Are there any limitations on deductibility by the employer?
How are disability benefits taxed from a deferred compensation plan?
How does a rabbi trust help to increase the ability of the key employee to receive benefits from a deferred compensation plan after there is a change in ownership or company management?
How does deferred compensation planning impact the key employee’s obligation for social security and medicare taxes?
How does the employer recover the costs of the plan?
How must deferred compensation plans be structured to avoid all but one minor reporting requirement of ERISA?
If the employer purchased life insurance to recover the cost of benefits from a deferred compensation plan, will it create an accumulated earnings tax problem?
May independent contractors be covered by a deferred compensation plan?
What are the advantages of a deferred compensation plan over a qualified plan?
What are the different types of deferred compensation plans?
What are the disadvantages of a deferred compensation plan over a qualified plan?
What are the plan design elements that keep the benefits of a deferred compensation plan tax deferred for a key employee or his/her beneficiary?
What are the rules that enable a key employee to defer taxes under a deferred compensation plans?
What does it mean for a deferred compensation plan to be “informally” funded?
What entities are not good candidates for deferred compensation plans?
What is a deferred compensation plan?
What types of benefit can be paid from a deferred compensation plan?
When would an employer want to consider a deferred compensation plan?
Q. Are there any limitations on deductibility by the employer?
A. Benefit payments are fully deductible in the year paid, provided that total compensation to the key employee in that year is not deemed by the IRS to be unreasonable [IRC Section 162(c)(1)].
Q. How are disability benefits taxed from a deferred compensation plan?
A. Disability income payments are fully includable in gross income and taxable to the key employee in the year paid. However, a limited tax credit is available under certain circumstances to some recipients who are permanently and totally disabled. [IRC Section 22].
Q. How does a rabbi trust help to increase the ability of the key employee to receive benefits from a deferred compensation plan after there is a change in ownership or company management?
A. A Rabbi Trust is a trust set up to hold property used for financing a Deferred Compensation Plan where the funds set aside in the plan are subject to the claims of the employer’s creditors. These trusts are designed to limit the ability of future company management to redirect trust assets from the payment of plan benefits. The IRS has agreed that trusts designed in this manner do not constitute formal funding in a tax sense. The DOL has a premise that these trusts do not cause Deferred Compensation Plans to be funded for ERISA purposes.
Q. How does deferred compensation planning impact the key employee’s obligation for social security and medicare taxes?
A. Amounts deferred under a Deferred Compensation Plan are not subject to social security taxes until the year in which there is no longer a substantial risk of forfeiture. In many cases, the key employee will have a nonforfeitable or fully vested interest in the plan before the actual year he or she receives money from the plan. In the year vesting in an amount occurs, if he or she has other taxable wages in excess of the OASDI (Old Age Survivor and Disability Income) portion of the social security tax ($87,000 in 2003), no additional OASDI tax would be payable. Since there is no limit in the Medicare portion, 1.45% from the employer and employee would be due on any newly vested amount. A third party administrator hired by the employer would be able to provide the requisite taxable amounts.
Q. How does the employer recover the costs of the plan?
A. The plan can be continued or terminated by the new business owners. The insurance policies can be continued for covered individuals. If a Rabbi Trust is used to fund the plan informally, the new owners cannot redirect the assets of the trust to any purpose other than to pay plan benefits or to satisfy the claims of creditors should the business become bankrupt.
Q. How must deferred compensation plans be structured to avoid all but one minor reporting requirement of ERISA?
A. ERISA exempts an “informally” funded plan which is maintained “primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees” from participation and vesting, funding, fiduciary responsibility, administration and enforcement requirements.
For a properly structured Deferred Compensation Plan to comply with ERISA, there is just one requirement. The employer must file a letter or statement with the Secretary of Labor within 120 days after the establishment of the plan, including the employer’s name, tax identification number, a description of the plan and the number of participants.
Q. If the employer purchased life insurance to recover the cost of benefits from a deferred compensation plan, will it create an accumulated earnings tax problem?
A. No. A business can accumulate the first $250,000 of its earnings and profits without being subject to the accumulated earnings tax. [IRC Section 530-537]. Any amounts over the first $250,000 may avoid the tax if the amounts are retained for the “reasonable needs” of the business. At least one court case (not involving a majority shareholder) held that the value of company owned life insurance met the “reasonable needs” test. (John P. Scripps Newspapers v. Commissioner, 44 T.C. 453 (1965).)
Q. May independent contractors be covered by a deferred compensation plan?
A. Yes. Like employer-employee arrangements, independent contractors may be included provided that the agreement is entered into before the compensation is earned. Consultants and outside directors are examples of independent contractors who might be included in the plan.
Q. What are the advantages of a deferred compensation plan over a qualified plan?
A. A Deferred Compensation Plan allows for much more flexible designs than a qualified plan. A Deferred Compensation Plan:
- Allows coverage of any group of highly compensated employees, or even a single key employee, without any discrimination requirements.
- Can provide an unlimited level of benefits to any one key employee, subject to “reasonable compensation” requirements for deductibility.
- Allows for different benefit amounts for different key employees, on different terms and conditions.
- A Deferred Compensation Plan has minimal IRS, ERISA and other governmental regulatory requirements, such as reporting and disclosure, fiduciary and funding requirements.
- A Deferred Compensation Plan can provide deferral of taxes for key employees. Note: the employer’s deduction is also deferred until payment of the benefit is made.
- Another advantage exists when the marginal individual federal tax rate is higher than the marginal federal corporate rate.
- A properly structured Deferred Compensation Plan provides “golden handcuffs” on the key employee by the employer.
Q. What are the different types of deferred compensation plans?
A. Deferred Compensation Plans can generally be broken down into four categories.
- 401(k) Mirror Plan – This is a plan that enables key employees to defer compensation in excess of what is permitted under the employer’s qualified 401(k) plan. This plan will also likely contain the same provisions contained in the qualified 401(k) plan that provide for contributions from the employer (matching or profit sharing) into the Mirror Plan.These plans typically maintain an account for the key employee where the contributions are deposited as premium into a life insurance contract and the participant’s account balance is equal to the cash surrender value of the policy. Another approach is to maintain a bookkeeping account where the contribution is credited along with “interest” at a set rate and the benefit is based on whatever accumulates. This second approach may or may not be matched against specific company assets (life insurance, investments, etc.).
- Salary Deferral Plan – In this plan a key employee defers of all or a portion of current salary, bonus or raise in exchange for a future benefit. Often, this type of plan will be referred to as a “true” deferral plan. Participant accounts are maintained for this type of plan using the same approaches described above for 401(k) Mirror Plans.
- Supplemental Executive Retirement Plan (SERP) – This is a plan that provides an additional fringe benefit for key employees. Typically the employer is the only source of financing for this type of plan. The plan agreement may define the benefit in terms of a monthly payment payable for a set number of years or for the life of the key employee or the benefit may be equal to what can be paid from an accumulation account.
- Ineligible Section 457(f) Plan – This is a plan for key employees of a tax-exempt organization. By law, only select, highly compensated individuals of a tax-exempt organization can participate. These plans are also made available to employees of state or local governments. Benefits are equal to what is accumulated in the plan account for a key employee. Special risk of forfeiture rules apply to these plans and dictate that federal taxes are due immediately on any plan benefit when there is no longer a substantial risk of forfeiture. For this reason, many Section 457(f) plans pay plan benefits in a single sum when vested which helps the key employee pay the taxes due.
Q. What are the disadvantages of a deferred compensation plan over a qualified plan?
- The tax deduction for benefits accruing to key employees is not available until payments are made which is also when the key employee’s tax is due.
- As a nonqualified plan, a Deferred Compensation Plan does not have the participant protections available with a qualified plan. For example, the vesting, fiduciary and funding requirements are not applicable.
- In a non-qualified plan, the employer makes an unsecured promise to pay the deferred compensation to participants. In the event the business ceases, the right to benefits is the same as the rights of creditors of the business. If future management wishes to renege on the promise, the only recourse is a civil suit under contract law. One solution to help protect payments from a plan against the whims of future management is to set up a “rabbi” trust.
- Not all employers are able to take advantage of a Deferred Compensation Plan. Those businesses include:
- S Corporations and partnerships since for tax purposes both use a pass-through tax structure.
- Many closely held businesses do not last beyond the current ownership or management. The business needs to be in place to pay the benefits, take the tax deduction, etc.
- To provide a true deferral plan, tax-exempt organizations can only use a Section 457 Plan, and then, only to its highly paid employees.
Back to General FAQs List
Q. What are the plan design elements that keep the benefits of a deferred compensation plan tax deferred for a key employee or his/her beneficiary?
A. The employer must be the owner and beneficiary of any asset used to informally fund a Deferred Compensation Plan. At the point rights to an asset are transferred, tax is due on the value transferred as compensation to the key employee, and a deduction in the same amount may be taken by the employer.
Q. What are the rules that enable a key employee to defer taxes under a deferred compensation plans?
A. Under Code section 451, an amount is treated for income tax purposes, even if it is not received, if it is “credited to the employee’s account, set aside, or otherwise made available”; this is the constructive receipt doctrine.
Constructive receipt does not occur if the employee’s control is subject to a “substantial limitation or restriction.” A requirement of a passage of time until the employee can receive the money is usually considered a substantial limitation or restriction. For this reason, the typical Deferred Compensation Plan will provide that amounts under the plan will not be paid for the later of five years or until the employee terminates employment.
A second tenet of the constructive receipt doctrine is that to defer compensation, and the associated federal taxes, the election to defer must occur before the compensation is earned. If the election is made after services have been performed, there must be a “substantial risk of forfeiture” to defer compensation.
Q. What does it mean for a deferred compensation plan to be “informally” funded?
A. From a tax point of view, a plan is formally funded if the employer sets aside money or property to pay plan benefits through means that restrict access to the funds by the employer’s creditors. To be “informally” funded is to have the employer set aside assets but to have these assets subject to the claims of the employer’s creditors, providing no explicit security to the key employees ahead of other creditors.
Q. What entities are not good candidates for deferred compensation plans?
A. Pass-through tax entities, such as “S” corporations, partnerships and Limited Liability Corporations (“LLCs”) will be prospects for deferred compensation plans for their nonowner key employees only. Owners of these entities will not realize the same tax leverage that is available to owners of “C” corporations. Also, closely held businesses that do not expect to last beyond the current ownership or management are not good candidates.
Q. What is a deferred compensation plan?
A. A Deferred Compensation Plan is a unsecured, unfunded contract or agreement between the employer and one or more of its key employees for future benefit payments. These plans are not tax qualified. In other words, the employer receives no current tax deduction for amounts promised or accumulating for key employees. The key employee receives tax deferral on benefit amounts called for in the plan until they are paid. At the point payment is made to the key employee, the employer receives a tax deduction. Because there is no tax favored treatment for these plans, there is great flexibility in designing plan benefits to meet the needs of the employer as well as key employees including the ability for employers to be selective about which employees participate in the plan.
Q. What types of benefit can be paid from a deferred compensation plan?
A. One of the primary purposes of a Deferred Compensation Plan is to enable key employees to accumulate money for retirement. These benefits can be in the form of a monthly payment at retirement or in the value of an account with the payments based on what has been accumulated in the account. Many plans also provide disability benefits to key employees and death benefits to the heirs of key employees.
Q. When would an employer want to consider a deferred compensation plan?
A. There are a variety of sound business reasons for a company to establish a Deferred Compensation Plan for its key employees. The following are a few of the more common motives. The employer wants to provide –
- a retirement benefit to a small group of key employees but is unwilling to establish a qualified plan for this purpose since the costs of covering a large number of non-key employees is prohibitive.
- additional deferral opportunities to key employees in addition to what is already available under the company’s qualified retirement plan.
- certain key employees with tax deferred compensation under terms or conditions that are different from those applicable to other employees.
- a plan for key employees that uses the employer’s tax savings to “leverage” the future benefits. For example, if the employer is in the 40% tax bracket when benefits are paid to the key employee, the after-tax cost of a $100,000 payment is only $60,000.
- an attraction to solve the problem of recruiting, retaining, rewarding and retiring(?) key employees.
- a benefit to key employees without having to offer stock in the closely held corporation.