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SERP Swaps - Tipping the Scale in Favor of Tax Savings by Integrating a Split-Dollar Policy with a SERP By Jeffrey P. Hart, Esq.

Thursday, August 16, 2001 - By: Jeffrey P. Hart

By Jeffrey P. Hart, Esq.

With the surging growth of our economy, many executives are now finding themselves in a position of having either fully funded, or over funded, their anticipated retirement needs using various retirement vehicles, including qualified defined benefit plans and defined contribution plans, individual retirement accounts, and non-qualified deferred compensation plans. Non-qualified deferred compensation plans, sometimes referred to as "Supplemental Executive Retirement Plans" ("SERPs"), are retirement savings vehicles utilized by some employers to provide highly-compensated employees ("Executives") with a means to accumulate retirement benefits in excess of those permitted under qualified plans.

More is not always better with SERP benefits. Today, many Executives find that their SERP plans have a balance in excess of their anticipated retirement needs, or a balance which, in time, will be excessive. SERP benefits which are not needed to fund the Executive's anticipated retirement needs will result in increased income and estate tax liability for the Executive and his or her beneficiaries.


A SERP plan is an agreement between an employer and an Executive under which the employer promises to pay the Executive a certain amount at a future time. Often, no amounts are set aside by the employer in favor of the Executive, but a bookkeeping or memorandum account is used to track and accrue the benefits to the Executive. The Executive's standing to claim benefits under the SERP plan is equal to that of an unsecured general creditor of the employer. SERP plans typically give an Executive the option to elect post-retirement benefit distributions in a lump sum payment or in annual payments over a stated number of years. All distributions made to an Executive from his or her SERP plan are subject to income tax, and any amount distributed, but not expended, will also be subject to estate taxes, unless such remaining proceeds pass to a surviving spouse in a manner eligible for the estate tax marital deduction, or to charity in a manner eligible for the estate tax charitable deduction. The rates at which estate taxes will be applied to remaining SERP plan benefits range from approximately 37% to 55%, assuming the Executive's applicable estate exclusion amount has been fully utilized. The potential net income and estate tax impact could be an astounding net 73%, resulting in only 27% passing to the Executive's beneficiaries.

If the Executive dies either prior to his or her retirement age or prior to having received all distributions from the SERP, any remaining amounts due under the SERP plan will be paid to the Executive's beneficiary and will be subject to both income tax and estate tax. Distributions from the SERP to the Executive's beneficiary will be classified as income in respect of a decedent ("IRD"), and, as such, will be included in the beneficiary's gross income for the taxable year in which the beneficiary receives a SERP distribution. Under IRC Section 691(c), the beneficiary will be entitled to an income tax deduction for estate taxes paid which are attributable to the inclusion of the IRD in the Executive's estate. However, because the beneficiary receives a deduction rather than a credit, there is not a complete offset to income tax liability for estate taxes paid.

The terms of the SERP may provide that distributions to the Executive's beneficiary may only be paid in a lump sum, or may provide that the beneficiary has the option to elect to receive distributions in annual payments over a set period of time. In either situation the beneficiary can apply a portion of the distribution received from the SERP to the income tax liability incurred on the distribution of SERP benefits. Similarly, with respect to estate tax liability, if the beneficiary receives a lump sum distribution, a portion of such distribution can be applied to the estate tax liability attributable to inclusion of the SERP in the Executive's estate. However, if a beneficiary is able to and does elect to receive annual payments from the Executive's SERP, as opposed to a lump sum, a liquidity issue arises. By electing annual payments, the beneficiary receives only a portion of the SERP plan proceeds each year, while the entire value of the SERP plan will be included in the Executive's estate. The estate tax liability generated by the inclusion of the SERP plan in the Executive's estate will range from approximately 37% to 55% and will be due and payable within nine months of the Executive's death. The estate tax liability may exceed the amount of the first annual distribution from the SERP plan to the beneficiary who has elected an installment payout. In order to pay the estate tax liability within nine months of the Executive's death, the executor or beneficiary, depending on which of the two, under the terms of the Executive's Will or otherwise, is liable for the estate taxes due with respect to the SERP, may be forced to liquidate other property.


There is, however, a relatively recent planning technique available to Executives and employers which may alleviate the tax burden associated with excessive SERP benefits and cause more property to pass to the Executive's beneficiaries. This technique involves "swapping" current or future SERP benefits for benefits under a split-dollar life insurance agreement ("SERP Swap"). The SERP Swap is achieved by either decreasing the Executive's current SERP account balance (thus decreasing the employer's future obligation to pay retirement benefits to the Executive), or by decreasing or eliminating future SERP account credits to the Executive and currently applying funds to premium payments on an equity split-dollar life insurance arrangement . The premiums to be paid for life insurance on the executive would be structured to approximate the present value of amounts which would have been payable to the Executive in the future under the SERP plan. The policy would be issued on the life of the Executive and owned by the trustees of an irrevocable life insurance trust (ILIT) established by the Executive. The trustee of the ILIT would be named as the beneficiary under the insurance contract. Using this technique, the Executive can change the form of expected retirement benefits, which would be subject to income and estate taxes as discussed above, to a death benefit which would pass to the beneficiaries of the Executive's ILIT income tax and estate tax free.

A portion of the premiums paid by the employer under the split-dollar agreement, an amount equal to the one-year term cost of declining life insurance, or the "economic benefit" of the arrangement, would be classified as income to the Executive, and a portion would be equivalent to an interest free loan from the employer to the trustee of the Executive's ILIT to be repaid upon the Executive's termination or death, or upon surrender of the policy. The trustee of the Executive's ILIT would collaterally assign the policy to the employer to secure the employer's claim against the policy for reimbursement of premiums paid by the employer. In turn, the Executive would be deemed to have made a gift to the ILIT of an amount equal to the "economic benefit."

Assuming the ILIT is structured correctly, upon the death of the Executive, the death benefits would pass under the insurance contract to the trustee for distribution under the terms of the ILIT and, thus, would not be includible in the Executive's estate. In addition, amounts received by the trustee would not be subject to income tax at the trust or beneficiary level.


Income Tax

Several potential income tax liability issues exist with respect to the SERP Swap technique and should be considered in each situation before utilizing the technique.

Constructive Receipt of Income: In Martin v. Commissioner, 96 T.C. 814 (1991), the Internal Revenue Service (IRS) argued that a plan participant was in constructive receipt of income when benefits under one deferred compensation plan were exchanged for benefits under another deferred compensation plan. However, the Tax Court in Martin held that, under the facts and circumstances presented in that case, the exchange with respect to plan benefits did not trigger constructive receipt of income to the plan participant.

Assignment of Income: Additionally, the IRS may argue that such an exchange between two separate plans is an assignment of income by the Executive. However, assuming the Executive's benefits under the SERP plan are unfunded and his or her claim to the benefits is no greater than that of an unsecured general creditor of the employer, the benefits should be considered to be subject to a substantial risk of forfeiture. Therefore, the Executive should have no income to assign.

IRC Section 83: Finally, the IRS may argue that the exchange of benefits under one deferred compensation plan for benefits under another plan triggers taxable income to the Executive under IRC Section 83 because the plan participant is receiving property in exchange for services. There is a counter argument which provides that the Executive does not receive, nor does he or she have a right to receive, any property under either plan at the time of the plan benefit exchange.

When analyzing a potential SERP Swap situation, all three issues noted hereinabove should be considered with respect to individual facts and circumstances.

Estate Tax

Additionally, with respect to estate taxes, there is a potential downside to be considered prior to utilizing the SERP Swap technique. In order to keep the life insurance proceeds from being includible in the Executive's estate, the Executive cannot retain any incidents of ownership, as defined under Treasury Regulation Section 20.2042-1(c)(2), in the ILIT or over the life insurance policy held in the ILIT. Therefore, the Executive cannot retain the ability to withdraw cash from the life insurance policy or take loans against the policy. The effect is that the Executive releases all claims to the policy and the proceeds thereunder, and therefore will not have the ability to reach the policy for any reason, including funding his or her retirement. Also, if the Executive is a sole or controlling owner of the employer, any incidents of ownership held by the employer will be attributed to the Executive to the extent the proceeds of the life insurance contract are not received by the employer. Treasury Regulation Section 20.2042-1(c)(6). Therefore, as with any split-dollar agreement, caution in the design and drafting of the agreement is required.


The SERP Swap technique is a powerful tax savings strategy for those individuals who have accumulated, or expect to accumulate, excessive retirement benefits under a SERP plan. Provided an individual's retirement needs are balanced with his or her goal of minimizing income and estate taxes and of passing property to beneficiaries, the SERP Swap technique is an excellent way to maximize tax savings and wealth transfer, while not compromising an individual's retirement needs.