SERPSWAP

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SERP-SWAP The Exchange of SERP Benefits for A
More Efficient Estate Tax Plan
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SERP-SWAP
Introduction
As a result of increased tax regulation in the
area of executive compensation, fringe benefit
plans have become an essential ingredient to
attract and retain key executives. In this
extremely competitive market for talented
executives, a corporation must review and amend
existing fringe benefit plans to match the
changing needs of its top management, or risk
losing such executives. Over the past decade
supplemental executive retirement plans (SERPs)
have become increasingly popular with both
private and public corporations. The surge in
SERP popularity can be attributed to (1)
Congressional restrictions on the amount of
contributions that may be made to qualified
retirement plans, (2) market pressure to provide
an incentive for key executives to remain with
their current employer and (3) the ability of a
SERP plan to avoid ERISAs burdensome and complex
requirements applicable to qualified retirement
plans.
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Taxation of SERPs
Under a SERP plan, the corporation promises to
pay the executive an additional benefit during
retirement. The executive is able to defer
paying income tax on this benefit until he/she
actually receives payment from the SERP plan
(presumably when the executive is in a lower tax
bracket). While SERPs are an excellent vehicle
for the accumulation of retirement benefits, they
may be inappropriate for preserving such wealth.
For those executives who have accumulated
significant other assets, the SERP assets not
consumed during lifetime can be subject to
combined state and federal income and estate
taxation in excess of 70. More specifically

• SERP payments made to the retired executive or
  spouse are subject to federal income taxes with
  rates up to 39.6 (an additional state income tax
  will likely apply)
• SERP assets remaining at death are includible in
  the executives taxable estate with rates up to
  55

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Mechanics A More Efficient Design Alternative
For some top executives, the SERP plan becomes
more of a tax detriment than a fringe benefit.
In order to remedy this situation, the
corporation offers its key executives the right
to exchange or swap the present value of the
SERP benefit for a survivorship life insurance
policy. (If the executive is not married, a
single life policy is used). The insurance
policy is funded by a split dollar
agreement. Under the split dollar plan, the
executives irrevocable life insurance trust
(ILIT) is the owner and beneficiary of the
policy. The corporation is required to pay a
majority or all of the premiums on the policy,
and retains the right to be reimbursed for its
aggregate premiums advanced. The diagrams below
illustrate the steps necessary to implement the
SERP-SWAP
Step One
Step Two
Calculate projected SERP benefit
Decide how much SERP benefit executive will SWAP
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Advantages
For the executive

• Flexibility - the executive determines how much
  of the SERP account he/she exchanges
• Tax Efficiency - unlike SERP benefits, the
  insurance proceeds held in trust avoid income and
  estate taxation
• Security - the key executives trust owns the
  insurance policy whereas the SERP benefit is an
  unfunded and unsecured promise to pay by the
  corporation

For the corporation

• Cost Neutral - SERP-SWAP does not increase the
  expense to the corporation present value cost of
  the SERP equals the present value cost of the
  split dollar arrangement
• Positive PL Impact - once swapped, the SERP
  liability is removed from the corporations
  balance sheet

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Accounting Treatment
The exchange of a SERP benefit is generally
covered under FAS 88, which contains settlement
and curtailment rules that are beyond the scope
of this presentation. However, John Hancocks
Estate Business Planning Group is in the
process of securing an advisory memorandum from a
national accounting firm that describes the FAS
88 treatment of a SERP exchange. This memorandum
will be available for review upon its completion.
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Proxy Disclosure
The exchange of a SERP may require disclosure
under SEC proxy disclosure rules. The disclosure
requirements are relatively straightforward. Two
examples of recent proxy disclosures follow. In
the first example of the J.W. Marriott
Corporation, the participant exchanged his right
to receive an accrued SERP benefit for a split
dollar arrangement
In 1996, J. W. Marriott, Jr. waived his vested
right to receive post- retirement distributions
of cash under Old Marriott's executive deferred
compensation plan and Old Marriott common stock
under Old Marriott's stock incentive plan. The
payments and stock distributions waived were
awarded to Mr. Marriott in 1995 and prior years
and were disclosed as required in earlier proxy
statements of Old Marriott or of Marriott
Corporation. In connection with this waiver, Old
Marriott agreed to purchase split-dollar life
insurance policies for the benefit of a trust
established by Mr. Marriott. This agreement to
purchase split-dollar life insurance policies has
been assumed by the Company. The cost of the life
insurance policies to the Company will not exceed
the expected after-tax cost to Old Marriott if it
had made the payments and stock distributions
that were waived by Mr. Marriott. For 1998, the
taxable economic benefit to Mr. Marriott as a
result of these life insurance policies was
58,509.
The second example involves Lucent Technologies
The Board of Directors restructured Mr. Schachts
1996 and 1997 compensation, reducing his 1996
annual bonus by 2,281,838, reducing his 1997
salary by 208,000 and reducing his 1997 annual
bonus by 1,510,162 and establishing a
split-dollar life insurance policy insuring him
and his spouse. Under this arrangement, the
Company will utilize the savings from the salary
and bonus reduction to pay premiums. The
aggregate premiums for this policy will be
4,000,000 over a three-year period. The Company
is a beneficiary of this policy. In fiscal 1997,
the annual value of the policy to Mr. Schacht of
5,362 was imputed as income.
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Tax Issues
The IRS has not issued a public or private ruling
on the income tax consequences of the SERP- SWAP
technique. If the IRS were to rule, most
commentators believe that the IRSs analysis
would focus on three possible theories
constructive receipt, economic benefit and/or
assignment of income. A detailed discussion of
each of these theories is beyond the scope of
this presentation. However, John Hancocks
Estate Business Planning Group has secured a
memorandum written by Lawrence Brody from the law
firm of Bryan Cave which analyzes the income tax
issues associated with the SERP-SWAP. Mr. Brody
is a nationally recognized expert in the area of
executive compensation planning. It is the
opinion of the Estate Business Planning Group
and Mr. Brody that existing authority does not
support taxing the executive on anything other
than the economic benefit from the split dollar
plan. Nevertheless, each client should have the
arrangement reviewed by his/her own tax advisor.
Enrollment Administration
If the corporation decides to offer the SERP-SWAP
to selected SERP participants, the following
checklist can be used as a timeline for assisting
with the process.

• 1. Collect current SERP information
• 2. Analyze existing SERP and model split dollar
  plan
• 3. Meet with selected executives and advisors
• 4. Illustrate underwriting process
• 5. Meet with internal auditors
• 6. Review SERP agreement

7. Draft split dollar agreement and
ILITs 8. Draft Board resolution authorizing
SERP-SWAP 9. Draft proxy disclosure
language 10. Reverse accrued SERP
liability 11. Issue new policies 12. Distribute
annual economic benefit reporting