Module 2 — Deferred Compensation Plans

In today’s highly competitive business environment, one of the key elements of a company’s ongoing success is its ability to retain and adequately reward key personnel. But when it comes to providing qualified fringe benefits — including profit-sharing and pension plans — federal regulations prevent an employer from discriminating in favor of a particular employee or class of employees. Yet many employers have a small group of employees who are indispensable to the success of the business. Nonqualified plans allow employers to target compensation to those most responsible for the company’s continued viability.

In recent years, Congress has tightened regulations concerning qualified plans — providing for tougher nondiscrimination rules and more stringent vesting provisions. Caps on salaries for computing qualified plan benefits have had adverse effects on providing retirement income for highly compensated employees. As a result, the popularity of nonqualified deferred compensation plans has grown considerably as federal regulation of qualified plans has become more complex and more restrictive.

For these reasons, employers are turning more and more to nonqualified deferred compensation plans to provide logical solutions for executive compensation concerns. Among these plans are top hat plans, SERPs, and excess benefit plans.

Upon completion of this Module, you should have a basic understanding of:

• The reasons for using nonqualified deferred compensation
• The types of deferred compensation plans commonly used
• The elements of a deferred compensation plan
• Federal tax rules governing deferred compensation plans
• Special issues important for majority shareholders of the firm

Deferred compensation programs can serve a variety of purposes:

The employer has complete freedom of action in the selection of employees to participate. Because no government approval is required, the plan can be — and almost always is — discriminatory. It can be tailored to fit the funds available and may be continued or terminated at will.

Regulations limit benefits that can be paid to the executive class of employees under qualified plans. An executive employed late in life may be ineligible for the formal plan or eligible for only a reduced pension. The deferred compensation plan overcomes this problem by supplementing existing qualified plan benefits.

In many cases, deferred compensation can give new key employees a greater fringe benefit program than they left behind at their previous employer.

An important employee can be deterred from leaving if leaving means the loss of substantial deferred compensation benefits. Because of this ability to retain participants, a deferred compensation plan is often referred to as “golden handcuffs.”

Deferred compensation plans may figure importantly in business succession planning. When business owners desire to see their families continue to own and operate a family business, deferred compensation can be employed to hold key people and keep the business alive until the owners’ children can assume management.

Because of the graduated tax structure, much of a pay raise or bonus to a key executive may be taken by taxes. Deferral of such a raise or bonus until after retirement may allow the executive to keep far more after taxes because a retiree may be in a lower tax bracket.

Owners of closely held businesses are reluctant to grant ownership interests — especially if it means losing effective control of the firm. Key employees may view minority ownership in a close corporation as having little value because of its lack of marketability. Deferred compensation is often preferred to a minority stock interest in many close corporations.

Deferred compensation plans come in varying sizes and styles, each designed to meet the needs of both the employer and the employee. The package of employee benefits in a deferred compensation plan might include:

• Retirement benefits for the plan participant
• Disability benefits for the plan participant
• Survivor benefits in the event of the employee’s death

Benefits can be expressed as a percentage of income or as a fixed-dollar amount. The benefits can be secured by assets in a trust or not; the plan can be funded, unfunded, or “informally funded” depending on the objectives of the employer and employee.

The most effective and efficient informal funding vehicle involves insurance — both life insurance and disability income insurance on the life of the plan participant. Life and disability insurance provide an effective means of assuring that funds will be available in the future to pay the benefits promised by these plans.

Executives who leave before retirement generally receive their total deferrals with modest accumulated interest — typically much lower than would apply if the executive had remained with the employer until retirement. There is therefore a substantial financial incentive for a participating executive to stay with the company until normal retirement.

Salary continuation plans (SERPs) typically pay no benefit at all to the executive who leaves the firm before the specified retirement date. If the executive leaves before the retirement date, the plan may provide for either no distribution, or a partial distribution according to a predetermined schedule.

There are many types of deferred compensation plans, each designed to meet specific needs of an employer and its key employees. The primary deferred compensation plan types are: Top Hat plans, SERPs, and Excess Benefit Plans.

A top hat plan is maintained by an employer primarily to provide deferred compensation for a select group of management or highly compensated employees. Under a top hat plan, executives forgo receipt of currently-earned compensation — such as a portion of salary, commissions, or bonuses — and direct these funds to be paid out at retirement. These plans are typically set up as defined contribution plans, where the amount of income deferred and its investment gain are credited to an account set up for the executive.

A SERP is the most popular type of nonqualified deferred compensation plan. A SERP satisfies the employer’s objective of enhancing executive retirement benefits and is often provided as a supplement to an existing qualified plan. Unlike a top hat plan, the SERP participant is not required to forgo any current compensation — the employer promises to fund eventual benefit payments.

The key difference between top hat plans and SERPs: in a top hat plan, the employee defers current compensation to fund future benefits; in a SERP, the employer promises to fund eventual benefit payments.

An excess benefit plan is used for executives who are already “maxed out” under their employer’s qualified retirement plan. It satisfies the employer objective of exceeding the maximum contribution and benefit limits for qualified plans — the so-called Code Section 415 limits. Regardless of how a deferred compensation plan is structured, it is intended to accomplish two important functions: to provide a benefit to the participant at some time in the future, and to avoid income taxation on that future benefit until it is actually received.

For the participating key executive to avoid current income tax liability, the promised benefits must not be secured in any way. Two income tax concepts are particularly pertinent to understanding how deferred compensation plans operate:

• Constructive Receipt Doctrine: Income that is not actually received may be taxed as if it had been received if it was set aside for the individual, credited to the individual’s account, or made available without any substantial restrictions. A mere unsecured promise to pay income in the future does not constitute constructive receipt.
• Economic Benefit Doctrine: An individual must recognize income if property has been handled in a way that provides a cash-equivalent economic benefit to the individual.

Each deferred compensation plan — regardless of how it is structured — has three important elements: a promise to pay certain benefits, forfeitability of promised benefits, and a method to pay the promised benefits.

The benefit may be expressed as a defined benefit (a specific income amount for a fixed period, often used in SERPs) or a defined contribution (retirement income based on what a cash fund will purchase at a given age, frequently used in top hat and excess benefit plans). Many plans also offer preretirement death benefits and disability benefits.

Benefits may be expressed as a percentage of final salary (which automatically adjusts with changes in earned income) or as a fixed-dollar amount (which offers administrative simplicity and a definitively determined benefit).

Deferred amounts are merely an employer’s promise to pay the employee sometime in the future. To defer income taxes, these amounts must remain subject to the claims of the employer’s creditors in the event of insolvency. Two important trusts have been developed to address the insecurity of promised benefits:

• Rabbi Trusts: Assets are placed in a trust that can only be used for the executive’s retirement, but the trust document leaves assets available to the claims of the employer’s general creditors. This preserves income tax deferral while providing some security against the employer’s unwillingness to pay.
• Secular Trusts: Funding assets are “earmarked” exclusively for the executive’s benefit, shielding them from employer creditors. However, all contributions are currently income taxable to the executive because the risk of forfeiture is sufficiently reduced. Perceived as valuable if income tax rates are expected to increase dramatically or if the corporation may be merged or sold to unfriendly future owners.

When there is something more than a simple promise — such as assets reserved to meet the obligation — the plan is said to be “informally funded.”

Benefits can be provided on a pay-as-you-go basis (purely unfunded), through reserves invested in stocks, bonds, or mutual funds, or — most preferably — through life insurance. If the employee is insurable, life insurance is the most financially attractive way to ensure the cash will be available when needed. Permanent life insurance builds cash values that can be accessed to help pay retirement benefits, and the cash value growth avoids current income taxation.

The most important provisions of a typical deferred compensation agreement relate to: the income to which the agreement applies; the unfunded nature of the plan; the source of retirement and other benefits; and conditions that must be met to receive a benefit.

The agreement must apply only to income that is unearned at the time of signing — only future income may be subject to a deferred compensation agreement. The employer’s agreement with the employee is a mere promise to pay an income benefit in the future. The employee has no right to any asset of the employer prior to the triggering events specified in the plan: typically disability, retirement, or death.

Conditions may also be included — for example, a provision that all benefits are lost if the employee competes with the employer after retirement, attempts to assign the deferred benefits, or does not remain with the employer until retirement age.

While there is no requirement that a deferred compensation plan be funded with insurance, many plans are — and for good reason. Generally, insurance is the least expensive way for the employer to create a fund to pay promised benefits. It is also the only financial vehicle that enables the employer to recover its costs — a factor that can be attractive to many deferred compensation plan sponsors.

A cash value policy — preferably whole life, universal life, or variable life — is usually recommended. In the insured deferred compensation plan, the employer often uses life insurance policy cash values at the plan participant’s retirement to fund the retirement benefit in whole or in part.

No connection exists between the amount of insurance on the participants and their contribution in a deferred compensation plan — this is critical to maintaining the “informal funding” distinction and preserving the tax-deferred nature of the plan.

The employer should apply for the insurance. The employer should be both the owner and the beneficiary of all incidents of ownership in the policy. If the employee’s spouse is made the policy beneficiary, or if the proceeds are made payable to a trust for the insured’s family, the premiums the employer paid may be taxed as additional compensation to the insured in the current tax year.

When the employee reaches retirement age, ownership of the insurance policy should remain with the employer. If the policy or any incidents of ownership are transferred or assigned to the insured employee, the fair market value of the policy at the time of transfer becomes taxable income to the employee.

Universal life insurance is particularly useful because of its flexibility. Premium flexibility — the hallmark of universal life insurance — is attractive to employers whose cash flow may be seasonal or irregular. In addition, the employer’s ability to access policy values through cash value withdrawals and policy loans means there may be no need to surrender the life insurance to provide cash to pay the benefit, allowing the employer to retain the death benefit needed for cost recovery.

The general income tax rule for nonqualified deferred compensation is straightforward: the employee does not recognize income until the benefit is actually received, and the employer does not receive a tax deduction until that same time.

Survivor benefits received under a deferred compensation plan are fully taxable as income to the beneficiary. The entire amount received is subject to ordinary income tax — there is no exclusion for amounts attributable to the employer’s cost basis.

If the employer makes the employee the owner of a life insurance policy it purchased on the employee’s life, the employee is subject to tax under the economic benefit doctrine in the year of the transfer. This is why it is critical that the employer — not the employee — retain ownership of all insurance policies used to informally fund the plan.

In a rabbi trust arrangement, the employee is taxed only when funds are withdrawn from the trust. The mere purchase of insurance by the employer or contributions by the employer to the trust do not trigger current taxation. This distinguishes the rabbi trust from the secular trust, where all contributions are immediately taxable.

The deferred compensation plan market offers significant opportunities for the insurance professional. Understanding who qualifies as a prospect — and who does not — is essential.

Public corporations face a specific limitation: the maximum amount of employee compensation that a public corporation may deduct is $1,000,000 per year for each covered executive. Deferred compensation plans can be especially attractive when executive compensation exceeds this threshold.

Any of the following organizations may establish a deferred compensation plan for an executive:

• A regular corporation
• An S corporation
• A partnership
• Any other business organization

Deferred compensation plans are generally most suitable for executives who are already maximizing contributions to qualified plans, who are in high tax brackets, and who are committed to long-term employment with the organization. Owners of closely held businesses often prefer deferred compensation arrangements over granting minority stock interests, particularly when there is a lack of market for shares or a desire to limit outside ownership.

All of the following would be reasons for an executive in a closely held corporation to prefer a deferred compensation plan rather than an ownership stake, except that deferred compensation plans normally give participants vested interests — in fact, they do not. Triggering events (disability, retirement, or death) must occur before benefits are paid, and the plan is intentionally unvested to preserve tax deferral.