This is the Third Clip in a series of three. Check out our articles for additional videos.

This is the Second Clip in a series of three. Check out our articles for additional videos.

There are three things that never seem to change here in America: no one lives forever, relationships rule and taxes aren’t going away. Death, taxes and relationships are here to stay, and they all play a role in the past, present and future of life insurance.

Yesterday, I called one of my widow clients. Her husband of 45 years passed away in a freak car accident, and now she’s trying to make it one day at a time. When our clients die, we walk in with cash to help when they need it the most. The loss of a loved one leaves a huge hole in our clients’ hearts. Life insurance can help them carry on when depression is knocking at the door.

Taxes are here to stay. The first federal income tax was enacted by President Abraham Lincoln in 1861 to assist in the Civil War effort and was meant to go away five years later. However, federal income taxes never went away. Today, with the national debt registering nearly $17 trillion of debt and $115 trillion of debt plus unfunded liabilities, we are beyond the point of no return.

So what can you do about these severe economic problems? Relationships will open doors to help you serve your clients with additional security in uncertain times. You have the solution of bringing in tax-preferred cash into desperate situations when everyone else is asking clients to pay their bills. For pennies on the dollar, you can bring guarantees into your clients’ unstable financial worlds.

In less than 3 years, U.S. employers may have a chance to use much of the money now spent on group health coverage for other purposes – such as increasing the income of highly paid employees.

Paul Fronstin, a researcher at Employee Benefit Research Institute (EBRI), Washington, writes about the possibility of employers dropping coverage — and using some of the savings to increase the pay of highly paid employees — in an analysis released by EBRI.

Some of the negotiators involved in drafting the Patient Protection and Affordable Care Act of 2010 (PPACA) went to great lengths to try to tailor the act in such a way that it would not crowd out much private group health coverage when major provisions take effect in 2014.

In 2014, health insurance exchanges are supposed to give consumers a ”one-stop” health insurance shopping system along with health coverage purchase subsidies delivered in the form of tax credits. Employers over a certain size will have to choose between offering group health coverage or paying a penalty.

To qualify for health insurance purchase tax subsidies, workers must have incomes below a cut-off. They also must be ineligible for employer-sponsored coverage or be eligible for group coverage that costs more than 9.5% of their income or covers less than 60% of the cost of covered care.

It’s possible that PPACA opponents could have the act repealed or declared unconstitutional, Fronstin says.

But, if PPACA takes effect and works about as expected, Congress could still throw off projections about PPACA private group health coverage by imposing a tax on all or part of employer group health benefits expenditures, Fronstin says.

Critics of the group health benefits tax exclusion argue that it will cost the government about $1.1 trillion in revenue from 2012 to 2016 while doing more to help higher-income workers than lower-income workers. About 53% of the U.S. residents who have employment-based health coverage have annual incomes over 400% of the federal poverty level, or about $88,000 for a family of 4, while only 6% have incomes under 133% of the federal poverty level — the 2014 Medicaid income cut-off, according to EBRI figures.

Employers that issue 250 or more W-2′s must start reporting the value of group health benefits on the forms starting Jan. 1, 2013.

“Given that the information on the value of health benefits will already be reported on Form W-2, employers will already be providing enough information to workers to include the value of the benefit on tax returns for purposes of taxation of the benefit,” Fronstin says. “Once employment-based health benefits are counted as taxable income, workers would start questioning the value of keeping such coverage rather than seeking coverage on their own in the insurance exchange.”

The typical worker could be paying about $1,500 in annual premiums for employer-sponsored employee-only coverage and about $6,600 for family coverage in 2014, Fronstin says.

“Some workers will find that the net premium in the health insurance exchange is lower than their share of the premium under an employment-based plan, even when the employer portion of the premium is excluded,” Fronstin says.”If employers gave workers 60% of the employer share of the premium for employee-only coverage, and only 21% of the employer share of the premium for family coverage, then all workers below 400% of the federal poverty level would be able to cover their full share of the premium in the insurance exchange…. Even if only a fraction of these workers preferred coverage through an insurance exchange, it would send a clear message to employers that millions of workers no longer valued employment-based health benefits.”

If workers signal to employers that they prefer buying health insurance through an exchange, “employers would then start to ask themselves why they should continue to offer health coverage,” Fronstin says. “At that point, they might simply drop the benefit, which would enable workers to get subsidized coverage in the exchange. Predicting how this might play out by firm size, industry, worker earnings, geographic region, among other things, is highly uncertain.”

The “buy your own coverage” approach would leave an employer about $2,000 left over per worker with employee-only coverage and about $8,500 per worker with family coverage, and the employer could use that extra cash to pay the $2,000 PPACA penalty for not offering coverage, Fronstin says.

“What about workers above 400% of the federal poverty level?” Fronstin asks. “Employers that dropped coverage could increase their compensation on an after-tax basis using part or all of the savings from the employer share of the premium that was not paid out to lower-income workers.”

Under § 457(b), state and local governments and tax-exempt entities may establish and maintain “eligible deferred compensation plans” for the benefit of their employees. These 457(b) plans may be maintained in addition to 401(a), 403(a) and 403(b) plans. They must, however, satisfy certain conditions, including an annual limit on the amount that may be deferred by each participant. If the conditions are satisfied, amounts deferred under the plans are not includible in income until they are paid to the participant. Generally, if a deferred compensation plan maintained by a governmental or tax-exempt entity is not a 401(a), 403(a) or 403(b) plan and does not satisfy the conditions of § 457(b), it is considered a 457(f) plan under which deferred amounts will be includible in income in the first year in which no substantial risk of forfeiture exists, regardless of when such amounts are actually distributed to the participant. For these purposes, a substantial risk of forfeiture exists so long as rights to compensation are conditioned upon the future performance of substantial services by any individual.

Prior to 1986, deferred compensation plans and arrangements maintained by tax-exempt entities were not subject to the requirements of § 457. Rather, such plans and arrangements were treated similarly to deferred compensation plans and arrangements maintained by for-profit entities, under which no annual limitation on deferred amounts exists. So long as a promise to pay deferred compensation in the future is unsecured, the deferred amounts are not includible in the employee’s income. The Tax Reform Act of 1986 (“TRA ’86″), however, extended the rules of §457 to deferred compensation plans maintained by tax-exempt organizations for tax years beginning after 1986. “Grandfathered” plans of tax-exempt employers, though, are not subject to the requirements of § 457.

A deferred compensation plan maintained by a tax-exempt organization is considered “grandfathered” to the extent that deferrals under that plan were fixed pursuant to a written document on August 16, 1986. For this purpose, a deferral was considered fixed on that date if the deferral was then determinable under the written terms of the plan as a (i) fixed dollar amount, (ii) a fixed percentage of a fixed base amount (e.g., amount of regular salary, commissions, bonus or total compensation), or (iii) an amount to be determined under a fixed formula. Additionally, even if the plan, by its terms, did not contain a fixed deferral amount on August 16, 1986, the deferrals continue to be treated as though they were fixed if the deferral formula was not changed after August 16, 1986. Provided the deferred compensation plan remained grandfathered, all deferrals made pursuant to the formula in existence on August 16,
1986, even if made in subsequent tax years, remain exempt from § 457.

A plan, however, will lose its grandfathered status and will be subject to § 457(b) (or 457(f) if the conditions of 457(b) are not satisfied) as of the effective date of any modification to the plan that directly or indirectly alters the (i) fixed dollar amount, (ii) the fixed percentage or (iii) the fixed base amount to which the percentage is applied or the fixed formula.

Because these grandfathered plans do not fall within any exceptions under § 409A, they (unlike 457(b) plans) are subject to the requirements of that section. It appears that in this instance the employer is amending the plan to ensure that its terms are in compliance with § 409A, particularly with regard to the timing of payments and the participant’s right to change the time or form of payment. Without expressing any opinion regarding § 409A, the Service ruled that the proposed amendments would not affect the grandfathered status of the plans in question.

This ruling is the first in this area in over twelve years and was probably triggered by the Treasury regulations and guidance existing under § 409A. For an example of a ruling issued in 1992 on this subject, see our Bulletin No. 92-61. Although PLRs cannot be used or cited as precedent, PLR 201117001 provides employers of grandfathered deferred compensations plans with some comfort that amendments to such a plan to comply with the § 409A time and form of payment requirements will likely not cause the plan to be subject to the current requirements of § 457.

Any AALU member who wishes to obtain a copy of PLR 201117001 may do so through the following means: (1) use hyperlink above next to “Major References,” (2) log onto the AALU website at http://www.aalu.org/ and enter the Member Portal with your last name and birth date and select Current Washington Report for linkage to source material or (3) email Anthony Raglani at raglani@aalu.org and include a reference to this Washington Report.

PDF Copy of this Summary – AALU PLR 201117001 Summary (Bulletin 11-46)

In order to comply with requirements imposed by the IRS which may apply to the
Washington Report as distributed or as re-circulated by our members, please be
advised of the following:

THE ABOVE ADVICE WAS NOT INTENDED OR WRITTEN TO BE
USED, AND IT CANNOT BE USED, BY YOU FOR THE PURPOSES OF
AVOIDING ANY PENALTY THAT MAY BE IMPOSED BY THE
INTERNAL REVENUE SERVICE.

In the event that this Washington Report is also considered to be a “marketed
opinion” within the meaning of the IRS guidance, then, as required by the IRS,
please be further advised of the following:

THE ABOVE ADVICE WAS NOT WRITTEN TO SUPPORT THE
PROMOTIONS OR MARKETING OF THE TRANSACTIONS OR
MATTERS ADDRESSED BY THE WRITTEN ADVICE, AND, BASED ON
THE PARTICULAR CIRCUMSTANCES, YOU SHOULD SEEK ADVICE
FROM AN INDEPENDENT TAX ADVISOR.

Executive Benefits: Beyond the Downturn and the Backlash …

Instead of merely paying a benefit equal to the appreciation in value of the “phantom” stock between the date the “phantom” shares are granted and the payment date, it is possible to structure the benefit so that it equals the entire value of the “phantom” shares as of the payment date. In addition, if the intent is to closely mimic actual stock ownership, the key employee’s “phantom” stock account could be credited with all cash, stock dividends, and stock splits which are attributable to the “phantom” shares.

Payment of the benefit generally occurs upon termination of employment as a result of retirement, death or disability, or at a specified future date, depending upon the company’s preference. The benefit can be paid out in installments (either in cash or common stock of the company) over a period of years. Generally, the benefits are paid in cash because the company does not want the key employee to actually have direct stock ownership.

Consequences of Phantom Stock Plan
A. Key Employee – No tax is payable by the key employee at the time the “phantom” stock is credited to the employee’s account. The employee is taxed when the benefit is actually paid.

If the plan is designed to make annual payments to the phantom plan participants to replicate the cash and stock distributions made to the company’s actual stockholders, the payments are taxable to the phantom plan participant as ordinary income and deductible to the company when paid.

B. Company – There is no deduction available to the company upon the initial crediting of the “phantom” stock to the employee’s account under the phantom stock plan. When the employee is paid the benefit, the company is entitled to a compensation deduction for the same amount as the employee includes in income.

C. Compliance with Employee Retirement Income Security Act of 1974 (ERISA) – Phantom stock plans are generally designed as “top hat” plans which are unfunded and maintained by the company for a select group of management or highly compensated employees. This exempts the plan from most of ERISA’s provisions and prevents the employee from recognizing any income when the “phantom” shares are granted. In order to comply with the ERISA reporting requirements for “top hat” plans, there is a one-time filing with the United States Department of Labor.

D. Informal Funding – While the payment of the plan benefits cannot be “secured”, it is possible to informally fund the benefit payments by having the company purchase a life insurance policy on the key employee’s life. However, the policy cash value, as well as the death benefit, must be subject to the general creditor claims of the company in order to avoid the arrangement being treated as a “funded” arrangement.

E. Accounting – The company must charge its earnings with compensation expense over the period during which the phantom stock is outstanding in an amount equal to the fair market value of the value accrued to the employee under the plan.

F. Compliance with Section 409A – Section 409A of the Internal Revenue Code was enacted as part of the American Jobs Creation Act of 2004 and sets forth various requirements relating to deferred compensation plans. A phantom stock plan is a form of deferred compensation and will need to be carefully structured to avoid any adverse tax consequences to the key employee under Section 409A. If the plan fails to satisfy the requirements of that section, the key employee would be taxed on the unpaid amount deferred under the plan and would be subject to penalties. Correctly structured the plan should qualify under Section 409A so that there will not be a problem of the key employee having income before the benefit is actually paid.

Issues to Consider
For companies that want to offer their key employees the opportunity to share in the company’s success without giving up an actual equity stake in the company, phantom stock plans provide a great deal of flexibility. Because these plans are written contractual relationships, the company is not subject to the legal requirements which would normally apply if the key employee received actual stock. The plan may be creatively structured with measuring criteria and vesting schedules that act as “golden handcuffs” to retain valued employees and to align the key employees’ interests with those of the company.

In determining whether to implement a phantom stock plan, some of the considerations are as follows:
1. Which key employees will participate? In order to obtain exemption from most of ERISA provisions, the plan must be designed to benefit a select group of management or highly compensated employees.

2. When will the “phantom” shares be granted and when will they vest?

3. What will be the cutoff or triggering events requiring payment (i.e., death, disability, retirement,
termination of employment or a specific date)?

4. How is the payment of the benefit to be made? Generally it will be made in cash as opposed to the company stock. Will the company have sufficient cash to pay the benefit?

5. Should the obligation of the company be informally funded through the acquisition of life insurance policies on the lives of those individuals covered by the phantom stock plan?

6. Will the compensation liabilities shown on the company’s books as a result of the phantom stock plan have any adverse effects on the company’s ability to obtain financing?

7. Will the payment of the benefit be in one lump sum or spread over a period of time?

8. How many “phantom” shares will be initially granted? Will there be any crediting for the equivalent of any cash dividends, stock dividends, or stock splits which would be attributable to the phantom shares? Keep in mind that the “phantom” shares while not direct equity interests in the company, dilute the existing equity of the company’s shareholders.

9. How will the valuation of the company be conducted in order to determine the value of the shares? The associated costs of the valuation need to be incorporated into the decision to implement a phantom stock plan.

Examples of plan designs:

• Employer will create a performance metric equal to a fixed dollar amount or percentage of profits, each year the value of the funds put aside will grow based upon the growth of the business or fixed rate of return
• Employer may assign a number of shares to the key person based upon a percentage of salary, which may or may not tie into the performance of the company.
• Employer might create a straight non-qualified “profit share” equal to a percentage of earnings and each year those funds will increase like a 401K but not vest until retirement, change of control or death of the primary shareholder – thus creating a true golden handcuff.