Businesses use deferred compensation plans for different reasons and different goals.
When should a business consider adopting a nonqualified deferred compensation plan?
By Scott E. Galbreath, J.D., LL.M. (Tax)
I’m often asked when should a business consider adopting a nonqualified deferred compensation plan. Businesses use deferred compensation plans for different reasons and different goals. The goals are usually a combination of: attracting and retaining key management employees; helping employees save taxes on their compensation; motivating performance; rewarding loyalty; supplementing retirement income by making up for the short-comings of a qualified retirement plan; and better aligning the employees’ interests with the employer as a whole. The type of deferred compensation implemented will depend on which goals the employer primarily wishes to accomplish. This article will briefly summarize common plan designs used for these goals.
Deferring Taxes. The simplest form of deferred compensation is deferred salary or bonus whereby the employee decides to defer the receipt of compensation before it is earned. Because it is deferred before it is earned, the employee doesn’t pay income tax on the compensation until it is received in the later year. If the employee is in a lower income tax bracket when the compensation is received he or she will save income taxes. Provided the deferred compensation is counted for Social Security and Medicare taxes when earned, neither the deferred compensation nor any of its earnings will be subject to these taxes again when it is paid. The disadvantage to the employer is that it is not allowed a deduction for the deferred compensation until the employee recognizes the income.
Motivating Performance. A plan can provide an employee with a deferred bonus to be paid in a later year if a performance measure is attained. This will provide motivation for performance. For example, a plan could provide the employee will receive an annual bonus of 10% of the amount that revenues exceed a certain threshold to be paid 3 years after the year earned.
Rewarding Loyalty. Subjecting deferred compensation to forfeiture unless the employee remains employed for a period of time rewards loyalty. This is done with a vesting schedule which could be “cliff “vesting whereby the employee is not at all vested until the vesting date when 100% of the deferred compensation is no longer subject to forfeiture (e.g., vested after 5 years) or graded vesting whereby each year a portion of the deferred compensation vests (e.g., 20% annually for 5 years). Tying a performance bonus to a deferred compensation plan with a vesting schedule will both incentivize performance and reward loyalty. Thus, the plan above could provide the employee will receive the bonus 3 years after the year earned, if still employed with the employer on that date.
Making up for qualified plan short-comings. Often higher paid executives are short-changed by a company’s defined contribution plan. For example, the limit on the amount of compensation that can be considered under a qualified plan ($275,000 in 2018) can prevent an executive from saving enough through the qualified plan. That is, if an executive is paid $400,000 annually, and the qualified plan provided for a 10% employer profit sharing contribution, the executive’s contribution would only be $27,500 not $40,000 because only $275,000 of his compensation can be considered under the qualified plan. This is only 6.875% of compensation.
Likewise, if the plan is a 401(k) plan (the most popular type of plan), the annual limitation on the amount of salary that an employee can defer ($18,500 in 2018) can also short-change a higher paid employee. For example, $18,500 is only 4.625% of a $400,000 salary. Even if the employee can defer $24,500 because he is over age 50 and the plan allows for make-up contributions, that amounts to only 6% of pay. Additionally, if the plan is subject to the ADP/ACP tests, this could impact how much a highly compensated employee can defer.
A general rule of thumb is one should save 15% of compensation for retirement to replace 70% of compensation at age 65. That is $60,000 for an executive making $400,000. The annual limit for contributions to a defined contribution plan is currently only $55,000. One can easily see that it is difficult to attain the goal of 15% at higher income levels.
A nonqualified deferred compensation plan can be designed to make up for these limitations of a qualified plan because they are not subject to the limitations of qualified plans.
Aligning Interests. Deferred compensation can also be used to help align the interests of key employees with that of the employer. Rewarding performance through incentive deferred compensation as mentioned above is one way. Another technique that aligns the employee’s interests with that of ownership would be a phantom equity plan. These are also sometimes referred to as synthetic equity. The names come from the fact that the plans provide a cash benefit based on equity in the employer but the employee does not receive any actual equity.
For example, an employee can be granted 100 shares of phantom stock that the employee can cash in upon the occurrence of a triggering event such as a future date, retirement, or termination of employment. Each phantom share is valued at the price of a share of actual stock at any point in time. A twist on phantom stock is the stock appreciation right which only pays the employee the difference between the value of the stock on the date of grant of the right and its value on the trigger date. Thus, the employee only receives the delta of the appreciation in the value of the stock.
Under phantom equity plans, employees are rewarded when the value of the employer company increases. Thus, both the employer and the employee benefit when the company value increases. Phantom or synthetic plans can help key employees learn to think and perform like an owner without having the legal rights (e.g., voting, inspection of books) or liabilities that come with actual ownership.
Conclusion. This article has summarized some of the most common deferred compensation techniques and their uses. However, there are a number of factors that must be considered in designing a deferred compensation plan to meet the goals of the employer. Additionally, there are a myriad of legal requirements these plans must meet to be effective. Failing to meet these rules can have unintended and drastic tax consequences. Therefore, it is important to consult an experienced professional to help design and draft a plan to accomplish the intended results.