TAXES

<body topmargin=0 leftmargin=0 marginheight=0 marginwidth=0> <table cellpadding=0 cellspacing=0 border=0><tr> <td valign="top" colspan=2 height=90 BGCOLOR="#006699" TEXT="#080000" bgproperties="fixed" background="0be285a1erlcgo.gif"> <div> <FONT SIZE="5" COLOR="#FFCC66" FACE="Arial" ><B>NONQUALIFIED PLANS</B></FONT><B>     |     </B><A HREF="index.htm" TARGET="_top" TITLE="NONQUALIFIED PLANS"><U><B>home</B></U></A><B>                              </B><A HREF="id19.htm" TARGET="_top" TITLE="TABLE OF CONTENTS"><U>TABLE OF CONTENTS</U></A>   |   <A HREF="id48.htm" TARGET="_top" TITLE="FINAL EXAMINATION"><U>FINAL EXAMINATION</U></A></div> <div> <A HREF="id22.htm" TARGET="_top" TITLE="NONQUALIFIED PLANS "><U>NONQUALIFIED PLANS </U></A>   |   <A HREF="id23.htm" TARGET="_top" TITLE="DEFERRED COMPENSATION"><U>DEFERRED COMPENSATION</U></A>   |   <A HREF="id24.htm" TARGET="_top" TITLE="EXECUTIVE BONUS PLANS"><U>EXECUTIVE BONUS PLANS</U></A>   |   <A HREF="id26.htm" TARGET="_top" TITLE="GROUP CARVE OUT PLANS"><U>GROUP CARVE OUT PLANS</U></A>   |   <A HREF="id25.htm" TARGET="_top" TITLE="TAKEOVER DEFENSES"><U>TAKEOVER DEFENSES</U></A>   |   <A HREF="id89.htm" TARGET="_top" TITLE="REVIEW QUESTIONS"><U>REVIEW QUESTIONS</U></A>   |   <A HREF="id50.htm" TARGET="_top" TITLE="PRINTABLE VERSION"><U>PRINTABLE VERSION</U></A></div> <div> </div> </td> </tr><tr> <td valign="top" width=210 BGCOLOR="#FFCC66" TEXT="#080000" background="0bdd2c00dkelyh.gif"> <div> <A HREF="http://www.wallstreetinstructors.com" TARGET="_top" TITLE="http://www.wallstreetinstructors.com"><U><IMG SRC="0caaf630.gif" border=0 width="175" height="99" ALIGN="BOTTOM" HSPACE="0" VSPACE="0"></U></A></div> <div> copyright © 2002-2007 Wall Street Instructors, Inc.  All rights reserved.  </div> <bR> <div> <TABLE BORDER="2" CELLPADDING="2" CELLSPACING="1" WIDTH="164" BORDERCOLORLIGHT="#C0C0C0" BORDERCOLORDARK="#808080" FRAME="BOX" RULES="ALL" ALIGN="BOTTOM" HSPACE="0" VSPACE="0" BGCOLOR=#FFFFFF > <tR> <tD VALIGN=TOP HEIGHT= 20 ><NOBR><div> <A HREF="mailto:instructor@wallstreetinstructors.com" TARGET="_top" TITLE="mailto:instructor@wallstreetinstructors."><U><B>E-Mail An Instructor</B></U></A></div> </NOBR></tD> </tR> </TABLE></div> <bR> <DIV ALIGN="LEFT"></DIV> <div> <B>Module 2</B></div> <div> <B>DEFERRED COMPENSATION</B></div> <div> <B>__________________</B></div> <div> <A HREF="id74.htm" TARGET="_top" TITLE="USES OF DEFERRED COMPENSATION"><U><B>USES OF DEFERRED COMPENSATION</B></U></A></div> <div> <A HREF="id75.htm" TARGET="_top" TITLE="PLAN BENEFITS"><U><B>PLAN BENEFITS</B></U></A></div> <div> <A HREF="id90.htm" TARGET="_top" TITLE="TYPES OF PLANS"><U><B>TYPES OF PLANS</B></U></A></div> <div> <A HREF="id103.htm" TARGET="_top" TITLE="DEFERRED COMPENSATION ARRANGEMENTS"><U><B>DEFERRED COMPENSATION ARRANGEMENTS</B></U></A></div> <div> <A HREF="id102.htm" TARGET="_top" TITLE="INSURANCE"><U><B>INSURANCE</B></U></A></div> <div> <B>TAXES</B></div> <div> <A HREF="id100.htm" TARGET="_top" TITLE="PROSPECTS"><U><B>PROSPECTS</B></U></A></div> <div> <A HREF="id92.htm" TARGET="_top" TITLE="Review Questions Module 2"><U><B>Review Questions Module 2</B></U></A></div> </td> <td valign="top" height=390 BGCOLOR="#FFFFFF" TEXT="#080000"> <div> <I><B>TAXES</B></I></div> <bR> <div> <B>Constructive Receipt and Economic Benefit Doctrines</B></div> <bR> <div> Two income tax concepts are particularly pertinent to deferred compensation: </div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">the constructive receipt doctrine; and</div> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">the economic benefit doctrine.</div> <bR> <div> Because effectively deferring the tax on deferred compensation requires that income not be constructively received and that the participant not receive an equivalent economic benefit, let's look at these concepts more closely. </div> <bR> <bR> <div> <I><B>Constructive Receipt Doctrine</B></I></div> <div>  </div> <div> The constructive receipt doctrine states that income that is not actually received may be taxed as if it had been received, if the individual constructively received the income. Constructive receipt occurs when income is</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">set aside for the individual;</div> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">credited to the individual's account; or</div> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">made available to the individual without any substantial restrictions on the individual's control over the income.</div> <bR> <bR> <div> <I><B> <A NAME="economic_benefit_doctrine"><IMG BORDER="0" SRC="1x1.gif" HEIGHT="1" ALIGN="bottom" WIDTH="1" HSPACE="0" VSPACE="0" ></A></B></I><I><B>Economic Benefit Doctrine</B></I></div> <bR> <div> The economic benefit doctrine requires that an individual recognize income if property has been handled in a way that provides a cash-equivalent economic benefit to the individual.</div> <bR> <div> Fortunately for deferred compensation purposes, a mere unsecured promise to pay income in the future does not constitute constructive receipt, provided the employee does not have access to the compensation that has been deferred. </div> <bR> <div> As a result, when properly set up, a deferred compensation plan usually will not result in current taxable income to the employee.</div> <bR> <bR> <bR> <div> <B>Employer's Deduction Based on Benefit Payment</B></div> <div>  </div> <div> A key difference between a nonqualified plan — such as deferred compensation — and a qualified retirement plan is the way the plan is taxed. Qualified plans give an employer an income tax deduction at the time that contributions are made to the plan, and the employee is not subject to income tax on that contribution until he or she takes the money out many years later. Furthermore, as long as the money remains in a qualified plan, the tax on investment earnings is also deferred. None of this is true of a deferred compensation plan.</div> <bR> <div> Because a deferred compensation plan is a nonqualified plan, the employer receives a tax deduction only when the benefits are actually paid to the plan participant or survivors or when they are no longer subject to a substantial risk of forfeiture. When the employer receives the income tax deduction, the plan participant or survivor is subject to income tax. The moment of taxation is the moment that the employee receives the payment or gains a right to the funds that is not subject to a substantial risk of forfeiture.</div> <bR> <bR> <div> <I><B>Question of Risk</B></I></div> <bR> <div> Income taxation may not occur until the employee receives the deferred compensation payment. However, income tax liability may occur earlier if the money is set aside for him or her in a way that protects the funds from risk. The two most common ways to do so are through the rabbi and secular trust discussed earlier.</div> <bR> <bR> <div> <B>Taxation When Rabbi Trust Is Used</B></div> <div>  </div> <div> Rabbi trusts postpone the moment of taxation because, although the trust affords some protection of the employee's money, it remains at substantial risk of forfeiture. Consequently, the deduction for the employer and taxation for the employee is postponed generally until the funds are paid to the plan participant or survivor.</div> <bR> <bR> <bR> <div> <B>Taxation When a Secular Trust Is Used</B></div> <div>  </div> <div> Secular trusts do not postpone taxation. The increased protection of the employee's benefit has been interpreted as removing the substantial risk of forfeiture. Consequently, the deduction for the employer and taxation for the employee is not postponed but occurs when payments are made to the trust. </div> <bR> <div> At first glance, this seems undesirable for the employee to be taxed without receiving the money. But, employees still might prefer this arrangement if they expect to be in a much higher tax bracket when they withdraw the funds or if they think the funds might be lost in a future merger. Understandably, however, secular trusts become somewhat less attractive to plan participants to the extent that the top individual tax rate is higher than the top corporate tax rate.</div> <bR> <bR> <div> <I><B>Necessary and Reasonable Tests</B></I></div> <bR> <div> For compensation that an employer pays to an employee to be income tax deductible, it must be both necessary and reasonable; deferred compensation payments must meet the same test. To be deductible by the employer, deferred compensation payments an employer made for majority shareholders also must qualify as ordinary and necessary business expenses and as a reasonable allowance for services actually rendered. These are not difficult tests to meet when the employer and the employee enter into a written arm's-length agreement to pay deferred compensation.</div> <bR> <div> The necessity and the reasonableness of the deferred compensation benefits may be issues when the employee is also a principal shareholder of the firm. In these cases, the corporation's deduction of a portion or all of the deferred compensation payments may be disallowed as being a distribution of dividends.</div> <bR> <bR> <div> <B>Survivor Payments</B></div> <div>  </div> <div> The Internal Revenue Code permits the deduction by the employer of payments made to the surviving spouse of a deceased employee under the terms of a deferred compensation contract. Income tax payments received by a survivor under a deferred compensation contract are reportable as gross income.  This rule applies even though the source of the payments is insurance proceeds the employer received, and which were excludable as income when received by the employer.</div> <bR> <bR> <div> <I><B>Survivor Payments Includible in Estate</B></I></div> <div>  </div> <div> The survivor receives these payments because of the deferred compensation contract, not because of the life insurance. As a result, the income the survivor received is not excludable from income taxation as amounts received under a life insurance contract. Payments to a surviving spouse under a deferred compensation contract also are considered in tax lingo to be "income in respect of a decedent".</div> <bR> <div> A deferred compensation agreement, <U>evidenced by a contract</U>, which promises benefits beyond the death of the employee, causes those future benefits to be included in the decedent's gross estate and subject to federal estate tax. This is based on the fact that the decedent had a contractual right to have his or her employer make these payments.  The amount includible in the plan participant's gross estate attributable to the deferred compensation plan is the present value of deferred compensation payments payable after the employee's death. Federal tables are used to value the present value of these future survivor payments.</div> <bR> <div> If a deferred compensation plan is <U>noncontractual</U> and the employer may modify or terminate it at any time before the employee's death or retirement, its death benefits may not be subject to estate tax.</div> <bR> <bR> <bR> <div> <B>Shareholder as Plan Participant</B></div> <bR> <div> What about deferred compensation for a plan participant who is also the principal shareholder of the corporation? The answer to this question is important to the insurance professional, because a principal shareholder is often a prime prospect for deferred compensation. As a result, it is considerably easier to sell deferred compensation for the principal shareholder than for any other employee.</div> <bR> <div> However, for the deferred compensation arrangement to be viable for the principal shareholder, special arrangements need to be made. Specifically, the plan should be structured so that benefits will be paid to the principal shareholder at retirement or to the shareholder's family at death, even in the event that the corporation is no longer in existence. The legal devices that may be used include the rabbi and secular trusts that we have already examined.</div> <bR> <bR> <div> <B>Other Tax Issues</B></div> <bR> <div> There are three issues whose answers we have already alluded to in this course. However, for the sake of completeness and clarity, let's briefly examine them again. They are:</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">insurance premiums;</div> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">the employer's tax deduction for benefits paid; and</div> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">accumulated earnings tax.</div> <bR> <bR> <div> <I><B>Tax Consequences of Paying Insurance Premiums</B></I></div> <bR> <div> The first issue, regarding insurance premiums, is a simple and straightforward one. Specifically, premiums paid by a corporation on an insurance policy it owns on the life of an employee — even a shareholder-employee — is not taxed to the employee. The payment is not deductible by the corporation either.</div> <bR> <bR> <bR> <div> <I><B>Deduction When Benefits Are Paid</B></I></div> <bR> <div> With respect to the employer's deduction, the employer may deduct payments made to an employee or survivor, provided that:</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">the payment of the benefits is a necessary business expense; and</div> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">the size of the benefit is reasonable in amount.</div> <bR> <div> The first requirement — the necessity of the deferred compensation payment — can be satisfied in most cases with a binding, written agreement at the time the deferral of income begins.  The second requirement — the reasonableness of the benefit — may give the employer more trouble than the first one, especially with a majority stockholder. </div> <bR> <div> With respect to the majority stockholder, the questions that need to be asked and answered are:</div> <bR> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Are the deferred compensation payments made to this employee reasonable compensation for services rendered and, therefore, deductible?</div> <div> <IMG BORDER="0" SRC="Symb075c00b700dc00000000.gif" HEIGHT="15" WIDTH="24" ALIGN="bottom" HSPACE="0" VSPACE="0">Should the deferred compensation payments be regarded as dividends flowing to this individual because of his or her stock ownership and, therefore, not deductible by the corporation?</div> <bR> <bR> <div> <B>Reasonableness of Executive Compensation to Shareholder</B></div> <bR> <div> There are few hard and fast guidelines with respect to the reasonableness of executive compensation paid to a majority stockholder.</div> <bR> <div> If the corporation has had difficulty during this shareholder-employee's working years justifying the reasonableness of the compensation paid, it is reasonable to expect that the corporation will find it even more difficult to justify significant deferred compensation levels after that individual retires. The primary problem is that justification for the deferred compensation payments is based on the total services he or she performed for the corporation during the working years.</div> <bR> <bR> <div> <I><B>Accumulated Earnings Tax</B></I></div> <bR> <div> The issue of corporate earnings that are accumulated to pay the deferred compensation liability involving a majority stockholder is one that also presents concerns. What of the corporation that accumulates reserves-rather than purchasing life insurance-to enable it to meet its obligation to the shareholder-employee? Can it argue that these accumulations serve a legitimate business purpose and, therefore, escape the accumulated earnings tax?</div> <bR> <div> When the employee is the principal shareholder, the corporation generally will find the money to pay the person a deferred benefit and, it could be argued, may not need to accumulate the funds to do so. Deferred compensation for a principal shareholder-employee continues to be an uncertain tax area that should be explored thoroughly by tax counsel before a deferred compensation plan is begun.</div> <bR> <bR> <div> <I><B>Life Insurance and Accumulated Earnings</B></I></div> <bR> <div> In addition to all of the other reasons to use life insurance to informally fund the deferred compensation plan, from the point of view of the accumulated earnings tax, the corporation should use life insurance to fund its deferred compensation obligations. That preference applies whether the deferred compensation plan participant is the majority shareholder or not. At any time during the employee's lifetime, there would be a smaller amount accumulated as annual premiums paid than with any other method of funding.</div> <bR> <div> In those cases in which the persons are minority shareholders, there appears to be no reason why they cannot be covered by a deferred compensation agreement, providing the amounts are reasonable in the best judgment of the directors and shareholders.</div> <bR> <bR> <bR> <bR> <DIV ALIGN="LEFT"></DIV> <div> <TABLE BORDER="2" CELLPADDING="2" CELLSPACING="1" WIDTH="76" BORDERCOLORLIGHT="#C0C0C0" BORDERCOLORDARK="#808080" FRAME="BOX" RULES="ALL" ALIGN="BOTTOM" HSPACE="0" VSPACE="0" BGCOLOR=#FFCC66 > <tR> <tD VALIGN=TOP HEIGHT= 23 WIDTH="64"><div> <A HREF="id100.htm" TARGET="_top" TITLE="PROSPECTS"><U><B>NEXT</B></U></A></div> </tD> </tR> </TABLE></div> <div> <I><B>  </B></I></div> </td> </tr></table></body>