The Tax Cuts and Jobs Act of 2017 (TCJA 2017) ushered in lower corporate and individual taxes for most. However, some changes are not so good and have a disproportionate impact on tax-exempt organizations like a credit union. 

Some background. Deductions for compensation as a business expense are available through Section 162(m) of the code. For many years, deductions for compensation that wasn’t performance-based compensation were limited to $1 million. (No surprise – the vast majority of organizations paid nearly all compensation above $1m as performance-based compensation, thereby preserving the deduction.) TCJA 2017 eliminated the exception for performance-based compensation. So, if a for-profit employer pays $2.5 million in compensation this year to their highest paid executive, the employer would not be able to deduct $1.5 million that exceeds the limit – effectively costing the employer 21% more in federal income taxes. 

New excise penalty on Credit Unions. Since credit unions generally don’t have deductions, the loss of one isn’t that concerning. In order to have “equal” treatment of for-profit and non-profit employers, TCJA 2017 imposes a 21% excise penalty on non-profit employers on any compensation they pay to an executive that exceeds $1 million. (This only applies to the top 5 executives.) If your credit union pays $2.5 million to an executive in total W-2 compensation this year, that would cost the credit union an additional $315,000. 

Disparate impact on Credit Unions. The problems stems with how supplemental executive retirement plan (SERP) benefits are taxed in a tax-exempt credit union vs. a for-profit employer like a bank.

• For example, assume a for-profit employer has promised a SERP benefit of $100,000 for 20 years. As long as the SERP benefit remains an unfunded liability of the for-profit employer, the executive owes income tax only on each payment as it is received despite being fully vested in the benefit upon retirement.
• In the tax-exempt world of credit unions, however, the executive owes income tax immediately upon vesting in the SERP benefit. The amount of tax is based on the net present value of the payments, which could result in a significant, immediate tax bill. To avoid a crushing cash flow burden on the executive from this timing difference (i.e., $100,000 of annual payments with a current tax bill of $500,000+), almost all SERPs in the tax-exempt world are paid in a lump sum. While having a lump sum is helpful to the executive, now under TCJA 2017 that results in W-2 compensation in a year that can very easily exceed $1 million. 

Options. SERPs in a credit union (aka 457f plans) remain a strong planning option but more attention will have to be paid to design for new plans. THERE WAS NO GRANDFATHERING UNDER TCJA 2017, so existing arrangements may be causing your credit union some pain. IZALE Financial Group has worked with multiple institutions since the enactment of TCJA 2017 to restructure credit union SERPs (aka 457f plans) to reduce – even eliminate – the excise penalty. While not all plans can be restructured, if you have a 457(f) SERP we welcome the opportunity to do a no-obligation review and share ideas we have successfully implemented at your peers.

Contact your IZALE representative directly or email us to learn how we can assist your Credit Union with these changes.

MARKET TREND:  As the hunt for additional revenue continues, one focus seems to be on limiting approaches to deferring compensation to mitigate taxes, possibly making retirement planning more challenging in the future. 

SYNOPSIS:  The draft “Tax Reform Act of 2014” and the President’s FY 2015 budget each contain several provisions that would affect tax-qualified retirement plans. In both cases, the provisions indicate an intent to enhance retirement savings (particularly by lower-income individuals), simplify the administration of qualified plans, restrict the maximum amounts that may accrue for the benefit largely of higher earning individuals and raising revenue for the federal government. Interestingly, however, the two reform proposals have only one specific provision in common, which may indicate that there may not be much consensus on this subject. In addition, the draft “Tax Reform Act of 2014” contains two other notable provisions relating to executive compensation. The passage of some or any of these proposals would lead to extreme changes to compensation planning across the board. 

TAKE AWAYS:  As noted in Part I of this WRMarketplace Report, the discussion draft and budget have not yet been introduced as legislation, and members of both parties have indicated that we are unlikely to see tax reform in 2014. However, these proposals are important because they may indicate potential law changes affecting qualified retirement plan implementation and operation and tax planning using qualified and nonqualified retirement arrangements. Given that several of the draft and budget provisions could affect AALU members who consult on retirement plan administration and/or tax planning relating to deferred compensation, heightened awareness is warranted, and continued monitoring and interaction with those who craft legislation will be crucial. AALU will remain vigilant in advocacy and monitoring these proposals. 

PRIOR REPORTS: 14-10; 13-16; 12-22; 12-10; 12-9; 11-22; 11-17; 10-81; 09-46; 08-33. 

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MARKET TREND: Compensation planning has become the “hot topic” among executives and employers, with wealth preservation and employee retention as the main focus. A tax-qualified retirement plan remains a key vehicle to accomplishing both of these objectives. These plans are available to a broader participant population than are nonqualified deferred compensation plans, and they provide greater security against loss that could result from an employer’s financial difficulties.

SYNOPSIS: Tax-qualified retirement plans generally come in two forms – “defined contribution” plans and “defined benefit” plan – with varying plan types within each category. Differences among plans include how the benefits for participants are determined, whether the employer or the employee has an obligation to make contributions, whether the employer or the employee bears the investment risk with respect to plan assets, the maximum benefit the plan can provide to the participant, the amount the employer can deduct in connection with the plan contributions, and when benefits can be paid. The table set forth below highlights the salient features for the most common types of plans.

TAKE AWAY: Combining an understanding of the conceptual and practical differences among plans, as described herein, with the technical aspects of the plan types will be valuable in advising executives and their organizations in the selection and implementation of an effective compensation plan that will appeal to both parties. To assist, see the attached table summarizing the key differences among the various types of retirement plans from the perspective of the tax-qualification requirements and restrictions.

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MARKET TREND: As planning approaches and products become more complex, care must be taken to avoid the retention or acquisition by the insured of powers over the policies that would cause the proceeds to be included in the insured’s estate at death.  Product sophistication using long term care riders and investment approaches with high cash value products has increased the array of planning options, offering insureds more flexibility but higher risks as well.

SYNOPSIS: Life insurance proceeds will be included in the insured’s estate for federal estate tax purposes if, at death, the insured has any right to the economic benefits, so-called incidents of ownership, in the policy, even if the insured does not actually own the policy.  “Incidents of ownership” include the power, directly or indirectly, to change the beneficiary or the contingent beneficiary, surrender or cancel the policy, assign the policy or to revoke an assignment, pledge the policy as collateral for a loan, and obtain a loan from the carrier against the surrender value of the policy.  In order to avoid inclusion of the proceeds in the insured’s estate, the insured must avoid holding any and all such incidents of ownership, even if attributed indirectly.  For example, if the insured holds a controlling interest in a corporation that owns policies on the insured’s life, the proceeds will be included in the insured’s estate to the extent the proceeds are not payable to or for the benefit of the corporation.  Policies purchased with community property funds also may cause both spouses to have incidents of ownership in the policies.  Second-to-die policies may give both insureds incidents of ownership and generally should not be transferred to an ILIT of which one of the insureds is a beneficiary.

TAKE AWAYS:  Inclusion of life insurance death benefits in the insured’s estate will occur if the insured holds any incidents of ownership in the policy.  “Incidents of ownership” encompass far more rights than actual policy ownership, including the ability to name policy beneficiaries or pledge a policy for a loan.  In addition, incidents of ownership may be attributed to an insured indirectly depending on the acquisition or ownership structure, such as with a corporate-owned policy where the insured is a majority shareholder, or a trust-owned policy where an insured is a trustee of the trust.  Thus, advisors can add value to the services they provide by helping clients identify situations where the insured may have retained or may acquire an incident of ownership and reviewing alternatives to eliminate the possibility for incidents of ownership and the potential estate tax exposure. 

MAJOR REFERENCES: IRC §2042; Private Letter Ruling 201327010; Chief Counsel Advice 201328030. 

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MARKET TREND:  With high-earning executives increasingly focused on income tax planning, deferring compensation often will be a primary objective.  Taxpayers and advisors will need to understand fundamental principles of income taxation to effectively implement deferred compensation arrangements as a part of the overall tax plan.

SYNOPSIS:  Individuals pay taxes not only on amounts actually received, but also on amounts they constructively receive, as well as the value of any economic benefit conferred upon them.  This report provides an overview of how these principles of taxation are applied, particularly with regard to compensation deferral.

TAKE AWAYS:  A fundamental understanding of the tax principles relating to constructive receipt and economic benefit will enable an advisor to better navigate the challenges of deferred compensation planning for his or her clients. PRIOR REPORTS: 12-32, 09-42, 09-12, 08-108, 07-44, 07-37, 04-135, 04-133.

MAJOR REFERENCES: IRC §409A, IRC §83, Treas. Reg. §1.415-2.

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