Deferred compensation plans have become a cornerstone of executive benefit planning, offering employers flexible tools to attract, retain, and reward key personnel beyond the constraints of qualified plans. Unlike qualified plans, nonqualified deferred compensation arrangements can be tailored exclusively to a select group, structured as top hat plans, SERPs, or excess benefit plans, and funded informally through life insurance or corporate reserves.
The three fundamental elements of any deferred compensation arrangement are: a promise to pay, forfeitability of promised benefits, and a method to pay those benefits. Mastery of the tax doctrines governing these plans — constructive receipt, economic benefit, rabbi trusts, and secular trusts — is essential for any financial services professional in this market.
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Review Questions
Benefits are based on the employee’s compensation from the employer both before and after adoption of the plan
✓The employer is named beneficiary if life insurance is used to fund the plan
The employee gains a nonforfeitable right to assets set aside to fund the plan after no more than five years of service
Benefits are paid after an employee’s termination of employment without further restriction
Zero
Cash value minus basis
✓Fair market value of policy at time of transfer
Amount of deduction employer took prior to retirement
Executive Bonus plan
✓Excess Benefit plan
SERP
Top Hat plan
Purchase of insurance on Joanne’s life by the employer
✓Withdrawal of funds from the trust
Purchase of life insurance by Joanne on her own life
Contribution by the employer to the trust
Demand payment at any time
Borrow from his account
Demand payment after five years of service
✓None of the above
Contributions to qualified plans are nondeductible items for federal income tax purposes
✓Qualified plans may not discriminate in favor of highly compensated employees
Benefits under qualified plans are not subject to dollar limits
Investment earnings in a qualified plan are tax-deferred
✓Employee’s terminating employment to work for a competitor
Employee’s disability
Employee’s death
Employee’s retirement
401(k) plan
Any qualified plan
Secular trust
✓Deferred compensation plan
The practice of establishing a deferred compensation plan on a handshake rather than putting it into writing
Any funding plan other than life insurance
✓Use of a corporate-owned non-allocated asset to meet the obligations of the deferred compensation plan
Setting aside specific assets to provide deferred compensation benefits
Qualified plan
SERP
Rabbi trust
✓Secular trust
✓Economic benefit doctrine
Transfer for value rule
Like-kind exchange rule
At-risk doctrine
Employer owns policy, beneficiary is employee
✓Employer owns policy and is the beneficiary
Employee owns policy and is the beneficiary
Employee owns policy, beneficiary is employer
Excess benefit plan
✓Executive bonus plan
Top hat plan
Supplemental executive retirement plan
✓SERP
Executive bonus plan
Rabbi trust
Group carve-out plan
The executive receives a lump-sum distribution
✓The executive forfeits the salary continuation benefits
The executive’s benefits are reduced by one-half
Nothing — salary continuation plan benefits are always fully vested
Deductibility of plan contributions
✓Whose money is used to provide the benefits
The executives that are covered by the plan
Cost recovery
Excess Benefit Plans
Executive bonus plans
✓Salary continuation plans
Group carve-out plans
Retirement benefits
✓Medical reimbursement benefits
Disability benefits
Pre-retirement survivor benefits
Survivor benefits are always tax-free
Survivor benefits are subject to capital gain taxation
Survivor benefits are income taxable up to the policy’s cash value
✓Survivor benefits are fully taxable as income
A regular corporation
An S corporation
Partnership
✓Any of the above
Lack of a ready market in which to sell shares
✓Deferred compensation plans normally give participants vested interests
Restrictions on the right to sell shares
A desire on the part of the owners to limit ownership
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