It's Not What You Earn That Counts, It's What You Keep

By Justin D. Toney

In the last two decades, America's corporate leadership has accumulated significant wealth through participation in nonqualified company-sponsored compensation and benefit programs. To the extent that these programs have facilitated access to equity returns, executives are enjoying the prospect of even greater retirement wealth.

With wealth comes taxes, however, and they are significant for those who are highly compensated. The combined income and estate tax bills arising from retirement dollars not spent can exceed 85%. In light of this, it is not surprising that most executives prefer to transfer excess wealth to heirs or charity rather than pay additional taxes.

Ironically, a relatively new and very effective way of controlling the destination of excess income is to give it up. That's right - this alternative approach allows the executive to exchange, or 'swap,' compensation and/or nonqualified benefits for rights to a cash value life insurance policy purchased by the employer. The sponsoring company will buy a policy on the employee's life that has significantly greater cash value and death proceeds than the income given up. The death proceeds transferred to the heirs are often five to ten times what would have been transferred after all taxes were paid on excess income in the estate. And just when you think this program can't get any better, under current tax law life insurance death proceeds are exempt from income and estate taxes when paid to an irrevocable life insurance trust for the next generation.

Underlying the considerable economic advantage of this new program is an old estate-planning adage: You can have ownership and pay taxes, or you can have control and avoid taxes. The benefit exchange effectively redirects income to a tax-advantaged investment vehicle before it is paid. Hence, ownership (and taxation) never occurs, but the insured can control who receives the death proceeds.

How can the company justify the premium cost? An insurance strategy called 'split-dollar' facilitates reimbursement of the company's total premium outlay at a pre-determined time in the future. Subsequently, the only long-term cost of the arrangement is the time value of money on the premium dollars, which can be made equal to the projected cost of paying the swapped benefits to create a cost-neutral situation for the employer. As for the impact on corporate earnings, current accounting standards allow the company to book its rights to the cash value as current income, which effectively offsets the premium expense. Compare this to the annual earnings charges from compensation expenses or nonqualified benefit liabilities, and the program is a win for employer's books as well as for the employee.

Sound too good to be true? Perhaps. The IRS has yet to rule on whether the benefit exchange creates a taxable event. Further, the tax treatment of split-dollar life insurance remains a hotly debated issue among accountants, tax attorneys, and insurance professionals. To minimize the risk of adverse taxation, a company and executive considering this program should hire a reputable and knowledgeable financial consultant to assist with the design and administration. As with any new idea, the long-term opportunities are much greater when the parties have contemplated all the issues.

Justin Toney is a Senior Associate, Marketing, with Mullin Consulting, Inc., an Executive Benefits Consulting firm. For further information, please contact Justin Toney or Mark Springett (Vice President), at 213-488-8500.

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