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Deferred Compensation, Part VII: Profit-Sharing Plans

2/13/2018

 
Adding a profit-sharing component to your 401(k) plan can increase your contributions while also motivating employees.  All of the previously-discussed rules apply: you can't have a top-heavy plan, you can't discriminate in favor of certain employees, etc...  

Here's a general description of what's involved from the code:

A profit-sharing plan is a plan established and maintained by an employer to provide for the participation in his profits by his employees or their beneficiaries. The plan must provide a definite predetermined formula for allocating the contributions made to the plan among the participants and for distributing the funds accumulated under the plan after a fixed number of years, the attainment of a stated age, or upon the prior occurrence of some event such as layoff, illness, disability, retirement, death, or severance of employment. A formula for allocating the contributions among the participants is definite if, for example, it provides for an allocation in proportion to the basic compensation of each participant.

The best part is the company is not required to make contributions every year; they can also determine the total amount of their contribution in the first quarter of the year, after sitting down with their accountant and getting a good idea for the previous year's performance. 

The total contribution is limited to the lesser of 25% of compensation or $55,000 (for 2018; $54,000 for 2017, subject to cost-of-living adjustments for later years).

In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program.  He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution.  He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog.  He is also an investment adviser with Thompson Creek Wealth Advisors. 

Deferred Compensation, Part VI: Minimum Participation Standards

2/6/2018

 
In general, a plan cannot specifically require that employees work for the company at least 1 year or attain the minimum age of 21.  For large employers with several divisions, this can happen accidentally.  Here are two examples from the accompanying Treasury Regulations:

Example 1. Corporation A is divided into two divisions. In order to work in division 2 an employee must first have been employed in division 1 for 5 years. A plan provision which required division 2 employment for participation will be treated as a service requirement because such a provision has the effect of requiring 5 years of service.

Example 2. Plan B requires as a condition of participation that each employee have had a driver's license for 15 years or more. This provision will be treated as an age requirement because such a provision has the effect of requiring an employee to attain a specified age.

Second, the plan cannot exclude an employee who attains a specific age.

Finally, there are minimum participation standards, which must comply with one of the following three rules.


1.)   The plan must benefit at least 70% of "non-highly compensated" employees


2.) The plan benefits--


     (i) a percentage of employees who are not highly compensated employees which is at  least 70 percent of


     (ii) the percentage of highly compensated employees benefiting under the plan.


3.) The company sets up its own classification system approved by the Secretary that benefits at least 70% of the non-highly compensated individuals.


In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program.  He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution.  He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog.  He is also an investment adviser with Thompson Creek Wealth Advisors. 

Deferred Compensation, Part V: Exemption Planning

1/30/2018

 
When a person declares bankruptcy, all of their property becomes part of the estate -- the total assets that are used to pay existing creditors.  Here is the exact definition contained in the bankruptcy code:

(a) The commencement of a case under section 301, 302, or 303 of this title creates an estate. Such estate is comprised of all the following property, wherever located and by whomever held:

      (1) Except as provided in subsections (b) and (c)(2) of this section, all legal or equitable interests of the debtor in property as of the commencement of the case.

       (2) All interests of the debtor and the debtor’s spouse in community property as of the commencement of the case that is --

        (A) under the sole, equal, or joint management and control of the debtor; or

        (B) liable for an allowable claim against the debtor, or for both an allowable claim against the debtor and an allowable claim against the debtor’s spouse, to the extent that such interest is so liable.

This is very similar to the definition the gross estate in the estate tax code or gross income in §61 -- it's an exceedingly broad definition, designed to include every piece of property owned by the debtor.  

The code, however, does allow several specific exemptions.  Under the federal statute, the debtor may choose federal or state law exemptions.  Under federal statute, retirement plans are excluded 

§522(b)(1) Notwithstanding section 541 of this title, an individual debtor may exempt from property of the estate the property listed in either paragraph (2) or, in the alternative, paragraph (3) of this subsection.

.....
​

     (C) retirement funds to the extent that those funds are in a fund or account that is                exempt from taxation under section 401, 403, 408, 408A, 414, 457, or 501(a) of the                 Internal Revenue Code of 1986.

 Most states allow this exemption as well.

Deferred Compensation, Part IV: Non-Discrimination

1/24/2018

 
     According to §401(a)(4), a deferred compensation plan cannot discriminate in favor of highly compensated employees (HCEs), which is a person who either owned 5% of the business at any time during the year or made more than $80,000 (inflation-adjusted) during the preceding year. 

     The regulations provide two safe-harbor tests for defined contribution plans (which comprise the vast bulk of 401ks).  The first is a "unified allocation formula," which requires all plan contributions to be allocated in one of three ways:
​
  • the same percentage of plan year compensation,
  • the same dollar amount, or 
  • the same dollar amount for each uniform unit of service (not to exceed one week) performed by the employee during the plan year.

While the rules do allow a C-Suite executive to benefit from the plan based on their status within the company, it doesn't allow them to benefit more than their status would allow.  
​


     The second method uses a "uniform points method" which are determined by summing "the employee's points for age, service, and units of plan year compensation for the plan year."
     The main point that advisers should take from these rules is that the regulations contain very rigid, mechanical rules that prevent the top of the employee ranks from rigging the retirement plan to their benefit at the expense of the rank-and-file.  


In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program.  He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution.  He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog.  He is also an investment adviser with Thompson Creek Wealth Advisors. 


Deferred Compensation, Pt. III: Non-Diversion of Trust Assets

1/15/2018

 

      In order for a deferred compensation trust to the “qualified,” it must comply with all of §401's specific requirements.  Complete compliance creates tax-deferred status.  §501 states (emphasis mine), “An organization described in subsection (c) or (d) or section 401(a) shall be exempt from taxation under this subtitle unless such exemption is denied under section 502 or 503.”

            One of 401s most important requirements is that funds can only be used for the benefit of the employees.  §401(a)(2) states in relevant part,

“(2) if under the trust instrument it is impossible, at any time prior to the satisfaction of all liabilities with respect to employees and their beneficiaries under the trust, for any part of the corpus or income to be (within the taxable year or thereafter) used for, or diverted to, purposes other than for the exclusive benefit of his employees or their beneficiaries…”

To borrow language from contract law, this section contains a condition precedent, which is, “...  an event which must take place before a party to a contract must perform or do their part.”  The following hypothetical illustrates: Company A owes a significant amount of money and also has a large, well-funded retirement plan.  401(a)(2) prevents the company from raiding the retirement fund until every possible obligation of the trust is paid. 

            The Treasury Regulations add additional color:

(2) As used in section 401(a)(2), the phrase “if under the trust instrument it is impossible” means that the trust instrument must definitely and affirmatively make it impossible for the nonexempt diversion or use to occur, whether by operation or natural termination of the trust, by power of revocation or amendment, by the happening of a contingency, by collateral arrangement, or by any other means. Although it is not essential that the employer relinquish all power to modify or terminate the rights of certain employees covered by the trust, it must be impossible for the trust funds to be used or diverted for purposes other than for the exclusive benefit of his employees or their beneficiaries.

The phrasing is unambiguous, providing no legal “wiggle-room.” 
​

In my introductory post on the topic, I specifically noted this code section uses trust language, placing a fiduciary duty and obligation on the sponsoring company.  This section furthers that observation.

Deferred Compensation, Pt. 2: ERISA

1/10/2018

 
29 U.S.C. Chapter 18 contains ERISA -- the Employee Retirement Income Security Act, which was passed in 1974.  Its purpose is to protect employee benefit plans from employer malfeasance, such as using employee plans to fund corporate operations or pay corporate debts.

Like the deferred compensation section of the tax code, ERISA itself its own legal specialty.   A complete discussion would be the subject of an entire course in law school.  For our purposes, the following points are salient:
​
1.) The statute gives federal courts jurisdiction over a large number of causes of action related to ERISA: ("Except for actions under subsection (a)(1)(B) of this section, the district courts of the United States shall have exclusive jurisdiction of civil actions under this subchapter brought by the Secretary or by a participant, beneficiary, fiduciary, or any person referred to in section 1021(f)(1) of this title. State courts of competent jurisdiction and district courts of the United States shall have concurrent jurisdiction of actions under paragraphs (1)(B) and (7) of subsection (a) of this section.).  This greatly increases the weight of potential litigation.
​
2.) The statute creates a complex compliance burden.  Here is a list of the sections contained in 29 U.S.C. Part I: Reporting and Disclosure:


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This is yet another reason why an entire industry exists to service deferred compensation plans.

The First Revenue Bulletin of the Year Covers Several Important Issues

1/8/2018

 
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Deferred Compensation, Part 1: Introductory Concepts

1/2/2018

 
           Certain sections of the tax code (such as §1031 like-kind exchanges and §482 transfer pricing) have become their own mini-specialty.  §401-§420 (deferred compensation) is another such area of the code.  In the following posts, I’ll go over the “high points” of these code provisions, starting with today’s general introduction to the topic.
            The opening sentence of §401 contains a large amount of important information:
A trust created or organized in the United States and forming part of a stock bonus, pension, or profit-sharing plan of an employer for the exclusive benefit of his employees or their beneficiaries shall constitute a qualified trust under this section— 
Here are that sentence’s key provisions:
  • “A trust:” trust law has over 500 years of common law history, dating back to Britain. There is an entire restatement on trusts which has been adopted by all U.S. states.  The legal tome Scott on Trusts is the leading academic treatise on the topic.  For an attorney, the word trust immediately leads to the phrase “fiduciary obligation,” which is best explained by these two phrases: “Alleged good faith on the part of the fiduciary forgetful of his duty is not enough…he must not have “honesty alone, but the punctilio of an honor the most sensitive.”[1] This is a very long and well-developed common law doctrine that has no wiggle room for legal shenanigans.  This is the duty placed on the company forming the plan regarding plan assets.  It’s also a primary reason why most companies outsource this task to third parties.
  • “organized in the United States – self-explanatory, but it should be noted
  • “forming part of a stock bonus, pension or profit-sharing plan:” Like “trust,” these words are also terms of legal art, each connoting specific concepts under the law. 
  • “for the exclusive benefit of his employees:” “exclusive” is the key word, which, according to the online Merriam-Webster dictionary, means, “excluding other from participation.” Management can only use trust assets for employees.  Put another way, management can’t use the funds for company purposes like funding ongoing operations or acquisitions.
  • “qualified trust” is a trust that complies with section 401(a) (Treas. Reg. 1-401(0)) which has 33 different sub-sections. Some are very broad while others are very situation specific.  Regardless, it’s a very technical section of the code, which further explains why compliance is usually outsourced to third parties.

In 2009, F. Hale Stewart, JD. LL.M. graduated magna cum laude from Thomas Jefferson School of Law’s LLM Program.  He is the author of three books: U.S. Captive Insurance Law, Captive Insurance in Plain English and The Lifetime Income Security Solution.  He also provides commentary to the Tax Analysts News Service, as well as economic analysis to TLRAnalytics and the Bonddad Blog.  He is also an investment adviser with Thompson Creek Wealth Advisors. 










[1] In Re Rothko, 43 N.Y. 2d 305 (I have reversed the order of the quotes for the sake of clarity).

Non-Qualified Deferred Compensation and Rabbi Trusts

12/19/2017

 
Revenue Procedure 92-64 contains model language for a “Rabbit Trust,” which is a trust a company can establish to set-aside funds for a NQDC plan.  Companies routinely use these structures to allay employee concerns about actually receiving NQDC payments.
You can read the entire Procedure at this link on the Legal Bit Stream website.

Non-Qualified Deferred Compensation: When Can You Make Distributions (pt. 2)?

12/5/2017

 
This is cross-posted on the Wealth and Risk Management Blog

As I noted in my previous post, the NQDC statute specifically states there are six events when a NQDC plan can make a distribution, one of which is when the service provider “separates from service,” which is defined in the Treasury Regulations as:

An employee separates from service with the employer if the employee dies, retires, or otherwise has a termination of employment with the employer.
As with other aspects of this statute, there is little room for a liberal legal interpretation of the definition.
The statute further defines “termination of employment” as,
Whether a termination of employment has occurred is determined based on whether the facts and circumstances indicate that the employer and employee reasonably anticipated that no further services would be performed after a certain date or that the level of bona fide services the employee would perform after such date (whether as an employee or as an independent contractor) would permanently decrease to no more than 20 percent of the average level of bona fide services performed (whether as an employee or an independent contractor) over the immediately preceding 36-month period (or the full period of services to the employer if the employee has been providing services to the employer less than 36 months).
The statute provides 2 tests.  Either there is a complete termination of employment or an 80% reduction in the amount of work performed (as compared to the preceding three years) by the service provider.  This is one of the few areas where a bit of definitional “play” exists in the statute.
Finally, the statute provides the following, non-exclusive set of factors to use in a “facts and circumstances” determination as to whether termination has in fact occurred:
1.) Whether the employee continues to be treated as an employee for other purposes (such as continuation of salary and participation in employee benefit programs),
2.) Whether similarly situated service providers have been treated consistently, and
3.) Whether the employee is permitted, and realistically available, to perform services for other service recipients in the same line of business.
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