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  • Writer's pictureJay Judas

Tier One: Executive Compensation Program Considerations for Nonprofit Organizations

Previously, I wrote about the growing use of loan regime split-dollar by nonprofit organizations to avoid having to pay the 21% excise tax levied under IRC Section 4960 on the top five executives earning $1 million or more.  The IRC definition comprises more than officers and includes a current or former employee who is or was among the five highest paid in a tax year beginning after December 31, 2016.  Once an employee is determined to be a covered employee, he or she will always be considered a covered employee.  This means the excise tax can very well end up being applied to more than just five employees after the first year.

In addition to this split-dollar strategy, nonprofit organizations are turning to a number of life insurance-based solutions for their executive compensation needs.  These include SERPs, IRC Section 162 “bonus” plans, endorsement split-dollar and salary renegotiation and reduction loan-based split dollar.

Supplement Executive Retirement Plan (SERP)

SERPs continue to be the staple of nonprofit executive compensation strategies.  Under IRC Section 457(f), nonprofits make a written promise to pay compensation at some point in the future.  These can either be defined benefit plans where a future amount is determined in the future or, defined contribution, where there is an amount of money set aside each year that typically grows according to some metric. Since the present value of SERP balances are includable all at once in an executive’s gross income when (1) when he or she has a legally binding right to the compensation or, if later, (2) when the compensation is no longer subject to a substantial risk of forfeiture, defined benefit SERPs are growing in use over defined contribution versions.

Jay Judas talking about executive compensation for non

Life insurance is purchased by the nonprofit to serve as the informal funding vehicle for a SERP.  A policy’s cash value can be withdrawn for use to make promised payments, which may also be required in the instance of a disability, and the death benefit can be used to cover any promised death payment to the executive’s family as well as to recover all plan costs to the nonprofit, including the time value of money.

SERPs under Section 457 can allow executives to defer payments, subject to a number of rules, including the deferred payment being at least 125% of the original payment on a present value basis, the deferral election is made at the beginning of the year, the decision is made more than 90 days in advance of the original vesting date and the deferral extension is for at least two years.

Further, a valid Section 457(f) plan must also conform with Section 409A and operate in conformity with that section, or the employee will lose the deferral of the compensation under the plan and be subject to a 20% penalty and retroactive interest.  There are many additional rules to consider and follow in implementing and administering these plans.

A significant problem with SERPs is that because the present value of a plan’s balance is includable all at once in the executive’s gross income, this can trigger the excise tax for the organization.

Executive Bonus Plans

Perhaps the most simplistic strategy for executive compensation, an IRC Section 162 bonus plan acts like an excess IRC Section 403(b) plan [401(k) plan for a nonprofit].  Under an executive bonus plan, key executives purchase a cash value life insurance policy on his or her life and use bonus payments from their employer to make premium payments.

Structurally, the policy is ‘maximum funded’ and only the minimum amount of death benefit required to meet the definition of life insurance is purchased.  By establishing the policy as a non-Modified Endowment Contract (non-MEC), the executive can later access the policy’s cash value in the form of tax-free withdrawals and loans.  The loans remain tax-free as long as the policy stays in-force during the insured’s lifetime.  Essentially, the policy funding is the same as for a Life Insurance Retirement Plan (LIRP).

The employer may also choose to ‘gross up’ the bonus amount to cover the taxes on the bonus so the executive has no out-of-pocket cost.  This is referred to as a ‘double bonus’, though the amount is usually just a small sum in comparison to the bonus.

In order to retain and incentivize the plan participant, the employer puts a restrictive endorsement in place.  This endorsement restricts the executive’s access to cash value for a period of time, encouraging them to meet performance measures to obtain additional bonuses and to stay with the employer until at least any restrictions on the plan are gone.  Employers will typically apply either a cliff vesting or a percentage by year vesting as a part of the restriction.

As with other forms of direct compensation, executive bonus payments could increase an executive’s income to the level where the excise tax is triggered.

Loan-Regime Split Dollar

A nonprofit can approach a split-dollar in one of two ways. The first is to make loans to the executive for the purchase of a life insurance policy with the loan(s) being in excess of other total compensation. Under split-dollar, the executive is only taxed on any imputed loan interest.  Later, after the executive re-pays the loan(s) from the policy’s cash value or from another source, the executive can take income tax-free withdrawals and loans from the policy to supplement income. The policy’s remaining death benefit can then be received by the executive’s chosen beneficiaries income tax-free.

Unlike IRC Section 457(f) plans that are reported starkly on Section J (Compensation and Benefits) of the nonprofit’s Form 990 when the benefits are accrued and, again, when benefits are paid out, a loan to the executive is reported more discretely on Schedule L.  The much smaller imputed interest loan obligations are reported on Section J.

This first approach to split-dollar works well if established at the on-set of a contract when all compensation is known.  The split-dollar can be designed so that that arrangement helps keep the executive’s compensation from the excise tax threshold.

The other approach to loan regime split dollar is helpful when an executive’s salary can be renegotiated so that, going forward, compensation is kept below the excise tax threshold.  This renegotiation usually results in reducing the salary of the executive.   That reduction can then be applied to a split-dollar arrangement, putting the executive in at least the same financial position, and not causing an excise tax to be paid by the non-profit.

In order to not trigger IRC Section 457(f) rules, any salary renegotiation must be treated at renegotiating future compensation and not viewed as deferring existing compensation. 

Endorsement Split-Dollar Arrangements

In an endorsement split-dollar, the nonprofit retains ownership of the policy but ‘splits’ the income tax-free death benefit with the executive. Under this arrangement, the nonprofit owns the policy, pays the premium, and retains all rights to the cash values for the length of the employee’s agreed-upon tenure.  

The nonprofit endorses a portion of the policy’s income tax-free death benefit to the executive to ensure that his or her beneficiaries receive financial support and/or to pay estate tax liabilities in the event of his or her death. However, the nonprofit retains control over the policy and its cash values. The executive pays taxes on the value of the life insurance protection, called the reportable economic benefit charge, each year.

The cash value of the policy is reflected as an asset on the organization’s balance sheet. The nonprofit can use or borrow against the cash value of the policy.  Generally, the premiums paid on a life insurance policy may not be deducted as a compensation expense; however, if the nonprofit transfers the policy to the key employee, the nonprofit may deduct the fair market value of the policy.  This transfer, though, may be considered a form of compensation and potentially trigger the IRC Section 4960 excise tax.

Many Choices

Life Insurance Strategies Group does not sell life insurance products.  We are engaged by individual and institutional clients to help them evaluate and acquire life insurance in situations where there is some complexity.  Life insurance may, or may not, be a part of an executive benefit solution and the team at LISG can assist in making that determination.  Our team can also support our clients in locating licensed life insurance professionals specializing in executive benefits and for appropriate plan administrators.


At Life Insurance Strategies Group, we do not sell products. We help our individual and institutional clients make decisions involving complex life insurance transactio


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