How Credit Unions Can Plan for the 457F Tax Implications

By Christie Summervill

How Credit Unions Can Plan for the 457F Tax Implications

Those million-dollar SERPs just became a major tax burden that your organization must adjust for.

In December 2017, the Tax Cuts and Jobs Act (TCJA 2017) added language which addresses compensation for senior executives. The changes from TCJA 2017 impose excise penalties for non-profit organizations (including credit unions), and eliminate the deduction by for-profit organizations (including banks), when compensation to certain employees exceeds $1 million in a year. Compensation packages that include supplemental executive retirement plans (SERP) have long been the standard for attracting and retaining executives as well as providing a guaranteed retirement nest-egg for executives. Particularly for non-profits like credit unions, the TCJA 2017 change could upend many plans.

We spoke with Scott Richardson, JD, CLU, ChFC, the president & CEO of IZALE Financial Group, to decode what this means for credit unions. A long-time strategic partner of BalancedComp as co-presenter of the How to Pay Your CEO webinar, Scott is our go-to expert for clarifying sticky executive compensation tax questions such as this.

For executives retiring within the next 12-18 months, Richardson warns that there is not much that can be done; the situation is inconvenient at best, costly at worst. Those organizations will incur an excise penalty that was not at play when the plans were designed. For executives retiring at least two years out, there may be ways to ease the burden.

He also shares how this affects both banks in the for-profit world antwittd credit unions in the non-profit world, and how he’s advising clients to work around and make sense of the confusion created by the new tax rules.

Effects on For-Profit Firms

New Tax Burden: Banks must now pay additional taxes on well-compensated and top-performing executives.

U.S. tax code sec. 162(m) prohibits a company from deducting a “covered employee’s” compensation in excess of $1 million annually. In the past, this rule was not applied to performance-based compensation or commissions, allowing the company to set a salary below the $1 million threshold and shift the rest of the compensation to a tax-deductible incentive plan. TCJA 2017 revokes the performance-based compensation exception, resulting in a loss of deduction for compensation in excess of $1 million.

In addition, the definition of “covered employee” has broadened to include any employee who served as CFO or CEO at any time during the tax year. Previously, only the employees holding these positions on the last day of the year were included in the definition.

Effects on Non-Profit Firms

New Tax Burden: Credit unions must now pay an excise tax on well-compensated and top-performing executives.

Where CUs and other non-profits haven’t had to worry about the tax implications at all, they are now on the hook for a 21% excise tax—paid by the employer—on all compensation in excess of $1 million (per person) to the top five highest compensated employees. “In practice, the new tax law has a disproportionate impact on non-profits because of the way these organizations typically distribute deferred compensation,” explained Richardson

Putting This into Practice

Richardson described a scenario shared by three of his clients:

  • $1B+ credit unions
  • All with 457(f) plans paying out in 5-9 years
  • Reasonably justified paying $2.5 million lump sums to retiring CEOs
  • Now they’re saddled with an extra $200,000 – $600,000 in excise penalties

While this is not the executive’s problem (as they’re guaranteed the SERP regardless of changes in the law) many executives want to help the credit union avoid this costly burden. Again, there’s not much to be done for executives retiring by fall 2019. Looking ahead, though, there are two solutions worth considering.

Testing Tax-Free SERP Solutions

There are two solutions (read: work-arounds) that have viability but still need to be stress tested against the new tax code—restricted bonus plans and split dollar loans.

“These will rarely, if ever, when designed properly, cause an executive at a non-profit to cross over that $1 million threshold (unless base salary is that high),” explained Richardson. “This is all based around SERPs, that’s where the biggest dollars are.”

Restricted Bonus Plan

Section 162 might be one of the best tools in the tax code for accumulating and distributing wealth. The employer can provide the executive with tax-free retirement distributions via a life insurance contract. The individual owns a permanent life insurance contract, which accrues tax free. The employer pays outright for the contract on the individual’s behalf. The employer pays the premium every year of active employment, provided, of course, that the insured is healthy enough for underwriting.

It’s very simple from an accounting standpoint. The annual dollar amount is, in the vast majority of cases, sufficiently below the $1 million threshold.

Split Dollar Loans

Similar concept with a different approach. Rather than make the life insurance premium payment for the executive, the employer lends the money for the premium and the employee will pay it back with interest. This interest has to, at minimum, meet the IRS requirements (most frequently the AFR, or Applicable Federal Rate; see current rates).

Here’s the trick…repayment is due no later than upon death. A collateral assignment of the insurance policy is made in favor of the employer…they receive the first dollars of the death benefit. The cost to the employee is merely the interest that they technically won’t even pay out of pocket, as it accrues and pays from the policy proceeds.

While the AFR is currently at its highest in about two years, it’s still about 2-4% lower that what is reasonably expected in retail insurance products.

Finding the Light in the Grey

“The organization is going to pay you some amount of money in a different form and different manner than has been typical, but in total, you will land in the same spot,” Richardson says about the grey areas of the new tax law as it applies to executive pay.

While CEOs and similar executives want to secure the best possible total compensation package, including SERPs, they also have the best interests of the organization at heart. For your executives retiring beyond fall 2019, it’s worth the investment of time and resources to have candid conversations about the tax implications on the organization and the ways in which the SERP can still be honored without unnecessary expense or burden. It’s possible to still sweeten a comp package with a multi-million retirement perk without sinking the proverbial ship.

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