Deferred compensation is an arrangement in which a portion of an employee's income is paid out at a date after which that income is actually earned. Examples of deferred compensation include pensions, retirement plans, and stock options. The primary benefit of most deferred compensation is the deferral of tax to the date(s) at which the employee actually receives the income.
In the US, Section 409A now imposes fairly detailed requirements on the timing of deferral elections and of distributions with the cudgel of imposing additional tax on the taxpayer prior to actual receipt of the deferred income if these requirements are not complied with.
This is not tax or legal advice. Any questions relating to a specific situation should be referred to qualified counsel. While technically deferred compensation is any arrangement where an employee receives wages after they have earned them, the more common use of the phrase refers to a specific part of the tax code that provides a special benefit to corporate executives and other highly compensated corporate employees.
What is deferred compensation? Deferred compensation is a written agreement between an employer and an employee where the employee voluntarily agrees to have part of their compensation withheld by the company, invested on their behalf, and given to them at some pre-specified point in the future. Deferred compensation is also sometimes referred to as deferred comp, DC, non-qualified deferred comp, NQDC or golden handcuffs.
Who gets deferred comp? Deferred comp is only available to senior management and other highly compensated employees of companies. Although DC isn't restricted to public companies, there must be a serious risk that a key employee could leave for a competitor and deferred comp is a "sweetener" to try to entice them to stay. If a company is closely held (i.e. owned by a family, or a small group of related people), the IRS will look much more closely at the potential risk to the company. A top producing salesman for a pharmaceutical company could easily find work at a number of good competitors. A parent who jointly owns a business with their children is highly unlikely to leave to go to a competitor. There must be a "substantial risk of forfeiture," or a strong possibility that the employee might leave, for the plan to be tax-deferred. Among other things, the IRS may want to see an independent (unrelated) Board of Directors' evaluation of the arrangement.
When is deferred comp used? ERISA, the Employee Retirement Income Security Act of 1974, created qualified plans. (They "qualify" to be considered part of ERISA). ERISA, which is too complicated to get into in this article, has a few important points that need to be mentioned, because what a non-qualified deferred comp plan is partially defined by what it's not - an ERISA plan. 1) Assets in plans that fall under ERISA (for example, a 401(k) plan) must be put in a trust for a sole benefit of its employees. If a company goes bankrupt, creditors aren't allowed to get assets inside the company's ERISA plan. Deferred comp, because it doesn't fall under ERISA, is a general asset of the corporation. While the corporation may choose to not invade those assets as a courtesy, legally they're allowed to and may be forced to give deferred compensation assets to creditors in the case of a bankruptcy. A special kind of trust called a rabbi trust (because it was first used in the compensation plan for a rabbi) may be used. A rabbi trust puts a "fence" around the money inside the corporation and protects it from being raided for most uses other than the corporation's bankruptcy/insolvency. However, plan participants may not receive a guarantee that they'll be paid prior to creditors being paid in case of insolvency. 2) ERISA plans may not discriminate in favor of highly compensated employees on a percentage basis. If the president of the company is making $1,000,000/year and a clerk is making $30,000, and the company declares a 25% profit sharing contribution, the president of the company gets to count the first $230,000 only (2008 limit) and put $57,500 into his account and $7,500 into the clerk's account. For the president, $57,500 represents only 5.75% of total income that grows tax deferred, and if the company wants to provide an additional tax incentive, DC may be an option. 3) Federal income tax rates change on a regular basis. If an executive is assuming tax rates will be higher at the time they retire, they should calculate whether or not deferred comp is appropriate. The top federal tax rate in 1975 was 70%. In 2008, it was 35%. If an executive defers compensation at 35% and ends up paying 70%, that was a bad idea. If the reverse is true, it was brilliant. Unfortunately, only time will tell, but the decision to pay the taxes once the rates have changed is irreversible so careful consideration must be given.
Where are deferred comp agreements made? Plans are usually put in place either at the request of executives or as an incentive by the Board of Directors. They're drafted by lawyers, recorded in the Board minutes with parameters defined. There's a doctrine called constructive receipt, which means an executive can't have control of the investment choices or the option to receive the money whenever he wants. If he's allowed to do either of those 2 things or both, he often has to pay taxes on it right away. For example: if an executive says "With my deferred comp money, buy 1,000 shares of Microsoft stock" that's usually too specific to be allowed. If he says "Put 25% of my money in large cap stocks" that's a much broader parameter. Again, ask legal counsel for specific requirements.
How do the taxes work? In an ERISA-qualified plan (like a 401(k) plan), the company's contribution to the plan is deductiable to the plan as soon as it's made, but not taxable to the participants until it's withdrawn. So if a company puts $1,000,000 into a 401(k) plan for employees, it writes off $1,000,000 that year. If the company is in the 25% bracket, the contribution is actually $750,000 (because they didn't pay $250,000 in taxes - 25% of 1M). In a deferred comp plan, the company doesn't get to deduct the taxes in the year the contribution is made, they deduct them the year the contribution becomes non-forfeitable. For example, if ABC company allows SVP John Smith to defer $200,000 of his compensation in 1990, which he will have the right to withdraw for the first time in the year 2000, ABC puts the money away for John in 1990, John pays taxes on it in 2000. If John keeps working there after 2000, it doesn't matter because he was allowed to receive it (or "constructively received") the money in 2000.
Other circumstances around deferred comp. Most of the provisions around deferred comp are related to circumstances the employee's control (such as voluntary termination), however deferred comp often has a clause that says in the case of the employee's death or permanent disability, the plan will immediately vest and the employee (or estate) can get the money.
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