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.

CITES:  PLR 201625001 (June 17 2016); Greene v. Commissioner, 85 T.C. 1024 (1985); Rev. Proc. 92-44; Rev. Proc. 2011-38.

SUMMARY:   The taxpayer inherited a non-qualified annuity from his father and wished to exchange the annuity for a new annuity issued by another insurance company. He assumed the exchange would be tax-deferred under Code Section 1035, but he failed to exchange annuity contracts as required by Section 1035. Instead, he cashed in the inherited annuity contract, taking a lump sum from the original insurance company, and deposited the proceeds
into his checking account. He then used the proceeds to purchase a new annuity. Informed of his mistake by his accountant, the taxpayer requested a private letter ruling from the IRS requesting favorable (no taxable event) treatment on the transaction. The IRS ruled the distribution was taxable in the year it was received to the extent
determined under Code Section 72(e).

RELEVANCE:   The result in this ruling should not be a surprise to life insurance professionals.  Code Section 1035(a) allows the exchange of a life insurance contract for another—or a deferred annuity for another—generally without requiring recognition of gain upon the exchange.  However, failure to understand and follow the technical requirements of Code Section 1035 can lead, as it did here, to an unanticipated adverse result. While lenient rulings involving partial exchanges of annuities have been accorded Section 1035 exchange treatment (See Rev. Proc. 2008-24 as amended by Rev. Proc. 2011-38), the Service has for the most part required certain formalities to be strictly followed to accomplish the appropriate tax deferral.

MARKET TREND:  Despite explicit prohibitions on taking loans from IRAs, some IRA holders have used rules applicable to tax-free rollovers to effectively “borrow” amounts held in their IRAs for short periods – generally, up to 60 days. A recent Tax Court decision and follow-on guidance from the IRS, however, will now limit this method of access to IRA funds. 

SYNOPSIS:  In Bobrow v. Commissioner, the Tax Court recently concluded that the rollover treatment that allows taxpayers to take money out of, and repay money to, IRAs on a tax-free basis is limited to one rollover per 12-month period per taxpayer, regardless of the number of IRAs held by the taxpayer. This ruling differs significantly from the previous IRS position, which applied the tax-free rollover rules on an IRA-by-IRA basis. After the Tax Court’s decision, however, the IRS issued Announcement 2014-15, indicating that it now will follow Bobrow’s interpretation of the IRA rollover rules. 

TAKE AWAY:  The Bobrow decision and the IRS’s revised position have significantly restricted an IRA holder’s ability to access his or her IRA funds on a short-term, tax-free basis. This, combined with the recent proposal to eliminate “stretch” IRAs found in both the draft “Tax Reform Act of 2014” and the President’s FY2015 Budget (see discussion in WRMarketplace#14-10), evidence that additional changes to the tax treatment of IRAs may be possible. Regardless, these savings vehicles currently remain important and popular tools for retirement planning. Thus, clients maintaining IRAs (and their advisors) must be aware of the IRS’s change in position to avoid inadvertent violations of the rollover rules, which could cause unexpected current taxation of amounts purportedly rolled over after December 31, 2014. 

MAJOR REFERENCES: Bobrow v. Commissioner, T.C. Memo. 2013-21 (2014);Internal Revenue Service Announcement 2014-15. 

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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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