Protecting Non Qualified Deferred Compensation Plans with Bankruptcy Insurance

Bankruptcy insurance policies offer employees an effective means of protecting their non-qualified deferred compensation plan (NQDC) benefits. When used in conjunction with a rabbi trust, it eliminates virtually all risks associated with a non-qualified deferred compensation plan. Unfortunately, such policies are not the ideal solution for all employees. Those in financially weak or private companies or employees who plan to continue working for 10 to 20 years may find that the cost of bankruptcy insurance policies outweigh the benefits.

History

In a private letter ruling issued on August 2, 1993, the Internal Revenue Service (IRS) addressed the issue of an employee's purchase of bankruptcy insurance to protect amounts set aside for him by his employer in a rabbi trust.

A Fictional Example - Jack and The Ubiquitous Jack was a participant in a non-qualified deferred compensation plan funded by a rabbi trust. Under his non-qualified deferred compensation plan, Jack would receive benefits from the NQDC plan if he completed a specified period of employment with his employer and retired under his employer's retirement plan. The plan specifically provided that any financing vehicle used by the employer to finance benefits under the plan (i.e., the rabbi trust) would be subject to the claims of the employer's general creditors.

In order to protect his benefits in the event of his employer's bankruptcy, Jack contracted with "The Ubiquitous", the Unplanned Bankruptcy Insurance Quoters and Underwriters International Trust Of the United States Company, for bankruptcy insurance. Jack negotiated all of the terms of the bankruptcy insurance policy with The Ubiquitous, including the amount of the premium. No Representative from Jack's employer was present at any of the meetings, and no representative participated in any of the negotiations between Jack and The Ubiquitous. Jack is required to pay all the premiums due under the bankruptcy insurance Policy. The IRS did note that Jack's employer will likely increase his compensation by an amount equal to the premiums he pays.

Under the terms of the bankruptcy insurance policy, The Ubiquitous agrees to indemnify Jack upon the occurrence of an "insured event". The policy defines this as a bankruptcy filing, an anticipatory repudiation, or repudiation of the non-qualified deferred compensation promise. The policy is designed to encompass those situations in which Jack's employer becomes unable to pay the promised benefits or notifies Jack that it does not intend to honor its non-qualified deferred compensation promise. In other words, the policy protects Jack from those few situations in which the rabbi trust does not offer sufficient protection.

The IRS ruled that Jack's purchase of the bankruptcy insurance policy did not place him in constructive receipt of the amounts set aside in the rabbi trust. Furthermore, Jack's purchase of the policy did not confer an economic or financial benefit upon himself. The IRS noted that under the terms of the non-qualified deferred compensation plan, Jack still has only his employer's unsecured promise to pay the benefits. Jack's independent purchase of the bankruptcy insurance policy did not cause his employer to transfer property to him or set aside assets from its creditors. According to the IRS, since Jack negotiated the terms of the bankruptcy insurance policy without any involvement by his employer, and The Ubiquitous issued the policy without entering into any collateral agreements with Jack's employer or without obtaining information about the employer (other than publicly available information), no economic benefit was conferred on Jack by his employer.

Purchasing Bankruptcy Insurance

Although private letter rulings cannot be cited or relied upon as precedent, they offer practitioners guidance on how the IRS views particular issues. Based on the foregoing private letter ruling, it is safe to assume that many employers and employees will begin looking into bankruptcy insurance as a means of protecting non-qualified deferred compensation plan benefits. Based on the particular facts in the private letter ruling, it is clear that if an employee seeks to avoid constructive receipt and economic benefit problems, the employee must ensure that his or her employer has very little involvement in the purchase of the bankruptcy insurance policy.

Employees seeking to secure their non-qualified deferred compensation plan benefits should contact a bankruptcy insurance company directly. If their employer is a public corporation, the bankruptcy insurance company should be able to price the policy based on readily available public information. However, if their employer is a non-publicly traded corporation, the employee may need more involvement from his or her employer. Because the price of a bankruptcy insurance policy is based, in large part, on the financial stability of an employer, bankruptcy insurance companies need the financial statements of companies sponsoring the non-qualified deferred compensation plan. Employees who want to purchase a bankruptcy insurance policy should request such information from the employer and furnish this information directly to the insurance company. Employees should carefully monitor the extent of their company's participation in furnishing this information. As the IRS made clear in its private letter ruling, an employer may not have any involvement or participation in an employee's purchase of a bankruptcy insurance policy.

Bankruptcy insurance policies protect employees in the event of their employer's bankruptcy or repudiation of a non-qualified deferred compensation promise. Generally, bankruptcy insurance policies are issued for a fixed period of time (e.g., five years) and contain a rolling extension endorsement. For example, an employee may be able to purchase a bankruptcy insurance policy protecting his or her non-qualified deferred compensation benefits for a period of five years. After a year of coverage transpires, the employee may have the option of purchasing an additional year of protection. Premiums are generally prepaid and noncancelable.

The price of a bankruptcy insurance policy depends upon the financial rating of the employer. An employee in a financially strong company seeking bankruptcy insurance for non-qualified deferred compensation benefits of $1 million would likely pay between $12,500 and $20,000 for five years' worth of protection. The price for a one-year rolling extension is generally one-fifth of the total premium, assuming the financial condition of the employer remains constant.

Because they are a relatively new product, premiums for bankruptcy insurance policies are rather high. Unfortunately, as the financial condition of a company weakens (thereby increasing the need for protection), the premium for the policy significantly increases. Also, for employers without a Standard & Poor's or Moody's rating, it may be difficult (and costly) to price the policy.

Furthermore, bankruptcy insurance policies cover only a limited period of time (with, perhaps, optional rolling extensions). An employee who does not plan to retire for 10 to 20 years would have to purchase a significant amount of insurance to protect his or her non-qualified deferred compensation benefits until retirement. Alternatively, employees thinking of retiring within a few years may find bankruptcy insurance policies an attractive way to protect their benefits.

A final problem with bankruptcy insurance is the unsettled issue of how much involvement employers can have in the purchase of a policy. Although employers may wish to alleviate employees' concerns regarding the risk of default, they must avoid the temptation to directly contact bankruptcy insurance companies on behalf of employees. Nevertheless, companies may encourage their employees to work together in selecting, negotiating, and purchasing a bankruptcy insurance policy. Such collaboration may reduce the amount of the premiums. In the end, however, it must be the employees who negotiate and contract with the insurance company. If the IRS determines that the employer had too much involvement in an employee's purchase of a policy, it will likely rule that the employer has conferred an economic benefit upon the employee. In other words, too much involvement by the employer may expose employees to immediate taxation of amounts set aside on his or her behalf in a rabbi trust.

Note: Jack and The Ubiquitous are fictional examples