Using Loan Regime Split-Dollar Life Insurance to Navigate Nonprofit Executive Compensation Rules
A loan regime split-dollar life insurance arrangement can be an important option to provide retirement benefits to nonprofit executives while mitigating the impact of tax provisions that impact other types of nonprofit executive compensation. Nonprofit organizations face unique challenges when designing competitive compensation packages for executives. The rules governing non-qualified deferred compensation plans under Section 457(f) of the Internal Revenue Code (the Code) generally require immediate recognition income tax upon vesting, resulting in a significant tax bill for the executive, even if the organization intends to pay the benefit over time. In addition, if the benefit causes total compensation to exceed $1 million, the nonprofit organization may be subject to the excise tax under Code Section 4960. These rules create significant and immediate tax burdens on both the executive and the organization for retirement benefits that are intended to be paid out over multiple years.
Executive Compensation Tax Rules
Under Code Section 457(f), any non-qualified deferred compensation provided by a tax-exempt organization is included in an executive’s gross income in the first year that the compensation is no longer subject to a “substantial risk of forfeiture.” As a result, when a nonprofit enters into a compensation agreement or arrangement triggered by an executive’s retirement, the result is that the executive is subject to taxation on the present value of the entire deferred amount upon vesting, which is typically on the date of retirement or sooner, even if the benefit is to be paid out over a period of years. The entire amount (often a large sum) must be reported on the nonprofit organization’s tax return as compensation on Schedule J of the Form 990, which may lead to unwanted attention (as casual readers of the Form 990 may not understand that the reporting is a one-time event reporting compensation that is attributable to many years of prior work). This amount is also included in the executive’s W-2 wages at that time.
In addition, when the 457(f) plan is funded (even if the plan is unvested), the amounts are reported on Schedule J as retirement or deferred compensation. As a result, amounts may need to be reported twice on the nonprofit organization’s publicly available tax return, once at funding, and again at vesting.
Compounding this issue is Code Section 4960, which imposes a 21% excise tax on the nonprofit organization for any remuneration paid to any “covered employee” in excess of $1 million in a single year. The amount of the executive’s income for Section 4960 is basically the executive’s W-2 income. If the 457(f) plan vests at once (i.e., upon retirement), the vesting can cause a large amount of compensation to be recognized in one year, and subject the executive’s total remuneration over the $1 million threshold (with the excess being subject to the 21% excise tax).
Split-Dollar Life Insurance as a Solution
A “loan regime split-dollar life insurance” arrangement is taxed under different rules set forth in the split-dollar Treasury Regulations, and is not generally considered compensation for income tax purposes. Instead, the arrangement is treated as a loan to the executive. This treatment allows for the benefit of this insurance to avoid the vesting rule of Section 457(f) and avoid 4960 excise tax.
A split-dollar life insurance agreement provides that an organization and an employee will share the costs and benefits of a single life insurance policy. In a loan-regime split-dollar arrangement, the nonprofit organization makes a loan to the executive to pay the premiums on a life insurance policy that builds cash value. These loans are secured by a collateral assignment of the policy. The loan principal (plus accrued interest at the IRS applicable rate) is ultimately repaid from the policy’s death benefit at the executive’s death.
The loan-regime split-dollar arrangement will provide that, if all requirements are met (including any provisions related to continued employment), the executive will be able to access the policy’s cash value by taking tax-free loans against the policy. The policy loans are not taxable income to the executive because the executive is treated as taking a loan from an insurance policy that the executive owns. Because these loans are not treated as compensation to the executive, tax under Section 4960 is avoided as well.
For the split-dollar insurance regime to be respected, the insurance loans must be bona fide loans under the Treasury Regulations. To qualify as a bona fide loan, there must be an expectation that the premium loans will be repaid in full, and repayment is typically secured by the policy’s cash value and death benefit. If the interest payments on the loan are later forgiven, the forgiven interest will be considered compensation to the executive at the time of forgiveness (see Treas. Reg. § 1.7872-15). In addition, the loans must be subject to an interest rate at least equal to the Applicable Federal Rate (AFR) published by the IRS.
A key consideration is that the insurance policy must appreciate at a rate sufficient to allow for loans to the executive while also ensuring that there is sufficient value to repay the organization. The organization may address this challenge by using life insurance products that provide a higher rate of return.
Reporting Requirements for Split-Dollar Arrangements
Instead of reporting as compensation under Schedule J (which is required for a 457(f) plan), a split-dollar loan regime benefit is reported as a loan on Schedule L. Under the current Form 990 instructions, the loan must continue to be reported for five years after the executive is no longer a director, officer, or employee of an organization ( a retiring executive will continue to be listed on the organization’s tax return for a period of time).
Mitigating Excess Benefit Risks
Because a split-dollar arrangement involves a tax-exempt organization providing a benefit to an executive (a “disqualified person” for purposes of IRS tax-exempt rules), it is subject to the excess benefit transaction rules under Code Section 4958. This means that the compensation must be “reasonable” and if the IRS determines that it is not, the executive and the nonprofit organization will be subject to excise tax.
To mitigate this risk, the nonprofit organization should obtain a comparability study to establish that the compensation is reasonable. If the nonprofit organization obtains and reviews this data, and then approves the compensation arrangement based on its assessment that it is fair and reasonable based on the data, the IRS will presume that this benefit is reasonable (this is called the “rebuttable presumption” for purposes of the excess benefit rules). The executive receiving the benefit, and any other directors or persons with an interest in the arrangement should not participate in the approval of the plan.
State Compliance Issues
Non-stock organizations are typically organized under a state’s non-stock corporation laws. Many states have adopted the Model Nonprofit Corporation Act (MNCA). The MNCA contains an optional provision applicable to loans to or guarantees for the benefit of directors and officers (MNCA Section 833). In the MNCA, the provision contains an exception to a general prohibition on loans to directors and officers of the corporation that allows for split-dollar loans. Some states have not adopted this optional provision, and other states have adopted a version that requires the board of directors to specifically approve any loan to directors and officers as being beneficial to the corporation. A nonprofit considering this arrangement should make sure to check its own state laws for compliance purposes.
For help navigating nonprofit executive compensation rules, please reach out to our nonprofit team.
