Financial Accounting Rules, Income Tax Life Insurance

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State Tax Issues  

The tax situation must be reviewed on a state as well as a national basis to ensure it results in the expected tax and economic position carefully. Some states may even apply an exit tax on any deferred compensation earned in that state but not taxed at the time of relocation.

Understanding Taxes on Life Insurance Premiums

Internal Revenue Bulletin: 2007-19

Accounting

An employer accounts for non-qualified deferred compensation plans on its books and records, rather than on the books and records of a separate trust as is the case for qualified plans.

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Two Sets of Rules

There are two separate sets of accounting “rules” that relate to non-qualified deferred compensation plans. The first set of rules is the “generally accepted accounting principles” that govern the preparation and reporting of financial statements for use by creditors, shareholders, and (in the case of publicly-

Held corporations) the public. These are the “financial accounting rules.” The other set of rules are those that govern the preparation of income tax returns. Those are the “IRS rules.”

Tax-Exempt 457(b) Plans: Key Characteristics and Common Mistakes

Financial Accounting Rules

The first pronouncement covering the accounting rules for deferred compensation arrangements is APB-12. This pronouncement includes both defined benefit arrangements and defined contribution arrangements. If a group of employees is participants in a non-qualified defined benefit

plan, however, a separate set of rules apply. Under APB-12, each deferred compensation arrangement is examined on an employee-by-employee basis. The amounts attributable to current services performed by each employee are accrued. The accrual covers the partial compensation benefits that will eventually be paid to the employee (or the employee’s beneficiary). A separate pronouncement, APB-8, as modified by FASB-36, comes into play if the following two factors are present:

(1) The defined benefit arrangement covers a “group”; and

(2) The plan, taken as a whole, is tantamount to a pension plan.

Eligible Deferred Compensation Plans under Section 457 Notice 2003-20

IRS Rules

The IRS does not permit a deduction on the employer’s tax return for the accrual of the deferred compensation liability during the pre-retirement years. The entries were accruing that liability, therefore, is not reflected in the calculation of taxable income. The accrued deferred compensation liability, on the balance sheet of the employer, on the other hand, is carried to the corporate employer’s income tax return at Schedule L. Similarly, an entry showing the “non-deduction” should be included in the Schedule M-1 on the corporation return.

Retirement

At the time the retirement benefit is paid to the employee, a deduction for the payment will be taken on the employer’s income tax return even though no expense, other than the accrual of interest, is reflected on the employer’s financial statements. This will, in turn, require another entry on the Schedule M-1, indicating the deduction (for Federal income tax purposes) of an item that was not deducted for financial reporting purposes.

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Estate Planning Considerations

Death During Deferral

Even though deferred compensation is primarily an income tax savings technique for the executive while he is alive, it can have important estate tax consequences as well as tax significance to the executive’s estate and beneficiaries after his or her death. The reason for this is that the executive may die before receiving any of the deferred compensation payments or after receiving only a portion of the payments. This is another risk to the employee and is usually addressed by a contract provision that allows for a portion of the benefit to be paid to the employee’s survivors if the employee dies prior to retirement, and a continuation of the retirement benefits to the employee’s survivors for a maximum number of years if the employee dies during the early years of retirement.

Example

For example, death before retirement could result in a payment to the survivors of the employee for ten years, while death during the first ten years of retirement could result in the continuation of the retirement payments through the tenth year after the date of the employee’s retirement. The latter feature is often designated as a “salary continuation” feature and is sometimes included as part of the deferred compensation agreement to allow “salary continuation” upon death even during the pre-retirement years.

IRC 457(b) Deferred Compensation Plans

Income Tax Consequences

For income tax purposes, deferred compensation paid after death is income in respect of a decedent and is taxable as ordinary income to the recipient whether the recipient is the estate, spouse, trust, or another beneficiary. However, the recipient is entitled to an income tax deduction for the estate tax, if any, attributable to the inclusion of the deferred compensation right in the executive’s estate. The allowance of this income tax deduction for the attributable estate tax has the effect of reducing the recipient’s income tax on the deferred compensation payments.

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Estate Tax Consequences

For estate tax purposes, the value of the beneficiary’s right to receive the deferred compensation is included in the gross estate of the executive at his or her death. Any estate tax attributable to the inclusion of the deferred compensation is deductible by the recipient for income tax purposes.

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Gift Tax Consequences

Under most circumstances, installing a non-qualified deferred compensation benefit does not generate a gift tax, even if an employee designates someone as surviving beneficiary. That’s because the survivor’s rights are contingent on the employee’s death. However, if the employee makes an irrevocable assignment of a nonprofitable benefit, a taxable gift could occur. If that happens, the gift probably does not qualify for the $14,000 (in 2017) annual gift tax exclusion because the gift would be considered the gift of a future interest. The primary task of the estate planner is to determine who should be the recipient of unpaid deferred compensation and take steps to see that the deferred compensation will be paid under the contract to the selected recipient or recipients when the executive dies.8-27-28

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