Dec 21, 2009


Life insurance can be an important executive benefit. Life insurance is important to high income employees as a means of providing income security to their families during the early part of their careers. In later years, it can provide or augment the executive's estate to be left to family and other heirs, or it can help provide liquidity to the estate to meet estate taxes and other expenses. A number of methods with favorable tax consequences have been devised to provide life insurance to executives. Generally, the aim is to provide insurance in a way that minimizes the current year-to-year income tax cost of the plan to the employee, and also keeps the life insurance out of the employee's estate for federal estate tax purposes. Some of the methods used include the following:

  • Many variations on the basic split-dollar approach are possible. For example, to avoid federal estate taxes, the plan is often designed so that the employee has no incidents of ownership in the policy. This can be done, for example, by having the policy applied for by a beneficiary such as a spouse or a family trust, with a split-dollar arrangement between the employer company and the policyholder. Although this arrangement may eliminate the federal estate tax in the employee's estate, it is still considered by the IRS to result in compensation income to the employee.

  • Death Benefit Only (DBO) Plans. A DBO plan is a form of deferred-compensation plan in which the benefits are paid only to a designated beneficiary upon the death of the employee. The purpose of this arrangement is to avoid federal estate taxes on the death benefit.

    Under the federal estate tax law, a death benefit from a deferred-compensation plan is included in the employee's estate if the employee had a nonforfeitable right to receive benefits while living, even if the employee never actually received such benefits while alive. Thus, the DBO benefit is designed to be paid only at death. If there is a DBO plan, the employer's fringe benefit arrangements for the employee must also be designed carefully to make sure the DBO plan will accomplish its intended purpose. The IRS will lump other deferred-compensation plans-not including qualified plans-together with the DBO plan to determine if the company provides a lifetime benefit to the employee.

    To provide a substantial death benefit even during the early years of the plan, DBO plans are usually funded informally with life insurance. That is, the employer owns insurance on the life of the employee, with the employer itself as beneficiary. At the death of the employee, the policy provides funds enabling the employer to pay the death benefit to the employee's beneficiary.

    For income tax purposes, a DBO plan is treated the same as any other deferred-compensation plan-death benefits are taxable in full to the beneficiary as ordinary income when received.

  • Group Term Life Insurance Plan. Under Section 79, a group term life insurance plan can have a special class for executives and provide them with amounts of group term insurance relatively greater than the amounts provided for other employees. However, if the plan provides amounts of insurance that are higher multiples of compensation for key employees, it probably will be deemed discriminatory and, therefore, the tax exclusion for the value of the first $50,000 of insurance will be lost by key employees.

Dec 19, 2009


The incentive stock option (ISO) is the current form of stock option plan eligible for special tax benefits, which are provided by Code Section 422. Under an ISO plan, the usual tax rules previously discussed do not apply. Instead, for stock purchased under an ISO plan, there is no taxation to the employee until the stock is sold. Employees do not realize any taxable income when they receive the option, even if the option has an ascertainable fair market value and, furthermore, there is no taxable income when the option is exercised. However, the difference between the option price and the fair market value at the time of exercise is a tax preference item that may be subject to the alternative minimum tax. Because there is no regular taxable income to the employee at either the grant or the exercise of the option, the corporation gets no deduction at any time.

Options under an ISO plan must generally be granted to employees within ten years of the plan's adoption or approval by the shareholders, and an option must be exercised by the employee within ten years after it is granted. The option price must equal or exceed the stock's fair market value at the time the option is granted. Any good-faith attempt to value stock will be acceptable if there is no readily established market.

ISO plans increase the tax benefit of stock options as a form of compensation by providing increased tax deferral and, therefore, represent an attractive executive benefit. However, they are most likely to be used in large corporations. If an option holder has stock with more than 10 percent of the total combined voting power of the employer corporation, taking certain stock attribution rules into account, there are additional restrictions on ISO plans that may make them unattractive for closely held corporations. In such cases, the option price must be at least 110 percent of the stock's fair market value at the time it is granted and the option must be exercised within five years after it is granted rather than ten. Also, an employee receives the maximum tax benefit from an ISO plan only when the stock is sold, and there may be no ready market for a stock of a closely held corporation. Furthermore, it may be undesirable to pass ownership of stock in a closely held corporation to outsiders. However, the plan may permit the employee to exercise an option and pay for the shares of stock with other stock of the employer.

The aggregate fair market value of stock for which an employee can be granted an option under an ISO plan during a single calendar year cannot exceed $100,000. There are carryover provisions if the employee does not use the full limit in any year.

Dec 16, 2009


A stock option is an offer to sell stock at a specified price at some time in the future or over a limited period of time with a specific termination date. Stock options have long been used for executive compensation to accomplish some of the same purposes as compensation with restricted stock. Over the years, Congress has designed special tax incentives to make certain types of stock option plans attractive. The type of tax-favored plan currently in effect is known as an incentive stock option (ISO) plan, which will be discussed separately. In this section, stock options in general-sometimes referred to as nonstatutory or nonqualifed stock options-will be discussed first.

Options to buy stock in the employer company are typically granted to executives as additional compensation at a favorable price, with the hope that the value of the stock will rise and make the option price a considerable bargain for the executive. If the stock price declines, the executive simply declines to exercise the option to buy the stock. This gives the executive a benefit whose potential value is tied to the fate of the company, but with no downside risk. This valuable incentive to the executive appears to cost the company very little, although this is somewhat misleading, as discussed below.

Stock options other than ISOs can be designed in any manner the employer and employee desire. Typically, a stock option runs for a period such as ten years, and is granted at a price equal to the fair market value of the stock on the date that it is granted.

Bill Kate is given an option in Year 1 to purchase up to 1,000 shares of stock at $50 per share, which is the current market price, with the option to be exercised over the next ten years. The plan may provide a waiting period before the option may be exercised, or it may provide that the option can be exercised only in successive installments-i.e., only 20 percent of the option can be exercised during the first two years, 40 percent over the first four years, and so on. The option has no value to Bill at the date of the grant because the option price was the same as the market price. Therefore, as of Year 1, there was no taxable income to Bill. Under the general tax rules in this situation, Bill will not be taxed until shares are actually purchased.

Suppose Bill purchases 400 shares in Year 4 for a total of $20,000. If the fair market value of the shares in Year 4 has risen to $40,000, the executive has $20,000 of ordinary income in Year 4. The company will get a tax deduction of $20,000 in Year 4, the same as the amount of Bill's compensation income, again assuming that Bill's compensation meets the reasonable compensation test for deductible compensation. However, the company gets no further deduction if Bill resells the stock and realizes a capital gain.

Options with an immediate value to the executive are sometimes used in executive compensation.

Suppose that the option had been granted at $40 per share, a bargain over the prevailing market price of $50 at the time of the grant. If the option has a determinable value and the option could be traded on an established market, the value of the option is taxable as ordinary income to Bill at the time of the grant, with a corresponding deduction to the employer. If tax is payable at the grant of theoption, there is no further taxable compensation income when the option is exercised later. This can be an advantageous approach if the stock is expected to appreciate substantially in value, because the taxable compensation income at the time of the grant is relatively small, while the remainder of the gain on the overall deal will be taxed as capital gain only when the stock is sold.

Suppose that Bill is granted an option for 500 shares of company stock at $40 per share in Year 1, the current market price being $50 per share. Bill has $5,000 of ordinary compensation income in Year 1, the year of the grant. In Year 4, Bill exercises the option and buys 400 shares for $16,000. There is no ordinary income tax to Bill at the time of the exercise in Year 4.

The stock option appears to be an almost ideal method of compensating executives, providing a valuable incentive-based compensation arrangement at practically no cost to the company. However, the company's cost is comparable to the cost of cash compensation. While it costs the company almost nothing to grant options and print stock certificates to provide shares when the options are exercised, the executive will exercise the option only when the stock has a substantial market value. If this is the case, the company could itself have sold the stock used in the option arrangement on the open market and received the full proceeds. However, the grant of an option does not result in a charge to the company's income statement, so this form of compensation can be attractive from an accounting point of view.

The tax rules applicable to nonstatutory stock options do not provide any particular tax advantage to the employer company in using stock option plans. Therefore, in designing a stock option plan the company must look for benefits to itself just as in the case of any other kind of executive compensation. Typically, stock option plans would be used where the executive has a strong desire to obtain an interest in the business, or where the executive has a direct impact on the company's profits and, therefore, its stock value.

Dec 14, 2009


An employee's compensation can be paid in either cash or noncash property. It is common for an executive's compensation to include payment in property, usually employer stock or securities, that is subject to some form of restriction at the time it is paid. The restriction on the property is usually designed to serve an employer goal, such as retaining a valued employee, and the restriction also can be designed to postpone taxability of the compensation to the employee and correspondingly postpone the employer's tax deduction.

Restricted stock or other restricted property is not an attractive benefit to an executive if the executive must pay income tax on the property when it is received, even though it is subject to restrictions. Therefore, most restricted property plans are designed around Code Section 83 that allows deferral of taxation to the employee if the restrictions meet certain requirements. Basically, the rules provide that an employee is not subject to tax on the value of restricted property until the year in which the property becomes substantially vested. Property is not considered substantially vested if it is subject to a substantial risk of forfeiture and not transferable by the employee free of the risk of forfeiture. As with most types of nonqualified compensation plans, the employer does not get a tax deduction until the year in which the property becomes substantially vested and includable in the employee's income.

The question whether there is a substantial risk of forfeiture depends on the facts and circumstances of each case. However, a substantial risk of forfeiture usually exists when the employee must return the property if a specified period of service for the employer is not completed-for example, five years of service. A forfeiture that results only from an unlikely event, such as the commission of a crime by the executive, probably would not constitute a substantial risk of forfeiture. Forfeitures as a result of failing to meet certain sales targets or going to work for a competitor could constitute substantial risks, depending on the facts and circumstances. If the employee is an owner of the company, the IRS is likely to be skeptical of any forfeiture provision in the plan, no matter how rigid it may appear on paper.

The nontransferability provision-the second half of the test-can be complied with in the case of the company stock by inscribing a statement on the share certificate to the effect that the shares are part of a restricted property plan. Thus, any prospective transferee is aware that the employee is not free to sell the shares to an outsider without restriction.

Suppose that executive Rita Bill is permitted to buy 500 shares of company stock at $10 per share in 2000, while the current market value is $100 per share. Rita must resell the shares to the company for $10 per share if she terminates employment with the company at any time during the next five years. The share certificates are also stamped with an appropriate statement to meet the nontransferability requirement. Rita pays no taxes on this arrangement until the restriction expires in 2005. If the unrestricted shares in 2005 have a market value of of $200 per share, Rita will have additional taxable compensation income for 2005 of $100,000, the market value of the shares, less $5,000, the amount Rita paid, or a net additional compensation income of $95,000. The company will get a tax deduction of $95,000 in 2005, but gets no deduction for 2000. Also, the allowance of the tax deduction to the company is, like all tax deductions for compensation paid, subject to the requirement that the total compensation package for the employee constitutes reasonable compensation for services rendered.

Many variations are possible in the design of restricted stock plans. The plan, for example, may provide that dividends on the restricted stock are payable to the executive during the restriction period; if so, these dividends are taxable currently to the executive as compensation income. The plan also might provide graduated vesting over a period of years, rather than full vesting at the end of a specified period like five years; this would mean that the executive would be taxed each year on the value of the property that became substantially vested that year.

In some plans, there are no forfeiture provisions; instead the stock is subject to other restrictions. For example, the employee may have a fully vested interest in the stock but may not be permitted to resell the stock without first offering it back to the company at a specified price. In that case, the value of stock to the executive would not be its market value, but would be a reduced value reflecting the restriction. Under the Internal Revenue Code, a restriction will be taken into account in valuing the property for tax purposes only if it is a nonlapse restriction-a restriction which by its terms will never lapse. The restriction in the example with a requirement of resale to the company at a fixed price would qualify as a nonlapse restriction. Other types of restrictions must be assessed on their own facts and circumstances, and the IRS tends to take a very limited view of what constitutes a nonlapse restriction.

Once an executive has become substantially vested in the restricted property and paid any tax on the compensation element involved, gain on a subsequent sale of the property is usually taxed as capital gain just as in the case of the sale of such property acquired by other means.

Dec 11, 2009


For qualified plans, imposes limits on the benefits or contributions that can be provided to any one individual. Annual additions to a qualified defined-contribution plan are limited to the lesser of 25 percent of the employee's compensation or $30,000. Correspondingly, for a defined-benefit plan, the maximum projected annual benefit is the lesser of 100 percent of the employee's compensation or $90,000. For very highly paid executives, it may be desirable to provide additional retirement income in excess of these limits. Also, in some cases, an employer does not have a qualified plan because the employer does not want to provide the kind of broad retirement plan coverage required by the nondiscriminatory coverage requirements. Thus, a common form of executive benefit is the provision of retirement income or deferred compensation outside of a qualified plan. Plans that do this are generally referred to as nonqualified deferred-compensation plans. Many names have been coined by consulting firms and insurance companies to describe specific plans of this type-for example, supplemental retirement plans, top-hat plans, and the like. The design of nonqualified deferred-compensation plans is open-ended and almost any combination of features can be provided in one way or another.

Objectives for the Plan

The design of a nonqualified deferred-compensation plan will reflect the objectives of the person establishing it. A broad distinction can usually be made between plans designed to meet employer objectives and those designed primarily to meet employee objectives. The employer's objectives in instituting the plan are usually to provide an inducement for hiring key employees and then to provide additional inducements to the key employees to continue working for the employer-especially so that employees do not leave and go to work for a competitor. Employee objectives are usually to obtain an additional form of compensation at retirement or termination of employment, with tax on the additional amounts deferred, if possible, until the money is actually received.

Employer-Instituted Plan

Eligibility in an employer-instituted plan is usually confined to key executives or technical employees who are difficult to recruit and keep. The plan does not have to specify a class of employees to be covered; it can simply be adopted for specific individuals as the need arises. However, the need for fairness among a similarly situated group of executives often dictates that the plan cover a specified class of employees rather than individuals.

A plan instituted for employer objectives usually has some kind of forfeiture provision to discourage key employees from leaving. The plan may require that the employee forfeit all rights under the nonqualified deferred-compensation plan in the event of termination of employment prior to normal retirement age without the employer's consent. The employer might wish to soften this forfeiture provision somewhat by including graduated vesting similar to that required under a qualified plan. However, as long as the plan avoids the applicability of the ERISA vesting provisions discussed later, no particular vesting schedule is required and complete forfeiture can be provided for any reason. The plan might include additional forfeiture provisions, such as a forfeiture of any unpaid benefits, if the employee enters into competition with the employer or goes to work for a competitor. The courts have held that such covenants not to compete can be enforced by the employer, so long as the scope of the prohibited competition is reasonable in terms of the geographic area over which it applies and the period of time during which it is in effect.

Nonqualified deferred-compensation plans often require that the employee remain available for consulting services to the employer after retirement, with possible forfeiture of benefits if the employee does not comply. Actually, consulting services provisions can be beneficial to the employee, as they often provide a means for the employee to receive additional amounts from the employer after retirement in return for relatively nominal consulting services.

Employee-Option Nonqualified Deferred Compensation

Different objectives for a nonqualified deferred-compensation plan come from the employee's side. Employees with enough income to have substantial savings programs often seek tax-favored methods of saving. Additional amounts of tax-favored savings can be provided beyond the limits of a qualified plan through a salary-reduction arrangement, with the amount of the salary reduction paid to the employee after retirement instead of currently. This provides tax savings because income tax on the salary reduction is paid in the future instead of currently, a valuable benefit because of the time value of money. It is also possible that the employee may be in a lower marginal tax bracket after retirement.

The initial problem in designing a plan for this objective is to ensure that the employee is not taxed currently on the salary reduction that goes into the plan. The salary-reduction arrangement must avoid the constructive receipt doctrine, under which income is taxable to a taxpayer if it is credited to the taxpayer's account, set apart, or otherwise made available, even though it is not actually received. To avoid this doctrine, the amount set aside must be subject to substantial limitations. This can generally be accomplished if the salary-reduction agreement is made prior to the time the income is earned by the employee and if the employee's receipt of it is deferred for a period of time, such as to termination of employment or retirement, which constitutes a substantial limitation.

Plans designed to meet employee objectives generally will have generous provisions and, in particular, there will be few forfeiture provisions-usually 100 percent immediate vesting-unless the plan is formally funded.

Funded and Unfunded Plans

A nonqualified deferred-compensation plan can be either funded by the employer or unfunded. With a funded plan, the employer sets aside money or property to the employee's account in an irrevocable trust or through some other means that restricts access by the employer and the employer's creditors to the fund. With an unfunded plan, either there is no fund at all or the fund that is set up is accessible to the employer and its creditors at all times, so that it provides no particular security to the employee other than the knowledge that the fund exists.

It might appear desirable from the employee's point of view to have a funded plan. However, there are significant disadvantages: The amounts put into a funded plan generally are taxable to the employee at the time the employee's rights to the fund become nonforfeitable, or substantially vested, a concept to be discussed under "Compensation with Restricted Property." This may occur well in advance of the time these funds are actually received by the employee, thus producing a tax disadvantage. Also, funded plans are subject to the ERISA vesting and fiduciary requirements, as discussed later, and this is usually undesirable from the employer's point of view.

As a result of these disadvantages, nonqualified deferred-compensation plans generally are unfunded. The employee relies only on the employer's unsecured contractual obligation to pay the deferred compensation. Because such plans provide no real security to the employee, their value as an inducement may be minimal if the company is risky; employees will then probably opt for greater benefits in current cash or property rather than deferred compensation.

Informal Funding

To provide some assurance, the employer can informally fund the plan by setting money aside in some kind of separate account, with this arrangement known to the employee but with no formal legal rights on the part of the employee and with the amount in the fund therefore available to the employer's creditors. Life insurance policies on the employee's life (owned by and payable to the employer) are often used to provide this kind of informal funding. Life insurance is particularly useful for this purpose if the deferred-compensation plan provides a death benefit to the employee's designated beneficiary, because if the employee dies after only a few years of employment, the life insurance will make sufficient funds available immediately to pay the death benefit. Sometimes a trust is set up by the employer to finance the plan. If the trust assets are available to the employer's creditors, the arrangement is deemed unfunded by the IRS. This type of arrangement is sometimes referred to as a rabbi trust because an early IRS ruling on this issue involved a rabbi.

Form of Benefits

Most nonqualified deferred-compensation plans provide for benefit payments in installments beginning at retirement or termination of employment. The five-year averaging provision available for qualified plan lump-sum benefits does not apply to nonqualified plans; benefits are taxable as ordinary income when received at the taxpayer's regular tax rates, assuming that the taxpayer has not already paid taxes on the amounts in prior years.

Nonqualified deferred-compensation plans often provide a death benefit, usually in the form of a benefit to a designated beneficiary in the amount the employee would have received if he or she had lived. If the plan uses life insurance as an informal funding medium, it usually also provides a flat-amount death benefit-usually related to the face amount of the life insurance policies-that is payable regardless of how much deferred compensation has accrued to the date of death. Death benefits are taxable as ordinary income to the beneficiary.

Employer's Tax Treatment

In a nonqualified deferred-compensation plan, the employer does not receive a tax deduction for deferred compensation until the year in which the employee must include the compensation in taxable income. This is the case even if the employer has put money aside through formal or informal funding of the plan in an earlier year. For an unfunded plan, the year of inclusion for the employee is the year in which the compensation is actually or constructively received. If the plan is formally funded, the employee includes the compensation in income in the year in which it becomes substantially vested.

Impact of ERISA and Other Regulatory Provisions

To retain design flexibility and keep administrative costs down, most deferred compensation plans are designed to avoid the fiduciary, vesting, and reporting and disclosure requirements of ERISA to the maximum extent possible. Generally, if the plan is unfunded and is maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees, the plan will be exempt from all provisions of ERISA. However, if the plan does not come within this exemption, most of the provisions of ERISA become applicable, and the plan must comply with almost all of the ERISA provisions that apply to a qualified plan. The nonqualified plan could discriminate in participation, benefits or contributions, but for all other purposes-vesting, fiduciary, and reporting and disclosure-the plan would have to be designed like a qualified plan without the tax benefits for qualified plans. Consequently, most nonqualified deferred-compensation plans are designed to be unfunded and are limited to management or highly compensated employees.

Dec 9, 2009


  1. Nonqualifed Deferred-Compensation or Supplemental Retirement Plans. A nonqualified deferred-compensation plan provides additional retirement or deferred-compensation benefits to key employees in addition to, or in place of, the amounts received under the employer's qualified plan, if any. There is a great deal of flexibility in the design of such plans, and many approaches have been used. (See later discussion.)

  2. Restricted Stock or Other Property. Restricted property plans provide compensation to executives in the form of property, usually stock of the employer company, that is restricted in such a way as to help retain the services of the executives or provide an incentive for good executive performance. (See later discussion.)

  3. Stock Options. Stock option plans are used for purposes similar to restricted stock plans; however, with an option plan, the employee is given an option to buy the stock at a stated price rather than an outright grant of the stock subject to restrictions. (See later discussion.)

  4. Life Insurance. Life insurance is a valuable benefit for key employees. As discussed later, it can be provided in a variety of ways.

  5. Severance Pay. Most employers have some form of severance pay policy for employees, often at a minimal level for rank-and-file employees. Executives, however, often negotiate favorable severance pay provisions as part of their compensation package. One particular type of contract regarded by Congress as abusive is the "golden parachute" contract, under which a company agrees to pay an executive large amounts of severance pay if the company changes ownership. Under Code Section 280G, tax deductions for golden parachute payments can be denied to the employer if the amount is excessive-generally, if it is at least three times the executive's average annual salary.

  6. Cash Bonus and Incentive Plans. Executive compensation plans often include plans for cash bonuses paid currently or deferred for a relatively short period of time that are tied to company or executive performance. Most of these programs are based in some manner on growth in company earnings during the executive's tenure in office. Often the bonus or incentive award depends on the attainment of specified target earnings objectives. There are many design considerations for such plans, including eligibility for the plan, the amount of the award and the benefit formula, and the period of time over which executive performance will be assessed. All these design features must be tailored to the employer's specific situation. There are no special tax complications for these plans; generally, the compensation is taxable to the executive when received and deductible to the employer at the same time.

  7. Additional Medical Expense Benefits. Additional health insurance is an attractive executive benefit, particularly where the company's basic plan has gaps in coverage.

  8. Disability Income Plans. As with health insurance, the company may wish to provide a disability income (salary continuation) plan for executive employees to cover any gaps in or to supplement the company's broad-based disability income plan. If the additional coverage is provided through insurance owned by the company, the premium is fully deductible to the employer but benefits are taxable to the employee when paid, subject to a disability income tax credit that disappears for higher income employees. If instead of relying on a company-provided plan, the executive purchases his or her own disability income insurance, the premium payments by the employee are nondeductible, but disability income payments are nontaxable. Because of this, many companies may prefer simply to provide extra compensation income to executives with the understanding that the executive will have the option of obtaining personally owned disability income insurance coverage.

  9. Loans to Executives. A plan providing loans from company funds to executives on favorable terms may be attractive to executives. If the executives are owners of the company, such a program also provides a means of withdrawing corporate funds on a favorable basis, that is, without being taxed on the receipt of a dividend. While interest-free and bargain loans were once used for this purpose, Code Section 7872 now prescribes a minimum interest rate for such loans, which is basically the interest rate applicable during the same period for federal marketable securities of similar term. If the employee loan has a lower interest rate, the bargain element is taxed as if the employee had received that amount as cash compensation. The purpose of this Code provision is to treat as nearly as possible a bargain-rate loan as if it is a market-rate loan, in order to discourage bargain-rate loans.

    Any employee loan should be a bona fide loan and should be evidenced by a formal written note with a fixed maturity date or a repayment schedule. The employee could be required to provide security for the loan, such as a home mortgage. Loan plans can be relatively unrestricted or can restrict executive loans to specific purposes, such as the purchase of a home or children's educational expenses.

    Interest on the loan will generally be consumer interest that is nondeductible to the employee unless secured by a home mortgage. Interest could also be deductible as investment interest if the loan proceeds are used for investments.

  10. Other Fringe Benefits. An infinite variety of perquisites and fringe benefits for executives is possible; for example, executive dining rooms, favorable expense account provisions, financial counseling and estate planning for executives, additional moving expense reimbursements, payment of professional association dues, and trips to professional seminars. The usefulness of these benefits depends entirely on individual facts and circumstances.

    The decision whether to provide any of these benefits is often affected by their federal income tax treatment because executives tend to be in high marginal income tax brackets and prefer to receive extra compensation in tax-free form.

Dec 6, 2009


The simplified employee pension (SEP) is an expanded version of the employer-sponsored IRA, designed by Congress to make it easy and attractive for employers to adopt a retirement plan which, although not a qualified plan as such, has similar features. A SEP is designed much like an employer-sponsored IRA, but the deduction limits are much higher-instead of a $2,000 annual deduction limit, the limit on deductible contributions for each employee is the lesser of $30,000 or 15 percent of the employee's compensation. The price for this expanded deduction limit is that the employer loses discretion as to who must be covered; there is a coverage requirement that in some ways is more stringent than that for regular qualified plans.

Eligibility and Coverage

If the employer has a SEP plan, it must cover all employees who are at least 21 years of age and who have worked for the employer during three out of the preceding five calendar years. Part-time employment counts in determining this; there is no 1,000-hour definition of a year of service. However, contributions need not be made on behalf of employees whose compensation for the calendar year was less than $300 (as indexed for inflation; 2000: $450). The plan can exclude employees who are members of collective bargaining units if retirement benefits have been the subject of good-faith bargaining, and it can also exclude nonresident aliens. Employer contributions to a SEP can be made for employees over age 70½; these employees are not eligible for regular IRAs, as discussed earlier.

Contributions and Deductions

An employer need not contribute any particular amount to a SEP in a given year or even make any contribution at all. In this respect, a SEP is more flexible than any type of qualified plan, even a profit-sharing plan, which requires substantial and recurring employer contributions. However, any employer contribution that is made must be allocated to employees under a definite written formula. The formula may not discriminate in favor of highly compensated employees. In general, the formula must provide allocations as a uniform percentage of total compensation of each employee, taking only the first $150,000 (as indexed for inflation; 2000: $170,000) of compensation into account. The SEP allocation formula can be integrated with Social Security under the usual integration rules for qualified defined-contribution plans.

Each individual in a SEP maintains an IRA and employer contributions to the SEP are channeled to each employee's IRA. For tax purposes, the employer contributions are treated as if they are paid to the employee in cash and included in income and then contributed to the IRA. The Code provides a deduction to both the employer and to the employee for these amounts.

If the employer maintaining a SEP also has a regular qualified plan, contributions to the SEP may reduce the amount that can be deducted for contributions to the regular plan.

Other Requirements

Except for the contribution, allocation, and deduction provisions, the IRAs maintained as part of a SEP are the same as other IRAs and the rules discussed in the previous section apply to them as well. For example, the rules for taxation of distributions from SEP-IRAs are the same as those for other IRAs. As with regular IRAs, loans to participants from SEP-IRAs are not permitted.

Labor and IRS regulations contain certain reporting and disclosure provisions for SEPs. These are simplified if the employer uses the IRS prototype SEP contained on Form 5305-SEP. This form was designed to simplify the adoption of SEPs by employers; however, it uses a nonintegrated formula.

When Should an Employer Use a SEP?

The term simplified in the name of these plans is somewhat misleading; a SEP is not really much simpler than a regular qualified profit-sharing plan, especially where a qualified master or prototype plan is used. However, installation costs are minimal where the government Form 5305-SEP is used; administration costs are low because the annual report form (5500 series) need not be filed. Thus, SEPs are attractive for cases where administrative costs must be absolutely minimized, such as a one-person plan. In other specific situations, the special coverage rules for SEPs may be more attractive than the regular coverage rules. From an employee viewpoint, the complete portability of the SEP benefit is attractive.

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