Nonqualified Deferred Compensation Funded by Life Insurance

Short version. A nonqualified deferred compensation plan is a written promise from a company to pay a key employee later, and the company can prepare for that promise by owning a life insurance policy on the employee. Because the company owns the policy, the cash value generally stays on the company's books, the employee isn't taxed until benefits are paid, and the plan can be offered to selected people rather than the whole staff. The trade is that the employee holds only a promise, so the paperwork and compliance matter a great deal.

How Nonqualified Deferred Compensation Funded With Life Insurance Works

Start with the promise. The company signs a written agreement with a key employee. It says that if certain conditions are met, such as staying through a set date or reaching retirement age, the company will pay a defined benefit. That agreement is the plan.

The plan itself holds no money. The promise is just that, a promise. So many companies pick a way to prepare for the day the bill comes due. One common choice is a permanent life insurance policy on the employee. The company owns it, pays the premiums, and is the beneficiary. Cash value builds inside the policy, and the company may draw on it when benefits are due. If the employee dies first, the death benefit goes to the company, which can use it to help cover what it owes.

The word for this is informal funding. It's informal because the asset belongs to the company, not to the employee. The employee has no claim on the policy. If the company runs into financial trouble, the employee generally stands in line with the company's other creditors.

Why Companies Use a SERP for Key Employees

A SERP, short for supplemental executive retirement plan, is the best known version of this idea. A company uses one when it wants to keep a valuable person without handing over ownership.

A few reasons come up again and again:

• It can be offered to a select group. A qualified plan like a 401(k) typically has to meet rules about covering the broader workforce. A nonqualified plan is generally aimed at a small group of management or highly paid employees.
• It can reward staying. The company writes the vesting terms, so the benefit can be tied to years of service or a retirement date.
• It can sit on top of what the employee already has. Qualified plans have contribution limits, and a SERP can add a benefit above them.
• It keeps the asset inside the company. The business owns and controls the policy, which matters to owners who want to keep that control.

Tax treatment is part of the appeal. The employee generally isn't taxed on the promised benefit until it's paid. When it is paid, it's typically ordinary compensation income to the employee, and the company generally takes its deduction at that time. Your CPA confirms how this applies to your entity and structure.

What the Life Insurance Policy Does in the Plan

The policy is a funding tool. It isn't the plan. Keeping those two straight prevents a lot of confusion.

Why Whole Life Is a Common Choice

A properly designed whole life policy builds cash value on a contractual schedule and carries a death benefit that doesn't expire. Those traits suit a promise that may come due in 10 or 20 years, or at an unknown date if the employee dies first. This is the No-Compromise Asset at work inside a business: protection the company needs AND money it can use while the employee is living. Dividends from a participating policy aren't guaranteed, and features vary by carrier and state.

Premiums and Proceeds

Premiums on company-owned life insurance are generally not deductible. That's different from an executive bonus arrangement, where the employee owns the policy and the bonus is generally deductible as reasonable compensation. Mixing those two up is an easy mistake, and it's worth a conversation with your CPA before the plan is adopted. We cover the basics of company-owned policies in our guide to corporate-owned life insurance.

Rules That Come With the Arrangement

Two sets of rules shape every one of these plans. Both carry real consequences if they're missed.

1. Section 409A. This part of the tax code governs when and how deferred compensation can be paid. Plans typically need a written document, and payment events such as separation from service, death, disability, or a fixed date have to be spelled out. Falling short can mean tax penalties for the employee.
2. Section 101(j). Because the company owns a policy on an employee, written notice and signed consent from the employee are generally required before the policy is issued. The policy has to fit a statutory exception, and the company reports annually on Form 8925. If the steps are missed, part of the death benefit may become taxable to the company. According to the IRS, Form 8925 is the annual reporting piece. We walk through the steps in our post on Section 101(j) notice and consent.

This is why the team matters. The attorney drafts the plan and confirms the compliance steps. The CPA confirms the tax treatment for your entity. Cornerstone designs the insurance and places it with a carrier that fits the plan. Nobody on that team does it alone.

The policy can back the promise. It can't replace a well-drafted plan.

How This Compares With Other Executive Benefits

A SERP is one of several ways to reward a key person. The right fit depends on who the person is and what the company wants to achieve.

• Executive bonus. The employee owns the policy and is taxed on the bonus now. Our post on the Section 162 executive bonus plan explains how that works.
• Restrictive endorsement bonus arrangement. A bonus paired with a carrier form that limits the employee's access to the policy. See our explainer on the REBA.
• Informally funded SERP. The company owns the asset and the employee holds a promise. There's no current tax for the employee, and the company takes on the 409A and 101(j) work.

One difference is worth pointing out. Because the employee owns the policy in a bonus arrangement, 101(j) generally doesn't apply to it. A company-owned policy behind a SERP does bring 101(j) into play. Neither route is better in every case. The people involved, the entity type, and the company's goals decide it.

A note for owners. These plans are typically built for non-owner key employees. If you own a pass-through business and want to fund your own retirement, other tools such as a cash balance plan are often a better starting point, and your advisors can help sort that out.

Questions to Settle Before Adopting a Plan

1. Who is the plan for, and what should it encourage them to do?
2. What triggers a payout, and how will it be paid, in a lump sum or over time?
3. What vesting terms apply if the employee leaves early?
4. Can the company afford the promise in a hard year?
5. Has the employee given written notice and consent for the policy?
6. Who is filing Form 8925 each year?

Our business owner strategy page shows where this fits next to buy-sell funding, key person coverage, and succession planning. If you're weighing a plan for a key employee, book a no-pressure conversation with us and we'll walk through the options alongside your attorney and CPA. You can also see how we approach permanent coverage on our whole life insurance page.