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Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises drake-business-planning

10-1. Qualified Retirement Plan. Up front deduction for employer Automatic tax-deferred built-up Segregated, protected trust funding Tax deferral for employee until benefits paid Mandated broad employee participation requirements Stringent vesting requirements to prohibit forfeitures

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Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises drake-business-planning

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  1. 10-1 Qualified Retirement Plan • Up front deduction for employer • Automatic tax-deferred built-up • Segregated, protected trust funding • Tax deferral for employee until benefits paid • Mandated broad employee participation requirements • Stringent vesting requirements to prohibit forfeitures • Mandated contribution and benefit limitations • Highly-regulated by Department of Labor (ERISA) and IRS Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  2. 10-2 Non-Qualified Deferred Compensation • No up front deduction for employer • No automatic tax-deferred built-up • No segregated, protected trust funding • Yes tax deferral until benefits paid (If done right) • No mandated broad employee participation requirements (Exact opposite – limited only to highly-compensated) • No stringent vesting requirements to prohibit forfeitures • No mandated contribution and benefit limitations • Not highly regulated by Department of Labor and IRS. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  3. 10-3 Non-Qualified Deferred Comp Plan Lingo . • “Elective Deferral Plan” or “Salary or Bonus Deferral Plan”: Executive makes election to defer income to later period. Pre-tax savings program. • “Supplemental Executive Retirement Plan” (SERP): Company funds a special retirement benefit for key employee(s). • “Excess Benefit Plan”: Provide benefits in excess of 415 qualified plan limitations to key employees. • “Short-Term Plan”: Executive elected deferral to accumulate for specific purpose – college, home balloon mortgage, etc. • “Death Benefit Only”: Benefit paid only on death of employee. Equivalent of life insurance. Can be structured to avoid estate tax inclusion. Escapes 2039 inclusion. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  4. 10-4 The Old Tax Traps . • Constructive Receipt Trap of 451. Key is to make deferral election before compensation earned and avoid pay-out elections after point of accrual. • Economic Benefit Trap. Employee taxed on economic benefit received. Key is to confer no economic benefit – keep promise unfunded, no power to assign rights. Keep as unfunded promise with rights no greater than general creditor of corporation. • Section 83 Trap. Property transferred as compensation taxable now if not subject to substantial risk of forfeiture. Good news: unfunded, unsecured promise to pay deferred compensation not “property” under 83. • “Reasonable Compensation” Trap. Risk factor when employee is also shareholder. Company deduction at stake. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  5. 10-5 The New Tax Trap – 409A • Fixed Distribution Events. Disability, separation from service, death, specific schedule, change of control, or unforeseen emergency. • No Distribution Accelerations. Very limited exceptions – domestic relations orders, forced divestiture, to pay FICA taxes on deferred amounts. • Deferral Election Before Year Earned. Exceptions for first year (election within 30 days of eligibility) and performance-based bonuses (election at least 6 months before year end) • Tough to Extend Deferral. At least 12 months in advance before effective date and first payment begins and for at least 5 yrs more. • No Assets Outside U.S. Foreign assets used to pay benefits deemed property under section 83. • No Employer Financial Health Triggers. Any related assets deemed property under section 83. . Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  6. 10-6 The Pain of 409A . • Immediate Taxation of All Deferred • Interest Calculated at One Percent Above Normal Underpayment Rate • Extra 20% Penalty on Deferred Amount • A Trap With Real Teeth! Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  7. 10-7 Key Structural Issues . • Mandatory or elective? • Who funds? Part of regular pay or something extra. • Any golden handcuffs – forfeiture provisions? • How does deferral grow – at what rate or based on what index? • Payout options – retirement, death, disability, defined date in future. • Hardship withdrawal rights. • General creditor risk – what can be done to hedge this? Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  8. 10-8 Deferred Comp – Collateral Issues • Financial statement impact – a real liability for the company • Qualified plan benefits – may reduce if elective deferral out of executive’s pay. • Accrual on benefit not interest to company – just additional deferred compensation. Albertson Case. • ERISA compliance can be handled with letter – employer info, plan for top-hat group, number in plan. • Staying Top Hat – smaller the better, promote exclusivity, for only the very privileged. • Shareholders (even big ones) can be included, but keep reasonable. • Tax implications at executive’s death – unpaid benefits included in estate; may qualify for marital deduction; subject to income tax as IRD under 691. • Social security - If no substantial risk of forfeiture, taxable in year earned, not paid. This good because executive probably already over cap in year earned. . Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  9. 10-9 Key Deferred Comp Strategies • Indispensable Executive - SERP with golden handcuffs • Owner Deferred Comp – Reflect real value against company’s limited capacity to pay • Booster to Do-It-Yourself Retirement - Something special for the privileged few • The financially irresponsible executive • The alternative to real equity . Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  10. 10-10 Problem 10-A: Go Fly Delivery • Plan elements • Document deferral before year deferral begins – nothing retroactive. • Specify payout options to comply with 409A – no discretion or wiggle room. • Real economic benefit, plus tax deferral. Company gets deduction when income recognized by Burt. • Golden handcuffs – hopefully not. • Growth on deferral – others may insist be modest. • Hardship withdrawal rights – others may object • General creditor risk – a given, business must succeed. . Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  11. 10-11 Company Naked Deferred Comp Option • Nothing funded • Executive General Creditor • Executive taxed on receipt of benefits • Company gets deduction when executive taxed Pay Benefits Per Agreement Executive Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  12. 10-12 Mitigating the Non-Payment Risk • Third Party Guarantee – parent company, majority shareholder. Guarantor can not be in the business. • Surety Bond – only if obtained and funded by executive. If company does it, will be considered funded plan. • Rabbi trust • Secular trust with Crummey type executive withdrawal powers. • Company owned life insurance program. • Split dollar insurance funded program • Bonus insurance program . Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  13. 10-13 Company Insolvency Reversion Rabbi Trust Option Rabbi Trust Company funds Agreement to pay benefits Executive Benefits paid on behalf of company Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  14. 10-14 Rabbi Trust – Why? • Company’s will to pay fades – Rabbi helps • Company doesn’t plan for payment burden – Rabbi helps • Company’s management doesn’t appreciate costs of plan – Rabbi helps • Company goes under – Rabbi doesn’t help Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  15. 10-15 Requirements of Rabbi Trust • Sole purpose to provide plan benefits, except revert on company bankruptcy or insolvency. • Duty to notify trustee of bankruptcy or insolvency. • Trustee must stop all payments when notified. • State law can not grant executive any priority rights in trust over other creditors. • Trust can’t be funded with securities of employer. • No insolvency trigger or other provision that could frustrate rights of general creditors of company. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  16. 10-16 Life Insurance Tax Benefits • Tax deferred inside build-up in policy – no income tax on growth of amount in policy. • Tax-free borrowing privileges against cash surrender value. Company can use to cover after-tax cost of payments during retirement. • Tax-free death benefit – company can use to fund after-tax cost of remaining benefit at employees death or to recoup amounts already paid out under plan. • Mitigate financial statement impact – policy shows as growing asset. Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  17. 10-17 Life Insurance Structuring Options • Straight Corporate Ownership • Rabbi Trust Ownership • Split Dollar – Executive has death benefit that can be estate tax- protected through ILIT • Executive Bonus Insurance with Gross-Up Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  18. 10-18 Policy Death Benefit Company Policy loans Company Owned Insurance Option Insurance Policy Premiums Pay benefits per agreement Executive Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  19. 10-19 Excess Policy Proceeds Company Insolvency reversion Rabbi Owned Insurance Option Rabbi Trust Company funds Agreement to pay benefits Death Benefit Pays benefits Premiums Policy loans Executive Insurance Policy Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  20. 10-20 Company Policy Loans Split Dollar Insurance Option Premiums Insurance Policy Pay benefits during life to executive Imputed income Gross-up? Death benefit over cash value Executive Executive ILIT Imputed gift- Crummey Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  21. 10-21 Restrictive endorsement – pre-retirement Company Bonus Insurance – Poor Person Trust Insurance Policy Contingent repayment obligation Comp for premiums Plus gross-up Premiums Executive Loan withdrawals Death benefit Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

  22. 10-22 Problem 10-B: Jurden Windows • Plan elements • Company funded, all forward looking, fixed retirement benefit for life (strong incentive) • Strong golden handcuffs – if Justin flakes, all is lost. Ideal for company would be performance criteria – very difficult to sell. • Deferral should be secure with close scrutiny to avoid all traps. • “Teeth” to show benefits will be funded could be handled with insurance. Company’s preference: corporate owned policy. Justin preference: Split dollar or bonus insurance. Possible compromise: Rabbi-owned insurance. . Copyright 2005 Dwight Drake. All Rights Reserved. Business Planning: Closely Held Enterprises www. drake-business-planning.com

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