For corporations and non-profits alike, trying to navigate the complexities of tax regulations around executive compensation can be a major challenge. The ever-evolving landscape of tax laws, particularly with executive compensation, demands innovative solutions. This article examines the use of split-dollar arrangements and their pivotal role in managing excise taxes within executive compensation plans for corporations and non-profit organizations.
Excise tax challenges
Excise taxes are a type of indirect tax imposed by the government on specific activities, goods, services, or transactions. They are distinct from income taxes and typically levied on particular events, products, or privileges. Excise taxes impact executive compensation plans for both corporations and non-profit organizations in several ways:
- Limit on compensation (Section 162(m)): This rule limits the amount of executive compensation a corporation can deduct from their taxes. The current limit is $1M annually for each executive.
- Excise tax on excessive compensation (Section 4960): This excise tax, established by the Tax Cuts and Jobs Act in 2017, applies to non-profit organizations, including tax-exempt 501(c)(3) entities. It imposes a 21% excise tax on the portion of compensation over $1 million paid to any of the organization's five highest-paid employees. It also applies to certain parachute payments upon termination or change of control. Since non-profits typically don’t pay taxes, they must be cautious in structuring executive compensation packages to avoid triggering this tax.
- Golden parachute excise tax: Under Internal Revenue Code Section 280G, corporations may be subject to a golden parachute excise tax when certain executives receive excessive compensation concerning a change in corporate control (e.g., merger or acquisition). The tax applies if the total payments exceed a specified limit (three times their average annual compensation). This tax can deter companies from providing generous severance packages and may impact executive compensation negotiations.
- Excise tax on deferred compensation (Section 409A): Section 409A of the Internal Revenue Code imposes excise taxes and penalties on specific deferred compensation arrangements that don't comply with the law's requirements. This can affect executives' deferred compensation and retirement plans, potentially leading to additional taxes and penalties if not structured correctly.
Understanding split-dollar arrangements
Regarding executive compensation strategies and navigating the intricate landscape of tax regulations, life insurance, mainly through split-dollar arrangements, can play a pivotal role. Here’s how:
Setting up a loan regime split-dollar arrangement
A split-dollar arrangement is a specialized agreement used in conjunction with a permanent life insurance policy. It allows two parties, typically an employer and an employee, to share a life insurance policy's costs, benefits, and ownership. For executive compensation plans, organizations can employ a loan regime split-dollar arrangement. Under this arrangement, the company effectively loans the executive a portion of their salary, which allows for tax and compensation benefits:
- Annual salary loans: Imagine an executive with a $2 million salary. Instead of paying the entire amount as salary, the organization loans a portion each year, thus reducing the executive's compensation to under the $1 million limit set by Section 162(m). This can be a crucial strategy to avoid excise taxes.
- Loan as a bonus: The additional compensation that exceeds the $1 million limit can be structured as a loaned bonus. This innovative approach allows organizations to provide substantial compensation without incurring additional tax burdens.
It’s important to note that the executive is typically required to pay interest to the company each year on the loan. In some instances, it is also possible for the loan interest to be accrued as well.
Leveraging the cash value in permanent life insurance policies
The key to making this strategy even more effective is using a cash-value life insurance policy in the split-dollar arrangement. The company max-funds the life insurance policy on the executive's life. This policy can accumulate cash over time, making it a valuable asset and allowing the executive to utilize it as income.
Loan Repayment Options
The loan repayment itself can be structured in two ways:
- Full repayment: The business can require the executive to repay the loan in full, effectively returning the borrowed amount to the organization.
- Loan forgiveness: Alternatively, the business can choose to forgive the loan, thereby providing a form of debt relief. However, it's crucial to understand that this debt relief is considered income to the executive and must be reported as such. They must pay taxes on the amount forgiven, while the business can claim a tax deduction for the forgiven amount.
In summary, split-dollar policies provide a powerful mechanism for corporations to optimize executive compensation while managing tax liability. By strategically incorporating loans in a split-dollar arrangement, businesses can craft compensation packages that align with their executives' interests and organizational goals while complying with tax regulations. However, organizations and executives must engage with financial and legal experts to navigate these complex strategies effectively.
Modern Life is a tech-enabled brokerage that can help advisors and their business clients purchase the best permanent policy for their split-dollar arrangements. Here’s how we make the entire buying journey as easy as possible:
- Client onboarding: Modern Life streamlines client onboarding with user-friendly digital forms and shareable links, reducing paperwork and saving valuable time.
- Document management and requirement tracking: Modern Life offers a secure platform for storing, organizing, and sharing client documents, facilitating seamless case management.
- Carrier and product choice: Split-dollar arrangements are complex legal documents, and Modern Life recognizes the need for diverse options. Advisors gain access to a wide range of carrier choices for permanent policies. Advisors can compare quotes and policy illustrations from multiple carriers, helping clients find policies that align with their unique needs and budgets.
- Fast quoting times: With Modern Life's digital underwriting capabilities and strong carrier connections, advisors experience a 41% shorter approval time, and clients save an average of 17% on their policies.
- Access to expertise: Whether it's clients with a stroke history or a criminal record, Modern Life's brokerage managers, with decades of experience, can provide valuable insights and assistance to secure coverage.
- Generative AI chatbot: Modern Life's chatbot is explicitly designed for life insurance advisors. It can answer common client questions, generate new sales concepts, and assist with creating marketing materials.
If Modern Life sounds like the best solution for your firm, fill out the form to speak to a brokerage manager today.