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As a nonqualified retirement plan, SERPs have various tax consequences to the sponsoring business to understand.

Specifically, one of the business tax consequences of SERPs is that contributions made to the SERP are not tax-deductible when they are saved, and a gain on the asset used to informally fund the benefits is not tax-deferred unless the asset itself is tax-deferred.

Thus, if an employer uses a permanent life insurance policy to informally fund the benefits, the policy’s cash value growth is tax-deferred (because the gain under a life insurance policy is tax-deferred). However, a mutual fund or other non-insurance product does not normally enjoy tax-deferral.

The insurance policies supporting the promised SERP benefits are owned and paid for by the employer, and no tax deduction is received for the payment of their premiums. Proceeds paid to the employer under those policies are generally income tax-free, provided the various requirements for employer-owned life insurance are met. However, the SERP benefits paid by the employer to the participant—including retirement benefits, disability benefits, and survivor benefits—are all deductible when paid by the employer, even though the insurance proceeds paid to the employer are generally tax-free. The SERP benefits paid by the employer are taxable as ordinary income to the executive, i.e., the retired or disabled plan participant or the deceased participant’s survivors.

So, life insurance death benefits an employer receives under a policy designed to informally fund a SERP are generally income tax-exempt, assuming the requirements for such favorable tax treatment (discussed next) are met.

Business Tax Consequences of  SERPs Using Employer-Owned Life Insurance Death Benefit Proceeds

For many businesses, the preferred informal funding vehicle for a SERP is permanent life insurance. As discussed with key executive life insurance and entity buy-sell agreements, death benefits received by an employer under a life insurance policy covering the life of an employee are income tax-exempt provided certain notice and consent requirements and the employee-status conditions are met:

  • The employee must be notified in writing that the employer intends to insure his or her life and be the policy beneficiary.
  • The employee must be notified in writing of the maximum face amount for which he or she could be insured at the time the contract is issued.
  • The employee must provide written consent to being insured and agree that coverage may continue after employment is terminated.
  • The employee-insured must have been:
    • an employee at any time during the 12-month period before his or her death or
    • a director or highly compensated employee at the time the life insurance policy was issued

Business Tax Consequences of  SERPs on Life Insurance Policy Withdrawals and Loans

When the promised SERP retirement benefits become payable, the employer may fund those benefits from its then-current revenue or may take cash value withdrawals and/or policy loans from the life insurance policy used to informally fund the benefits. Regardless of its method of financing the retirement benefits, such payments are tax-deductible by the employer. However, accessing the policy’s cash value offers additional income tax benefits.

As long as the funding policy is not a modified endowment contract (MEC), withdrawals from cash value enjoy “first in, first out” (FIFO) tax treatment. Under FIFO tax treatment, withdrawals are tax-free until the employer has withdrawn an amount equal to its cost basis. Only subsequent withdrawals will be deemed taxable as ordinary income. For example, if the corporation paid $100,000 in premiums for the life insurance policy and it had a current cash value of $145,000, the corporation could withdraw $100,000 tax-free. Withdrawals of the remaining $45,000 would result in taxable income.

Because of this tax treatment, an employer using life insurance policy values to finance retirement benefits under a SERP generally chooses to take cash value withdrawals until it has recovered its cost basis tax-free. When the cost basis has been recovered, the employer then changes its cash value access to policy loans and begins taking loans to pay the promised SERP retirement benefits. When the policy death benefits are eventually paid at the time of the insured’s death, the entire benefit—although reduced by prior withdrawals and any unpaid loans—will be income tax-free.

Because the benefits paid to the participant by the employer are tax-deductible and withdrawals are tax-free to basis, the employer enjoys a certain amount of tax leverage. For example, if the employer is a corporation in a 21 percent tax bracket, a $100,000 annual retirement payment actually costs the employer $79,000; the other $21,000 comes from its reduced income tax liability resulting from the tax-deductible payment. Consequently, the employer would take a policy withdrawal in that year equal to its net after-tax cost of $79,000.

Policy loans are also received tax-free provided the policy is not subsequently surrendered. (If surrendered, the outstanding loan balance is deemed to be a part of the surrender proceeds and may increase the policyowner’s gain and consequent income tax liability.) To make this arrangement even more favorable for the employer, the interest paid by the employer on loans from policies insuring a key person is deductible to the extent that the indebtedness does not exceed $50,000.

The retired executive receives the deferred compensation payments as taxable income in the year in which they are received.

Business Tax Consequences of  SERPs Disability Benefits

If a SERP plan provides for disability benefits and if these benefits are funded by a disability insurance policy, the policy is usually owned by, and benefits are payable to, the employer. In these cases, premiums are not deductible. However, the insurance benefit received by the employer is tax-free; when it is subsequently paid by the employer to the executive, it is tax-deductible by the employer. To the executive, the disability benefit is income taxable.

Alternatively, an employer may elect to pay premiums on a disability income policy owned by the executive. In such a case, the disability benefits would be paid directly to the executive by the insurer. The premium paid by the employer for a disability income policy owned by the executive is tax-deductible to the employer but is not taxable to the executive. The disability benefits, however, are taxable to the executive under this arrangement. In a minority of situations, executives and employers sometimes agree that the executive will own the disability income policy and the employer will pay the premiums but deduct the payment as compensation to the executive. In such cases, the tax treatment changes, causing the executive to be liable for any income tax on the premium payment, but any disability benefits paid under the policy to the executive would be tax free.

Business Tax Consequences of  SERPs Survivor Benefits

An executive participating in a SERP may die while working for the employer. Because the life insurance policy used by the employer to informally fund the survivor benefits is usually owned by the employer who is also its beneficiary, the entire tax-free death benefit is paid to the employer when the executive dies.

Benefits are then payable by the employer to the executive’s survivors in accordance with the terms of the SERP agreement. The survivor benefits are considered taxable income when received by the survivors and tax-deductible when paid by the employer.

In some cases, employers and their executives choose to combine an employer-owned, endorsement-method split dollar plan with a SERP. Under that approach, the death benefits paid to the survivors are paid by the insurer rather than the employer. The tax advantage of using a split dollar plan to provide the survivor benefits is that the death benefits received are income tax-free.

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