, executive talent.
If a tax-exempt institution wants to provide benefits above and beyond what this combination provides, then they need to follow the rules of 457(f), which allows for any amount of compensation to be deferred for an executive. However, 457(f) has some onerous requirements:
Amounts deferred are subject to creditors.
If the executive voluntarily leaves the organization, the account balance will most likely be forfeited.
Most importantly, as soon as any amount deferred becomes vested to the executive, it is taxable.
From a planning perspective, rolling vesting amounts reduce the effectiveness of the plan's retention goals. Having a plan that only vests at retirement might discourage an executive from joining the organization or staying with it. Also, having a plan that is taxable once vested requires that payments be made in a lump sum, meaning the executive must immediately have the funds available to pay the taxes.
In addition, IRC Section 4960 applies a 21% excise tax to tax-exempt organizations that pay an executive total compensation in excess of $1 million annually. Taken together, these restrictions and conditions can create a high bar for tax-exempt organizations that want to take advantage of 457 plans.
IRC Section 4960 applies a 21% excise tax to tax-exempt organizations that pay an executive total compensation in excess of $1 million annually. As the example below shows, when base, bonus, and payments from a 457(f) plan are included, this can easily occur.
457(f) Account Accumulation Example
Assumptions
Age: 50 Assumed Interest 5.75%
Date of participation: 1/1/22 Assumed tax rate: 40%
Contribution (BOY): $225,000 Assumed fully vested: Age 65
Contribution growth: 4%
NPV of Contributions at 3%: $2,766,616 Account balance at retirement: $3,260,347
NPV of Excise Tax at 3%: $699,581 (portion may be taxable)
Total: $3,466,198 Annual income from lump sum: $223,227
Annual income from lump sum: $372,045
(pre-tax equivalent)
Contributions made as of beginning of year or as noted. Columns are noted as of beginning (boy) or end of year (eoy). Contributions are made directly into either account (DCA or Vested DCA) depending upon age and/or number of years of service. Interest rate and tax bracket as noted above.
SPLIT-DOLLAR PLANS FOR EXECUTIVE RETIREMENT BENEFITS
Because of the restrictive nature of the 457 rules and the addition of 21% excise tax under Section 4690, many organizations have looked to split-dollar life insurance as an alternative way of providing executive retirement benefits.
There are a number of reasons why this approach has gained significant popularity:
It is not subject to the rules of 457 or 4960.
Loans carry historically low Applicable Federal Rate (AFR) rates.
The policy is owned by the executive.
It offers flexible vesting options.
The investment choices within the policy are controlled by the executive.
It creates favorable accounting to the tax-exempt organization.
There is potential tax-free income out of the policy.
There are two approaches to a split-dollar plan: economic benefit and loan regime. Since the economic benefit approach generally applies to corporate-owned policies, we will examine loan regime split-dollar, which is more common in non-profit plans.
In 2016, the University of Michigan kicked off a trend of using split-dollar plans to attract head coaches for sports teams. As a means to nab head football coach, Jim Harbaugh, the university offered him a loan regime split-dollar life insurance arrangement as an alternative to deferred compensation. Since then, other colleges have followed suit, including Clemson, Louisiana State University, and the University of South Carolina.
STRUCTURING LOAN REGIME SPLIT-DOLLAR PLANS
The IRS has said that if an organization is paying the premiums on a policy owned by an executive, those premiums will be treated as taxable income to the executive unless certain conditions are met. In order for the premium payments not to be taxable income to the executive, those payments need to be considered loans to the executive, hence “loan regime.”
The mechanics of this approach is that the policy is owned by the executive, but the premiums are paid by the organization in the form of a loan to the executive. There is a split-dollar agreement between the parties that spell out the loan terms—including the loan rate, recovery either at a specific age or death of the executive, vesting, and provisions for early retirement. The insurance company provides a form that allows the executive to collaterally assign the policy to the organization in order to protect its interests.
An important factor in the success of these arrangements is the way the loans are structured, which determines the chargeable interest rate. The premium advances can be structured as either a demand or term loan:
Demand loan—the interest rate to be applied is based on an annual blended rate published by the IRS—the AFR.
Term loan—the appropriate AFR is determined based on the term of the loan (short-term, mid-term, or long-term) and the AFR of the month in which the loan is made.
Sample Executive Loan Regime Split-Dollar Life Insurance Plan
Assumptions
Premium: $225,000 Current long-term AFR (6/2022): 3.11%
Assumed index: 5.74% net Employee (EE) tax rate: 40%
Assumed applicable federal rate (AFR): 3.50% Premium recovered at mortality
*Insurance projections based upon hypothetical rates, current costs, and charges. Results are not guaranteed. See insurance ledger for all details. 5/15/2022
THE ADVANTAGES OF LOAN REGIME SPLIT-DOLLAR FOR TAX-EXEMPT ENTITIES
So why does this approach work so well for tax-exempt organizations? To start, most tax-exempt organizations tend to be around for a very long time. Unlike public or private companies that may or may not continue to operate for many years, most tax-exempts are long-term survivors, even if they merge with another.
This is important because the most common approach used in a split-dollar plan is a long-term loan where the death benefit of the policy is used to repay the premiums paid by the organization and the interest generated from the loan to the executive. As the average age of an executive participating in these plans is typically in their 50s, it can be a long time until the organization is repaid. This might not be attractive for a for-profit company that plans on selling itself in the future, but a long-term loan is often a non-issue for most tax-exempts.
A review of the features of a loan regime split-dollar reveals further why tax-exempt entities might prefer this method as a funding option:
Since Sections 457 and 4960 do not apply, both parties have more flexibility to design the program with reasonable vesting, creditor protection, keyperson coverage, and the avoidance of the 21% excise tax.
The current interest rate environment has allowed these programs to be designed with low loan rates that, with proper design, can be locked in.
There are various types of policies that can be utilized that provide the executive with numerous investment choices similar to 401(k) options.
The organization records a premium expense as well as a receivable for the loan, often making this a neutral expense on the income statement and balance sheet.
Since all life insurance policies allow the insured to withdraw cash value basis first (the sum of premiums) and then tax-free loans, these plans can often produce lifetime tax-free income to the executive.
The Loan Regime Split-Dollar Process
The tax-exempt entity and executive enter into a split-dollar plan. As part of the agreement, the executive collaterally assigns the policy’s cash value to the organization.
In exchange for the collateral assignment, the organization pays the premiums on the policy. The amount of the premium payments is structured as either a term or demand loan and charged the appropriate Applicable Federal Rate (AFR).
When the executive passes away, the death benefit is used to reimburse the entity for the cost basis of the loan, plus interest.
The balance of the death benefit (minus the loan and interest) is given to the executive’s designated beneficiaries.
STRESS-TESTING A SPLIT-DOLLAR AGREEMENT
While the loan regime split-dollar approach can be very attractive for non-profits, there are risks that need to be addressed and monitored. In addition to having a properly drafted agreement between the parties, the success of the arrangement will be largely dependent on two factors: loan rates and the performance of the policy’s cash value.
Loan rates
As mentioned, loan rates are determined by the AFR rate in effect in the month the premium payment is made. The U.S. has been in a period of very low interest rates, similar to home mortgages. If there will be 10 years of premium payments, then there will be 10 separate rates that make up the overall loan rate, as each premium payment is its own loan. As interest rates start to go up, more interest is due—reducing available cash value for the executive to draw upon. Once all premiums have been paid, then the full loan rate is locked in.
One solution is to lock in all future premiums at the current rate. This can only be accomplished if the full value of future premiums is considered. To accomplish this, carriers offer a premium deposit account that can hold the sum of future payments and deduct from this account on an annual basis when premiums are due. There is also the possibility to renegotiate the loan in the future if rates go down, provided there is value to both parties to do so.
Cash value performance
Carriers offer various options, including dividend-paying whole life, universal life, indexed accounts, and variable polices where the insured invests in mutual funds within the policy. Because of the different types of market and interest rate risk inherent in these policy types, each of these approaches has positives and negatives that need to be discussed based on the client’s risk tolerance.
When designing a proper split-dollar arrangement, it is critical to use AFR rates and policy crediting assumptions that reflect all of the feasible scenarios that could occur. This allows for a stress test of the likely outcomes of the arrangement.
CONCLUSION
Tax-exempt organizations can struggle in competing with for-profit companies for top talent due to fewer executive benefit retirement options. Loan regime split-dollar plans help level the playing field by allowing tax-exempts to offer a substantial executive retirement benefit while also adhering to IRC Section 457. If properly structured, a loan-regime split-dollar plan can provide executive retirement benefits while simultaneously protecting the interests of the organization.
This material and the opinions voiced are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. To determine what is appropriate for you, please schedule a time to connect. Information obtained from third-party sources are believed to be reliable but not guaranteed.
The tax and legal references attached herein are designed to provide accurate and authoritative information with regard to the subject matter covered and are provided with the understanding that neither TRC Financial, nor M Financial are engaged in rendering tax, legal, or actuarial services. If tax, legal, or actuarial advice is required, you should consult your accountant, attorney, or actuary. Neither TRC Financial, nor M Financial should replace those advisors.