An Innovative and Successful Way to Attract & Retain Key Employees

< Back to Insights
Contemporary office for a feature image.

A nonqualified deferred compensation plan is a great way to not only retain key talent but also promote long-term growth.


What is a Nonqualified Deferred Compensation Plan?

A nonqualified deferred compensation (“NQDC”) plan is an arrangement that an employer and employee agree to where the employer accepts to pay the employee sometime in the future. Executives often utilize NQDC plans to defer income taxes on their earnings. They differ drastically from qualified plans, like 401(k)s.

NQDC plans allow corporate executives to defer a much larger portion of their compensation and to defer taxes on the money until the deferral is paid.

What are the Advantages of NQDC Plans for Employers?

NQDC plans provide significant plan design flexibility and help employers recruit, retain, reward, and retire top talent. NQDC plans can also motivate the executive’s job performance.

As opposed to qualified plans such as 401(k) plans, NQDC plans are largely exempt from the ERISA nondiscrimination and reporting requirements. This can be a breath of fresh air and offer huge flexibility for plan sponsors.

Yes, NQDC plans are subject to rules under Internal Revenue Code Section 409A, but as long as you work with an experienced executive benefits attorney with regard to plan design, drafting, funding, and implementation, it can be a huge benefit to both you and your employees.

What is Insurance Premium Funding?

Insurance premium funding is a method of premium finance typically used by high-net-worth individuals and businesses to fund large life insurance policies, which often have high premiums that can be difficult to pay for out of pocket. The premium funding structure involves a third-party lender (a bank) that borrows money via the low-cost institutional capital markets to address premium payments and related interest payments. The client’s liability is limited to the “gap” collateral, which represents approximately 15-30% of the face amount of the policy. The “gap” collateral assets are pledged. This provides the means for the bank to pay both the premium and the interest due on the institutional capital.

The theory is that it is better to collateralize instead of capitalize the premium payment and interest obligation. The pledged collateral is reduced and released over time as the cash value grows versus the borrowed capital. For example, a business or corporation utilizing a premium funding structure to obtain life insurance on its key executives will not need to be concerned with selling or liquidating existing assets to fund the insurance premiums, thus avoiding tying up their own capital in their insurance policies. This allows corporations to create large life insurance policies in a tax-efficient structure with only the use of collateral to satisfy a limited guarantee.

What are the Advantages of Using Premium Funding/Corporate-Owned Life Insurance to Informally Fund Deferred Compensation Plans?

Corporate-owned life insurance (“COLI”) policies are a way for a company to minimize its tax burden, increase after-tax net income, finance employee benefits, and help cover the expenses associated with replacing an insured employee upon that employee’s death.

The corporation generally buys a cash-value life insurance policy for an individual employee or group of employees and pays the associated policy premiums. If the corporate entity utilizes a premium funding mechanism, instead of paying for the policy premiums and interest, the entity is only required to pledge the gap collateral amount. In addition, the entity can both own and act as the COLI policy beneficiary. The corporation can be the owner and beneficiary of the COLI policy. In essence, the entity retains all rights to the benefits under the policy, including the cash value buildup and the death proceeds.

Under a properly designed plan, the cash-value accumulated under the policy will not be subject to federal income tax as it accumulates. The corporation can also borrow against the policy. The borrowed funds can then be used to pay the policy premiums and/or to fund nonqualified plans. In addition, the corporation may be able to deduct all or part of the interest it pays on a policy loan.

The advantages of using life insurance as an informal funding mechanism for NQDC plans include the following:

  • Creditor Protection
  • Asset Diversification
  • Additional Executive Benefits
  • Tax Advantages

How Does This Work in the Real World?

Here are some examples illustrating the deferred compensation plus premium funding process:

  • Roofing Company: Had excessive income due to significant hail year. Used deferred compensation plan to defer income and taxes over next five years.
  • Catering Company: Granted deferred compensation awards to two key successors. Used deferred compensation plan to retain the key employees and facilitate the business success plan/buy in.
  • Closely-held private business: Established financial goals for new CFO. Deferred compensation plan included both service period and performance award components.
  • Commercial real estate company: Setup deferred compensation plan for 5 c-suite executives. Used plan to retain employees for 20+ years. Purchased life insurance on each executive to informally fund the plan.

What are the Risks?

The key legal issues related to premium funding arrangements are: (1) drafting and reviewing any related plan or policy; (2) potential tax issues due to defaulting on the loan; and (3) avoidance of modified endowment contract (“MEC”) status

An attorney with premium finance experience can help draft and review any plan or policy that relates to or is informally funded by life insurance.

With regard to default, federal tax law takes the position that a contingent liability cannot be taken into account for tax purposes until it matures, and thus a contingent liability can only result in tax consequences when it becomes fixed or is paid. Thus, as long as the insured or grantor is working with experienced premium funding/insurance consultants and legal counsel, there is virtually no chance that the loan will go into default, thereby mitigating any potential risks.

Finally, with regard to MEC status, all life insurance policies can provide a tax-advantaged way to transfer money to an individual’s beneficiaries. One of the biggest advantages of permanent life insurance comes from the death benefit, as well as the tax-free growth of the policy’s cash value.

The bottom line is that with premium funding or any premium financing structure, you must make the assumption that short-term debt obligations will be less than long-term market returns inside the life insurance policy. Historically, short-term debt has been less than long-term market returns.

What are the Next Steps for Informally Funding a NQDC Plan Through the Premium Funding Model?

NQD plans are excellent employee benefit plan options with the flexibility to meet many types of business objectives due to their “nonqualified” nature. If properly structured, the use of premium funding to informally fund a NQDC plan will keep the plan exempt from most ERISA provisions and provide substantial tax advantages and cash flow benefits for the corporation.

By working with an experienced employee benefits attorney and a certified estate planner or life insurance professional, a corporation can implement and maintain one or more customized NQDC plans funded by COLI in a legally compliant manner that best achieves its goals.

Authored by:

This article has been prepared for general information purposes and (1) does not create or constitute an attorney-client relationship, (2) is not intended as a solicitation, (3) is not intended to convey or constitute legal advice, and (4) is not a substitute for obtaining legal advice from a qualified attorney. Always seek professional counsel prior to taking action.

Get in the Know

Want to receive updates on changes to the legal landscape or exciting news at Fraser Stryker? Click below to subscribe to our mailing list!

Get the latest updates via RSS:
RSS feed (what is RSS?)