Do any of your executives currently earn more than $1 million in annual income? Perhaps not. But consider additional benefits and compensation for retirement, such as a 457(f); do any of your executives exceed the $1 million a year mark? These are the questions credit unions have begun to ask since the 2017 Tax Act was introduced, including provisions that affect nonprofits with highly compensated employees. For example, the law could impose a 21% excise tax on credit unions that pay more than $1 million to an executive in a calendar year. This has thrown a wrench into the credit union world, as the law also factors in all taxable executive benefits and compensation, including 457(f) distributions.
In these situations, many credit union boards have called on the assistance of Rick Miller, executive benefits attorney, and C.U. on the Show guest. Rick has been helping credit unions evaluate their compensation plans to avoid or minimize the impacts of the excise tax.
The strategy Rick recommends is to consider transitioning 457(f) plans to a collateral split-dollar or loan regime split-dollar, which allows the executive to take tax-free loans from the policy and incorporates life insurance protection. Rick and Doug discuss the details of this approach, as well as:
- The advantages that make a collateral split-dollar a desirable executive benefit
- The factors that could hinder the conversion process from a 457(f) to a split-dollar plan
- How credit unions can accelerate income payments to reduce the tax burden when an executive is uninsurable
Stream the full episode to hear how you can protect your credit union while continuing to offer a robust executive compensation package.
Audio Transcription (pulled from the podcast)
Doug: (00:03)
Hello credit union executives. Welcome to C.U. on the Show, where we give you up-to-date information on how you can reduce risk, keep key talent, and take a strategic approach to your personal financial wellness hosted by me, Doug English, a CERTIFIED FINANCIAL PLANNER™ and former credit union insider with ACT Advisors
Doug: (00:30)
On today’s podcast is Rick Miller. Rick is an executive benefits attorney with more than 12 years of deep experience, helping C-suite executives and boards of directors navigate executive benefit planning and compensation issues. In this episode, we talk about how the recently imposed excise tax impacts executive compensation benefit plans and strategies credit unions can take to mitigate its effects. Hi Rick. Tell me about how you got started in working with credit unions.
Rick: (01:01)
Well, so I’ve worked with a lot of different institutions over the years, and back in about 2006, I was working for a company here in Atlanta and they had just started developing compensation and benefit plans for credit unions. And I was on their staff as their lead attorney. And so I was heavily involved in starting to work with credit unions at that point. Prior to that, I worked for a company in Minnesota and we had explored the possibility of working with credit unions, but because of certain tax advantages and disadvantages, it didn’t make sense for them at that time. So, it was in about 2006 that my new company in Atlanta decided that it was time to get into that area. And I’ve been doing it ever since.
Doug: (01:56)
Awesome. Well, as we both know, in credit unions in 2017, the world changed, right? And we had some laws put in place that caused an excise tax to be payable. So can you tell us a bit about situations when that comes into play and then more importantly about the work that you’ve done in helping credit union leaders address 457(f) rescue plans, if you would, or just strategies to try to avoid or minimize that excise tax?
Rick: (02:29)
Yeah, so the excise tax was put in place, like you say, at the end of 2017, and it applies to certain executives at nonprofit institutions, which includes credit unions and also includes a lot of educational institutions, universities, other private schools and things. And what it does is it poses a 21% excise tax. It’s actually linked to the corporate tax rate, but it imposes a 21% excise tax on the institution itself if they pay out more than $1 million to one of these highly compensated executives during one calendar year. And so of course this threw a big wrench into the credit union industry because there are a lot of plans out there that were designed under section 457(f) of the tax code that pay out this type of compensation. And so I’ve been working with executives throughout the credit union industry since that time, since the beginning of 2018, to try and mitigate the impact of this new law on their compensation benefit plans.
Rick: (03:43)
And so couple of things that we’ve done, and this is probably the main thing, and this is actually a strategy that’s been recommended by just about every accounting and tax firm that I’m aware of, they’ve recommended transitioning over to collateral assignments, split-dollar also called loan regime split-dollar. Loan regime split-dollar is a benefit design that allows the credit union to loan the executive money that the executive then uses to pay premiums on a life insurance policy that grows over time. And at a certain point in time, the executive then is allowed to take policy loans from the policy. Those policy loans are tax-free and they do not count against the $1 million threshold under the tax act. So in essence, you’re taking a 457 plan that is fully taxable and you’re transitioning it to a collateral assignment benefit, which is essentially non-taxable. And so that avoids the 21% excise tax for the credit unions. It is a better tax outcome for the executive and everybody walks away happy. That’s the first way it’s done.
Doug: (05:04)
When you convert a 457(f) to collateral assignment, does the credit union or the executive have any kind of a tax impact? Obviously there’s legal costs for processes that need to be gone through, but is there any hit that they take when they make that conversion?
Rick: (05:22)
No, there’s not. There has been no compensation paid, no income received. So no, no tax impact. I do typically have executives sign an acknowledgement saying that they understand that they’re giving up a benefit that their beneficiaries, their heirs, have no right to claim that 457 benefit from the credit union. And it also says that there could be unanticipated tax implications that come from this that we just don’t know about. So they need to understand that. But other than that, there’s no tax impact that I’m aware of.
Doug: (06:11)
Excellent. So I know when I see a collateral assignment as part of an executive’s financial plan, it is the most desirable instrument that I like to see in the plan because of the way it works together with the 401(k) and the 457(b); everything else is usually taxable. And then you’ve got this one nice tax-free asset that you can use for all sorts of leverage and inflection points around Roth conversions, around qualifying for Obamacare, around any kind of timing issue, about when you want to recognize income, or when you want to not recognize income, like the year of the tax code changes, right? Don’t recognize income in that big year; recognize income in the year beforehand. So the 457(f) over to collateral assignment, is there any downside to the executive on that? Obviously there’s lots of upside, which is the tax-free nature of the income, but is there anything they give up?
Rick: (07:10)
No, I would say that it’s all a net gain for them. They’re giving up a plan that’s taxable for a plan that’s non-taxable; they’re also gaining life insurance protection, which is something they wouldn’t get from the 457 plan. So the non-tax ability of the policy loans they get, plus life insurance protection, it’s just a great benefit. And life insurance continues to be what I would consider to be sort of a unicorn in the benefit compensation industry, because you have the tax-free gain on the policy, it grows tax-free, and then you’ve got the life insurance protection. I mean, it’s really an unusual, but a very valuable benefit.
Doug: (07:55)
It really does work well. Now over your years of doing this, obviously this issue has only been around for the last three. Have you seen a credit union decide not to go forward with the conversion? And if so, can you tell us some reasons that someone didn’t do it, didn’t go over to the collateral side?
Rick: (08:12)
Yeah, I would say the biggest reason is that executives themselves are a little bit nervous about borrowing that much money from a credit union. I mean, I’ve got executives out there who borrowed millions of dollars, and they have a promissory note in place that says they’ll pay it back. And so that can make executives nervous thinking that I’ve got this multimillion dollar loan sitting out there that I have to pay back, but what they need to remember is that they don’t personally pay that loan back. That loan is paid back through the policy death benefit. And so as the policy grows, the executive takes out cash value. And then at some point a death occurs that policies are designed so that the death benefit more than pays back the loan. In fact, it pays back the loan to the credit union plus interest plus there’s death benefit left over for that executive’s family.
Doug: (09:12)
How about things changing as far as maybe a change of control, a merger or acquisition? Talk about those things, please.
Rick: (09:19)
Terms can change control. The excise tax could apply in that situation, too. So you’ve got the more than a million dollars payable; if there’s a change in control and payment is paid out to the executive, then that could also trigger the excise tax. So collateral assignment fixes both problems. Because again, once you take that 457(f) plan away, you no longer have those payments that are subject to the excise tax.
Doug: (09:50)
When a credit union is thinking about making this conversion, how long does it usually take to go from a 457(f) plan and get the contracts redone and work with the insurance company and get it finished? How long is that process?
Rick: (10:06)
Yeah, so that’s a good question. The process can move fairly quickly or it can move slowly. And a lot of it depends on the health of the executive. The underwriting of the insurance policy is typically one of the factors that slows the process down. So if you’ve got somebody with a health history, diabetes, or something else, sometimes the underwriting can take awhile. And so the policy is not issued until the policy is issued you can’t have a collateral assignment. The actual drafting of the legal documents is not at all an issue. I mean, I can get legal documents drafted in a couple of days and turn that around. So it’s just a matter of the insurance side. And I divide this up into two kinds of compartments. You’ve got the insurance side of the arrangement. You’ve got the legal side of the arrangement. Legal side can be very quick. The insurance side is often what takes the most time in getting that executive underwritten and the policy issued.
Doug: (11:09)
So you brought up an interesting subject there, which is the underwriting process. Some of these executives I’m sure are not insurable. When they’re not, what do you do? Leave the 457(f) as it is, or what’s next?
Rick: (11:23)
Yeah. I mean, you really have no choice if you can’t get them insured, then they are stuck with 457. And that doesn’t mean that the excise tax automatically is going to get triggered. I mean, for one thing, I would say it’s probably a small minority of 457(f) plans that actually pay out more than a million dollars in a year. I mean, you’ve got to have a credit union that has substantial assets, and that is compensating executives in the top tier of their peers. So I would say a lot of credit union executives are not going to ever see this problem, but you will have some, and if they can’t be insured, then there are some ways we can work around that under 457(f). The rules in the tax code allow us to accelerate payments. And so that is the other major approach that we use to help mitigate this tax.
Rick: (12:26)
So, just for example, let’s say that you’ve got an executive who in the year 2025 is expecting a 457 payout of $2 million. And you know that’s going to trigger the excise tax. So what we can do is we can modify their vesting schedule so that rather than vesting in that full $2 million in 2025, we can vest them in a portion of it in earlier years. So maybe in 2023, we give them $500,000, and in 2024, we give another $500,000 or, you know, some combination so that in one particular year they don’t exceed that $1 million threshold. And by doing that, we obviously changed the plan design, which has its pros and cons, because maybe you don’t want to pay that executive out early. Maybe you don’t want to accelerate those payments, but if you want to avoid that excise tax for the credit union, which can be a very expensive proposition for them, then you’ll have to consider doing this. Especially if they’re uninsurable.
Doug: (13:35)
Let’s talk about ongoing reporting requirements or legal requirements. Any kind of ongoing activity that you’re usually involved in with credit unions for a 457 F or collateral assignment, when they get into one of these things? What are they going to be doing on an annual basis? I know what they do with the executive benefits specialists, but what do they do with their attorneys?
Rick: (13:56)
Well, my involvement really is minimal. Once I’ve drafted the documents and sent them to them for signature, if they’re doing a 457 plan, they have to file something called a top hat letter with the Department of Labor. The top hat letter just simply tells the Department of Labor that we have a non-qualified deferred compensation plan here in place. It has X number of people. Here’s the name of it. Here’s when we started it. And that’s it, that’s one of the only other legal requirements of putting in a 457 plan. You don’t have to do that with a collateral assignment plan because it’s not considered an ERISA top hat plan. Some people choose to do it as sort of a defensive filing, you know, just sort of a belt and suspenders approach for the collateral assignment, but it’s not required. And then as far as other ongoing compliance, it is important that credit unions continue to look at both of these plans on an ongoing basis to make sure that they fulfill the requirements under the NCUA regulation 701. 19, which says that you have to actually have an obligation to the employee in order to maintain these plans.
Rick: (15:10)
So if you’ve got everybody who’s in the plan, if they’ve all retired and you don’t have anybody there, then you need to reconsider the plan. And then of course, with both plans, you also have ongoing accounting and regulatory requirements that I don’t really get involved in that much. Usually the third- party plan administrator will do that. Whoever is providing their third-party recordkeeping makes sure that plan stays in compliance. And then I get called in if there’s a question about something or a change, something like that.
Doug: (15:44)
Great, Rick. Well, thanks for your time today. We appreciate your insight.
Rick:
Yeah. Happy to help.
Doug: (15:53)
That’s all the insider credit union knowledge we have for this episode. Are you enjoying the conversation? Be sure to subscribe and share your thoughts with other credit union leaders by leaving us a review. See you next time on C.U. on the Show.
Speaker 3: (16:14)
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