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DEFERRED COMPENSATION ARRANGEMENTSby Marc Haberman Download this article:
 Deferred Compensation Arrangements› (PDF, 17KB)
Clients should consult their tax and legal advisors to assure that their nonqualified deferred compensation arrangements comply with the new rules.
What is a Deferred Compensation Arrangement?
“Deferred compensation” is an arrangement established by employers to provide retirement income and perhaps death and disability benefits to a select employee or a select group of highly compensated employees. The arrangement is a contractual commitment between an employer and the participant that specifies when and under what circumstances future compensation will be paid. When properly arranged and administered, the participant can postpone federal income taxation until the benefits are paid.
A deferred compensation arrangement may provide that an employee will receive a stipulated sum for a fixed period of time, or for life, beginning at the employee’s retirement or some other specified trigger date. If an employee dies during the deferral period or after payments have begun, the arrangements often directs that benefits be paid to a designated beneficiary or to the participant’s estate.
The arrangement may provide that the employee will receive future compensation as a result of a current salary reduction or in lieu of a bonus or salary increase. In some arrangements, the employer commits to pay future compensation in addition to current earnings, which are not reduced by participation in the arrangement.
Why Deferred Compensation?
A deferred compensation arrangement can provide business owners with the kind of flexibility that is unavailable with a qualified plan. The business can cover “top hat” employees on a pick-and-choose basis without fear of running afoul of anti-discrimination rules or IRC Section 415 ceilings. Employers can provide generous benefits to select, key-executive employees, including a different level of benefits for different employees. No governmental-imposed minimum vesting or funding standards apply, and the arrangement can be customized to suit many individual situations. Paperwork and administrative costs can be kept to a minimum.
Suitability
The increasingly restrictive regulatory environment imposed on qualified plans coupled with costs of plan administration, anti-discrimination rules and caps on contributions and benefits, have made executive benefit planning through nonqualified arrangements more attractive. A nonqualified arrangement may be used as a supplement to, or as a substitute for, a qualified retirement plan.
Deferred compensation is most useful in the following situations:
- The employer is a C corporation
- The employer wishes to benefit a select group of highly compensated employees
- The owner-employee of a business wants to improve his/her own compensation package
- The employer has a need to attract, retain, or reward one or more key employees
- The participating employee is “maxed out” under the employer’s qualified plan
- The employer has no qualified retirement plan and does not want to establish one
Funded vs. Unfunded Arrangements
In unfunded arrangements, the participant has only a contractual right: an unsecured promise to receive benefits in the future. An arrangement is considered unfunded if:
- Either there is no reserve set aside to pay the promised benefits, or reserves are established but remain a general asset of the employer, subject to attachment by the employer’s creditors: and
- The employee has no current beneficial interest in any set-aside funds.
When an employer sets aside specific assets to meet future obligations, with the select employee as beneficiary, and these assets are out of reach of the employer’s creditors, the arrangement is considered funded for tax purposes. A totally secure fund may trigger immediate taxation to the employee.
The challenge is to create a balance between financial security and tax deferral. One useful device in this regard is the rabbi trust. A rabbi trust holds trust assets in an irrevocable trust out of the reach of the employer, or any of the employer’s successors. But, while rabbi trusts generally shield funds from employer invasion, they do not protect assets from attachment by the employer’s general creditors as a result of bankruptcy or insolvency. None-the-less, rabbi trusts provide participants with some measure of security.
Funding the Employer’s Obligation
Most businesses choose to set aside funds to meet their future obligations.
Life insurance can be used to “informally fund” a deferred compensation arrangement without losing income tax deferral. The select employee is insured. The employer is the policy owner, premium payor, and beneficiary. As a business asset, the policy is available to creditors, and the employee has no beneficial ownership rights in the policy. Life insurance can be a cost-effective method to help employers pay the promised benefits with little or no drain on future earnings. Life insurance offers: - Recovery of plan costs through death benefits
- Proceeds help assure that funds will be available to pay promised benefits regardless of when death occurs
- The cash values of a life insurance policy accumulate income tax deferred, unlike other vehicles which may require the employer to pay tax during the accumulation period
- Policy settlement options provide remarkably flexible accumulation and distribution features
- Death benefit proceeds are generally federal income tax-free to the beneficiary (the employer in this case). The proceeds lose their tax-free character when paid out as benefits to the employee’s survivor.
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