This article discusses how the benefit exchange concept may provide the executive a tax-advantaged method to obtain estate liquidity by exchanging the unneeded deferred compensation beneficiary for split dollar life insurance.

 

In a benefit exchange an employee exchanges one nonqualified employee benefit for another. Most commonly, a nonqualified deferred compensation benefit is exchanged for a life insurance policy owned under a split dollar arrangement.  (Split dollar is a method of financing life insurance in which two parties agree to split the costs, cash value and death benefit of a life insurance policy.)

Because certain deferred compensation arrangements are called Select Employee Retirement Programs, or SERPs, the benefit exchange concept is sometimes referred to as a SERP swap.

 

For most wealthy individuals, a deferred compensation payment will be subject to income and estate taxes.  Split dollar life insurance owned outside of the estate can be a tax efficient method to provide liquidity to pay estate taxes. 

 

An employee can achieve significant tax savings if the deferred compensation benefit (subject to income and estate taxes) can be exchanged for split dollar life insurance (which creates an income and estate tax free death benefit, if properly structured). The key is to avoid income tax recognition at the time of the exchange.

 

The executive and her employer agree to exchange her deferred compensation benefits for split dollar life insurance.  Instead of paying the deferred compensation benefits, the company funds a split dollar life insurance arrangement with the insurance policy owned by an irrevocable trust set up by the executive.  Under the split dollar arrangement the executive is subject to income tax only on the economic benefit (PS 58 cost) of the life insurance.

 

The executive is also deemed to make a gift to the trust beneficiaries equal to the economic benefit.  At the executive's death, the life insurance proceeds should be received by the trust free of income and estate taxes.

 

Tax Recognition.  The primary issue with a benefit exchange is whether the exchange can be completed without income tax recognition to the employee.  No direct authority exists, however in Private Letter Ruling 199901006 the IRS allowed employees to exchange stock options for a deferred compensation benefit without recognizing gain.

 

Ideally, the employee should not be vested in the deferred compensation at the time of the exchange.  Even if the employee is vested, a benefit exchange may still avoid tax recognition if the employee does not immediately vest in the policy cash value after the exchange. 

 

Fairness.  Because of the complexity and variety of nonqualified benefits, determining a fair exchange can be difficult.  The differing tax treatment of deferred compensation and split dollar life insurance for the both the employer and the executive may allow the employer to provide an equivalent after-tax split dollar benefit at a lower cost.

 

Transfer for Value.  If the employer funded the deferred compensation program with a life insurance policy on the executive's life, it may be beneficial to use that policy for the split dollar arrangement.  However, a transfer for value problem may arise if the policy is transferred to the trust.

 

Briefly, Internal Revenue Code Section 101(a) provides that if a life insurance policy is transferred for value, policy proceeds are taxable income to the extent they exceed policy basis, unless the transfer falls within one of several exceptions from the transfer for value rules.  Making the irrevocable trust a grantor trust is a possible solution to this issue.

 

Where an executive has an unneeded deferred compensation balance and a potential estate tax problem, the benefit exchange concept may offer a tax-leveraged method to obtain life insurance. Although attractive, the benefit exchange concept is untested and should be considered only by clients who are fully informed of the risks and are convinced that the potential benefits are worthwhile.

 

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