It's a rare event indeed when an IRS ruling is cause for celebration, but such was the case in April when the tax-meisters made some alternative deferred-compensation funding investments more tax friendly.

Specifically, the IRS ruled that an employer using derivative financial products to hedge its deferred-compensation obligations would not be required to recognize any income until the investments were liquidated to make payments. Since an employee is only taxable on deferred compensation upon payment, this meant that no one would pay any tax on these investments until liquidation.

This opened up a range of new options to financial planners and their clients, who typically have favored life insurance and annuities as tax friendly deferred-compensation funding vehicles.

Lifelines

By way of background, employers, small and large alike, often purchase life insurance policies and annuities to fund and hedge their obligations to executives under deferred-compensation plans. These policies are purchased instead of direct, actual investments (i.e., stocks, bond and mutual funds) because the investment returns under life insurance and annuities are tax deferred. By contrast, the earnings on actual stock, bond and mutual fund investments would be currently taxable to the employer corporation.

In this new ruling, the IRS indicated that an employer corporation could use derivatives to economically replicate an investment in stocks, bonds and mutual funds and yet recognize no current income from the derivative investments.

This approach to funding deferred compensation should appeal to employer corporations and high-net-worth clients (many of whom are small- and medium-sized owners or executives at larger companies, eligible to use or create deferred-compensation plans).

Deferred-compensation plans can be set up at businesses of any size, even companies owned by one or two persons. For a wholly owned business, a deferred-compensation plan could take on many of the same characteristics as a jumbo nondeductible IRA, except that unlike an IRA, there is no requirement to begin taking distributions in the year following the year when a participant attains the age of 70, no penalty for taking distributions prior to age 59 and no annual contribution limit (currently $3,000).

Similar to an IRA, this approach to deferred-compensation funding will be most tax efficient for an employee when the reference funds or investments are in the taxable fixed-income category or of a type which do not produce primarily long-term capital gains or qualified dividends (which are both currently taxable at a maximum rate of 15 percent).

It is probable that other financial products — including forward sales, index options, total return asset contracts (TRAKRS) and structured notes that are not principal protected — will also qualify for deferred-tax reporting under the analysis in the ruling. If an employer corporation was uncomfortable with the complexities associated with derivatives, a financial advisor could execute the hedge by selecting publicly registered structured notes.

Some structured notes are listed and trade on the American Stock Exchange, and a listing of them can be found at amex.com under the structured products menu. Some recently issued examples of nonprincipal protected structured notes include Merrill Lynch's Select Utility Index Strategic Return Notes, which pay an amount based upon the total return of 20 dividend-paying utility stocks from the S&P Utilities Sector, and Merrill Lynch's Industrial Index Strategic Return Notes, which pay a return based upon the top 15 dividend-yielding stocks from a group of certain stocks in the S&P's Industrial Index.

Planners now have available a powerful alternative to offer clients who desire to fund deferred-compensation plans on a tax-efficient basis, but who do not want to use variable life insurance policies and annuities. Though the use of derivatives, structured notes and other nontraditional investments will require some time to evaluate and structure; the enhanced returns available from the tax deferral more than compensates for this.

Writer's BIO: Robert S. Bernstein is a partner in the Jacksonville office of Foley & Lardner. His practice focuses on international taxation, employee benefits, trusts and estates and tax matters. rbernstein@foley.com