This document discusses deferred compensation plans, which allow employees to defer portions of their salary or bonuses until future years. The summary is: Deferred compensation plans provide a tax benefit to employees by allowing them to defer current income taxes on portions of their salary or bonuses until the deferred compensation is paid out in future years. However, the deferred funds are not protected if the company declares bankruptcy. Deferred compensation plans are best for large, stable companies to help retain key executives and provide additional retirement benefits for highly-paid employees. While these plans provide tax benefits, they also carry some risks for both employees and employers.

1. 5 Common Questions
About Deferred Compensation
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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.
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