What is a deferred compensation plan
Key employees may receive two forms of deferred compensation:
- Qualified deferred compensation benefits
- Non-Qualified compensation benefits.
The difference lies in the tax consequences to both the company and the Key employee.
A deferred compensation plan is:
- a contractual agreement
- between a corporation and one or more of its key executives (members of a select group of management or highly compensated employees)
- where the corporation promises to pay benefits in the event of retirement, disability and/or death
The deferred compensation plan is outlined in a compensation agreement between the employer and the executive. This contract describes:
- the benefits to be provided; and
- the requirements the executive must meet in order to receive those benefits.
Unlike qualified retirement plans, deferred compensation plans can discriminate and include only selected key executives.
When the benefits are being provided with employer dollars, the deferred compensation agreement usually contains certain requirements that the executive must meet in order to receive the benefits. Most frequently this is a requirement that the executive does not terminate employment prior to retirement.
For this reason, deferred compensation plans are frequently referred to as “golden handcuffs.” The key executive who is considering terminating employment must take into account the loss of valuable benefits.
Originally, deferred compensation was a deferral of a portion of the executive’s current salary, or of a salary increase or bonus, until the executive’s retirement or death prior to retirement. At that time, the corporation then paid those accumulated amounts to the executive or his/her heirs.
This traditional approach to deferred compensation is known as a salary reduction plan By deferring a portion of current income (which would otherwise be currently taxed if not deferred), a higher tax bracket executive can have the entire amount invested for his or her retirement, resulting in a higher retirement income than would be available if the executive were to invest after-tax dollars.
The cost to the corporation is equal to the loss of the income tax deduction which could have been taken if the amount deferred had been paid as salary.
The second type of deferred compensation plan, the executive does not defer any current income. Instead, the benefits are fully paid for by the corporation and are over and above those provided by other company-sponsored benefit programs.
This incentive approach to deferred compensation is known as a salary continuation plan. In addition to providing important benefits, a salary continuation plan also provides the executive with more spendable income, income that he or she might otherwise have to spend to provide these same benefits.
A decision must be made as to whether the plan will be funded or unfunded.
A funded plan is one in which the employer establishes a trust or escrow fund to satisfy its future obligations to the executives. Unless the rights of the executive to the assets in a funded plan are subject to substantial risk of forfeiture and nontransferable, the executive will be currently taxed on the employer’s contributions. In an unfunded plan, the executive receives only the employer’s unsecured promise to pay the benefits. No separate assets are set aside and the executive is not taxed until the benefits are actually received.
A form of an unfunded plan is the informally funded plan where the employer purchases a life insurance policy to provide cash to meet its future obligations. The policy is applied for, owned by and paid for by the corporation, which is also its beneficiary. As a result, the policy is considered an asset of the employer, carried on its balance sheet and available to creditors, so the payment of premiums does not generate taxable income to the employee.
|Plan||Forfeiture Provisions?||Tax Consequences|
|Funded||Yes, substantial||No taxation until benefits received|
|Funded||No||Executive taxes on contributions as made|
|Unfunded||Yes or No||No taxation until benefits received|
|Informally Funded||Yes or No||No taxation until benefits received|
Deferred compensation plan taxation
When properly arranged, a deferred compensation plan presents these tax consequences
|To the Corporation||To the Executive|
In order to accomplish a primary objective of deferring current taxation to the executive, the plan must be properly arranged so that:
- the constructive receipt doctrine will not arise if the executive and corporation enter into the deferred compensation agreement before the performance of services that generate the income to be deferred; and
- the economic benefit doctrine does not arise.
In order to avoid the economic benefit doctrine, the plan must either be:
- unfunded, so that the executive has no control over the income and no rights to the benefits other than that of a creditor; or
- funded, with the executive’s rights nontransferable and subject to a substantial risk of forfeiture
A deferred compensation plan can be established by a corporation exclusively for the benefit of its key executives in addition to, or in lieu of, a qualified retirement plan. The plan can be custom tailored to pay retirement, death and/or disability benefits according to the needs of the executive and the objectives of the corporation.
Since the corporation entering into a deferred compensation arrangement incurs a future liability to make specified payments, it is sound business practice to hedge, or protect itself, against this liability by establishing some type of fund from which the future benefits can be paid.
Because of the unique tax advantages of and benefits provided by permanent life insurance, it is usually the ideal informal funding mechanism for deferred compensation plans.
Life insurance the ideal informal funding vehicle for deferred compensation plans?
- Earnings inside the permanent insurance contract generally accumulate income tax deferred (although there may be corporate alternative minimum tax complications).
- At the executive’s death, the corporation receives the entire death proceeds free of income tax if the AMT does not apply.
- The corporation receives an income tax deduction for all benefits it pays out under the program.
This combination of tax advantages results in the tax leverage that enables the corporation to recover all of its costs of participating in the program.
Differences between Qualified and Non-Qualified compensation plans:
|Qualified Retirement Plan||Non-Qualified Retirement Plan|