5 Common Questions About Deferred Compensation

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What are

deferred

compensation plans?

Deferred  compensation  plans  have  been  around  as  a  form  of  executivecompensation  for  a  long  time.  Broadly  defined,  deferred  compensation  plansare  an  agreement  between  employee  and  employer  in  which  the  employercommits  to  an  unfunded  promise  to  pay  a  portion  of  the  employee’scompensation  in  the  future.  

The  commitment  can  be  a  salary  or  bonus  deferral  by  the  employee  oradditional  money  set  aside  by  the  company  for  performance  and  retention.    

These  plans  should  be  distinguished  from  more  common  retirement  planssuch  as  401k(s),  which  are  called  qualified  plans.  Unlike  401(k)s,  deferredcompensation  plans  are  not  qualified,  meaning  only  the  employee  receivesan  immediate  tax  benefit  from  the  deferral.  Also,  to  avoid  current  taxation,the  plan  election  to  defer  must  take  place  before  the  compensation  isearned  and  the  employee  is  subject  to  risk  of  creditors  until  paid.  Themoney  for  401(k)  plans,  on  the  other  hand,  is  funded  into  a  separate  trustand  protected  from  company  creditors.  

What are the

tax benefits

of deferred

compensation?

The employee benefits by excluding the deferral amount ofcompensation from taxable income in the current tax year. In other

words, the income the employee elects to defer is not taxed until thecompensation is received in the future.

Under a hypothetical scenario, if an employee filing jointly is scheduledto make $750,000 in 2013, he or she would see a tax increase of roughly

$18,300 compared to 2012 tax rates (including the new 0.9 percentMedicare tax on higher income taxpayers). But for every dollar above$450,000 deferred, the employee would defer tax of roughly 40 cents(the new Medicare tax probably would not be deferred). An employee

who deferred $50,000 would see a tax deferral of $20,000.

If the employee’s tax bracket is lower at the time of receiving the

deferred income, he or she would realize not only tax deferral but

tax savings because the income would be taxed at a rate lower than

39.6 percent.

There is not an immediate tax benefit for employers. However, the

employer will be able to deduct the benefits when the compensation

is paid out in the future. The primary purpose of the deferred

compensation plan for the employer should not be to capture a tax

benefit for the company, but rather to help attract and retain

executive talent.

How are

deferred

compensation plans

invested?

Typically, the company takes the money that was to be paid as

compensation to the employee, and the employer retains control of the

assets. The company can commit to grant a fixed crediting rate or tie

the earnings rate to performance of a portfolio of mutual funds, stocks,

bonds, etc.

The company can allow various investment choices as desired by the

employee. Life insurance is often used as an investment vehicle in

those situations where a death benefit may be desired by the family,

the company or the lender.

Typically, high cash value life insurance products are used to fund life insurance

needs in a deferred compensation plan. The asset allocation within the policy

must be reviewed regularly with the executive or investment committee to ensure

the plan meets the objectives of the core group of employees. It is suggested that a

written investment policy statement (IPS) be embedded in the process to meet new

fiduciary guidelines.

A challenge for some companies is the requirement to create an unfunded liability

on the employer's balance sheet and the inability to use that cash for short-term

needs to support the business. Sometimes this may cause debt covenant issues,

but also may be a source of financing growth of the company.

Which

companies

should consider

deferred

compensation plans?

Deferred compensation plans are most ideal for large

companies or companies with plenty of free cash flow. The

companies establishing these types of plans typically do

so for other business reasons, such as retention of key

executives or allowing retirement savings for executives

who have “maxed out” under the qualified 401(k) plan

(current limit is $17,500). Some high-growth companies

may consider it for intermediate financing options.

It also only makes sense to consider a deferred compensation plan if

the company is structured as a C corporation -- not a pass-through

entity (related: check out my previous post on choosing the right

business entity). A pass-through owner who participates in a

deferred compensation plan is really not deferring income. The

deferred amount of compensation results in higher taxable income

to the company because the compensation isn’t paid to the business

owner, and the higher company income is passed through on the

business owner’s K-1.

However, a pass-through entity can consider a deferred

compensation plan for non-shareholder employees because those

employees will receive the desired tax benefits.

What are

some of

the risks

involved?

The principal downside is the funds are not protected in the case of

bankruptcy. The funds in the deferred compensation plan would

belong to the company’s creditors in a bankruptcy event. Also, once

the income is deferred it will be difficult for the employee to gain

access to the funds if needed.

Techniques, such as a Rabbi Trust, are available to provide

additional protection to the employee in the event of a change in

control.

A deferred compensation plan is just one of many tax planning

strategies to consider. As with any tax strategy, be sure to meet

with your local CBIZ tax advisor before making any final decisions.

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