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Five Common Questions About Deferred Compensation


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Is a deferred compensation plan right for you? Here are five common questions about deferred comp. …

Is a deferred compensation plan right for you? Here are five common questions about deferred comp.

Corporate deferred compensation plans for highly compensated employees are a planning tool that companies and key executives should explore. They are attractive because of the significant increase in ordinary income tax rates on compensation. Such plans are also a fringe benefit that can attract and retain key executives.

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  • 1. 5 Common Questions About Deferred Compensation
  • 2. What are deferred compensation plans?
  • 3. Deferred  compensation  plans  have  been  around  as  a  form  of  executive compensation  for  a  long  time.  Broadly  defined,  deferred  compensation  plans are  an  agreement  between  employee  and  employer  in  which  the  employer commits  to  an  unfunded  promise  to  pay  a  portion  of  the  employee’s compensation  in  the  future.   The  commitment  can  be  a  salary  or  bonus  deferral  by  the  employee  or additional  money  set  aside  by  the  company   for  performance  and  retention.    
  • 4. These  plans  should  be  distinguished  from  more  common  retirement  plans such  as  401k(s),  which  are  called  qualified  plans.  Unlike  401(k)s,  deferred compensation  plans  are  not  qualified,  meaning  only  the  employee  receives an  immediate  tax  benefit  from  the  deferral.  Also,  to  avoid  current  taxation, the  plan  election  to  defer  must  take  place  before  the  compensation  is earned  and  the  employee  is  subject  to  risk  of  creditors  until  paid.  The money  for  401(k)  plans,  on  the  other  hand,  is  funded  into  a  separate  trust and  protected  from  company  creditors.  
  • 5. What are the tax benefits of deferred compensation?
  • 6. The employee benefits by excluding the deferral amount of compensation from taxable income in the current tax year. In other words, the income the employee elects to defer is not taxed until the compensation is received in the future. Under a hypothetical scenario, if an employee filing jointly is scheduled to 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 percent Medicare 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.
  • 7. 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.
  • 8. How are deferred compensation plans invested?
  • 9. 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.
  • 10. 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.
  • 11. Which companies should consider deferred compensation plans?
  • 12. 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.
  • 13. 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.
  • 14. What are some of the risks involved?
  • 15. 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.