Page 92 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

78 The Complete Guide to Executive Compensation

Funded vs. Nonfunded
A funded plan is one where the benefits promised by the employer are secured by rights to
property (e.g., stock, insurance, or some other negotiable item). Distinction may be
drawn between informal and indirect funding, and formally funded plans. In the former, the
company sets up a reserve or possibly even takes out an insurance contract or invests in a
mutual stock fund for the amount of the liability but retains sole control over its application.
Thus, in case of financial failure of the company, the employee stands in line as a
general unsecured creditor seeking settlement of a claim. In a formally funded plan, the
funding of the liability is direct and the payment will be made from the property set aside.
A nonfunded plan is one backed simply by a promise of the employer to pay. The mere
promise to pay does not trigger an income tax liability to the recipient as long as such prom-
ise does not include earmarked funds that would put the recipient ahead of general
creditors of the company according to Revenue Ruling 70–435 by the Internal Revenue
Service (IRS).
Typically, companies look to fund their deferred compensation agreements indirectly. If
done directly, the executive incurs a tax liability. Typically, this is done focused either on after-
tax or pretax amounts needed. The former focuses on the cash flow impact of amounts
deferred by the executive and the amount that will be paid out (after tax). The pretax
approach is focused on the income statement, ensuring that sufficient amounts have been
expended. The most common vehicles are mutual funds or other investment vehicles and
corporate-owned life insurance. It is far easier to do an indirect funding with the former than
with the latter.
If the company wishes to fund the payments through a life insurance contract on the
executive’s life, it will probably use a corporate, variable, universal life policy rather than a
retail or traditional whole-life type of policy. The premiums will be invested in mutual funds
held inside the policy. This strategy will allow the company to provide the executive with
investment options that are similar to those available in a 401(k) plan. A number of insurance
companies have developed such policies specifically for the corporate market.
Most policies that have been designed for this market have been priced so that the spon-
soring company does not incur a charge to earnings as a result of acquiring such policies, and
therefore, they are desirable assets to informally fund the liabilities associated with deferred
compensation. This is true because of the tax-free, inside buildup afforded cash values of
policies that comply with Section 264 of the Internal Revenue Code (IRC).
Companies choosing to employ this strategy often will fund the liabilities in the aggre-
gate rather than attempt to fund liabilities by purchasing specific policies on participants
and match assets and liabilities on an individual basis. This strategy further distances the par-
ticipant from the funding used to support the plan and therefore reduces the possibility of
constructive receipt. The policies are owned by the company and all benefits are paid to the
company for the purpose of offsetting liabilities associated with the deferred compensation
plan. Corporate-owned life insurance is often referred to as COLI or TOLI (trust-owned life
insurance).
Conversely, an executive may go to an insurance company for a surety bond that will
ensure payment. If the executive pays the premium, there is no tax liability; if the company
pays, it is taxable income to the executive. Other ways in which the employer can fund the
payments include mutual funds, company stocks (own or others), and/or bonds (governmen-
tal or corporate). As will be described later in a discussion of tax treatment, it is important to