A deferred compensation plan is a type of “golden handcuffs” designed for use in a proper business continuity and succession planning which provide incentives for a valuable employee to remain loyal to a company while also managing the company’s risk of losing a key asset of the business.
There two basic types of deferred compensation plans which are qualified and non-qualified plans. The classification depends upon the extent of the tax benefits sought after AND the needs of the company setting up the plan.
Non-qualified plans are much more flexible for small businesses AND there are unique concerns for small, privately owned companies that go beyond the concerns of public companies.
This article will serve as an overview the basics of deferred compensation plans AS THEY APPLY to non-public or privately owned companies. Issues for small or family owned businesses who are considering these plans will also be discussed because these plans are only advisable under limited circumstances due to IRS scrutiny.
Other planning ideas for golden handcuffs AND risk management using cash value life insurance are featured in previous articles and include keyman insurance plans, executive bonus plans AND split dollar plans.
Deferred Compensation Plans: Qualified and Non Qualified
A Deferred Compensation Plan is a Written Agreement Between and an Employer and Employee Where the Employee Agrees to Have Part of the Compensation Withheld By the Employer, Invested and Returned at Some Point in the Future.
Qualified and non-qualified deferred compensation plans differ greatly in how they are administered pursuant to IRS rules because qualified plans must comply with ERISA and are less flexible than non-qualified accounts for businesses.
Deferred compensation plans are usually put in place at the initiative of a company’s board of directors. The written agreement is prepared by the company’s lawyers and defines the scope and boundaries of the company’s plan.
There a few initial questions to consider when deciding upon either a qualified or unqualified deferred compensation plan:
- Does the company require the flexibility to treat some employees differently than others?
- Does the company desire to treat those employees who are chosen for plans differently between one another?
- Does the company desire to provide the benefits to independent contractors as opposed to employees only?
- Does the employer desire to deduct contributions to the plan?
- Does preventing the employee from having to pay taxes until the proceeds are actually taken an important concern?
If the board of directors answers YES to the first 3 questions AND is flexible as to the last 2 questions then a non-qualified plan may be advisable.
If the reverse is true and the first 3 are of lesser importance but the last 2 are important, then a qualified plan may be desirable.
Qualified Deferred Compensation Plan Basics
A qualified deferred compensation plan is governed by ERISA, a federal law known as the Employee Retirement Income Security Act of 1974, that also regulates retirement accounts for various types of organizations.
The 401(k) applies to public and private (for profit) companies, 403(b) applies to public education employees, 501(c)3 applies to non-profit organizations (charities) and 457(b) applies to state and local governments.
So, a more thorough definition of a qualified deferred compensation plan would be an ERISA qualified plan. What are the requirements of an ERISA qualified plan?
Hint, we gave you a clue in our 5 initial questions above…
ERISA qualified plans have a number of requirements which include:
- The employer CANNOT treat employees differently from one another AND thus must offer the same plan to everyone.
- The employer AND employee CANNOT allocate over a certain amount to the plan which limits contributions and vesting to a percentage of a maximum qualifying income.
- Assets must be put in a separate trust for the employee’s benefit and this means they are not general assets of the corporation for asset protection purposes.
- The company’s contribution is deductible by the employer when made but not taxable until actually withdrawn by the employee.
So, if you’ve deduced that the ERISA qualified plan is heavily regulated, inflexible and yet offers some powerful tax advantages, you’re on track. What you should also know is that because of the uniformity and stringent nature of these plans, they may not be appropriate for smaller operations and family businesses.
Non-Qualified Deferred Compensation Plans
In contrast with ERISA qualified plans, non-qualified deferred compensation plans offer greater flexibility including:
- The employer can decide who may be offered deferred compensation plan benefits without worrying about treating one (or one class of) employee differently from another.
- The benefits offered do NOT have the vesting rules or income limits applied to qualified plans.
- The employer may offer the plan to independent contractors as well as employees.
- The employer’s contributions are NOT tax deductible and the employee will be responsible to pay taxes on benefits upon “constructive receipt” of the income.
So, if a private company is seeking to offer incentives to select valuable employees, the only real choice under the rules is to opt for a non-qualified plan. Unless of course, ALL of the employees are highly valuable enough to justify the golden handcuffs.
Deferred Compensation Insights
[Small Private Companies and Family Businesses]
Now that the differences between the 2 types of deferred compensation plans is relatively clear, there are some things that every business owner, or board of directors, should consider when deciding if such a plan is appropriate.
The purpose of a deferred compensation plan, as mentioned, is to provide golden handcuffs for valuable employees, offering an incentive for them to remain with the company and thereby limiting the company’s risk of losing them.
The intent of a deferred compensation plan is ONLY to provide this incentive to employees who are extremely valuable to the company and to whose loss would be detrimental to the company. There also should be a serious risk that the valuable employee could leave for another company.
For example, a highly paid sales person with substantial ongoing accounts would characterize a highly mobile person who could realistically leave for another company.
For family businesses, this risk factor associated with the employee’s likelihood to leave is question of special concern to the IRS.
Allow me to explain…
Regardless of whether the deferred compensation plan is qualified or non-qualified, the IRS cares about these plans. Even in a non-qualified plan, the employee is allowed to defer some income and thereby avoid paying taxes, until such time as they are in “constructive receipt” of it, at which time it is subject to taxes. More about “constructive receipt” in a bit.
So, there is a tax benefit realized and these benefits, as discussed above, are even more significant under qualified plans and thus they are more highly regulated.
With that in mind, under the IRS rules, deferred compensation plans ARE ONLY for employees of public entities OR for senior management or other highly compensated key employees of private companies.
A deferred compensation plan is NOT restricted to public companies; however, the IRS requires that there must be a serious risk of the key employee leaving to work with a competitor. If a company is a closely held private company or family business, the IRS will look more closely at the this risk.
Backtracking to our example above, a key salesperson in a competitive industry could easily leave to work with a competitor and this would likely pass the test under the IRS rules. The IRS is looking for a “substantial risk of forfeiture” or an otherwise “strong possibility” that the employee may defect to another company.
In contrast, a parent who owns a business with their adult children would be unlikely to leave to work with a competitor for any reason, and thus the deferred compensation plan would probably NOT pass IRS scrutiny.
The Deferred Compensation Agreement
[Purpose, Constructive Receipt and Taxes]
Most references to deferred compensation plans are directed at non-qualified plans due to the flexibility offered for all of the reasons discussed above. The goal is always the same…to dangle a carrot in front of the key employee, providing an incentive for them to remain loyal to the company.
Other than the taxation rules discussed above, the rest of the deferred compensation plan arrangement is in control of the employer (or the employer’s board of directors) and the employee, and subject to the agreement to be prepared by the lawyers.
An important part of the arrangement is that the key employee cannot have control of the investment choices of the plan OR have the open option to receive the money. If either of these situations occurs, the employee may be deemed in “constructive receipt” of the income and will have to pay taxes on the deferred compensation amounts immediately.
The key employee’s level of control over the account is a determining factor. For example, to be able to select a group of funds (i.e. large cap stocks) is okay, whereas the option to invest all the money in a particular stock would be deemed constructive receipt.
Most of the deferred compensation plan agreement is concerned with defining the rights and obligations of the employee and issues, such as how much control the employee has, (i.e. voluntary termination of the plan), are primary concerns. As an estate planning measure, most plans require that if the key employee dies, the plan will end and the account will be paid to the employee’s estate.
Of course, the rest of the deferred compensation plan (if structured to stay within the rules described above) can be as creative as needed to provide the needed incentives for key people to remain faithful long term team members.
Using Permanent Life Insurance
[For Non-Qualified Plans]
The financial vehicle to use for a deferred compensation plan is largely a matter of financial advice AND we aren’t purposing to serve as a financial advisor in raising this question for this or any other article. However, concerning non-qualified plans, we suggest that a cash value life insurance policy offers some keen advantages for employers and should be carefully considered when conducting due diligence for these plans.
A few of the advantages offered are:
- Stable, guaranteed tax deferred growth of cash value.
- High liquidity and easy access to the cash value.
- Flexibility in making contributions to the plan.
- Death benefit to protect the employer and/or employee’s loved ones.
Would deferred compensation apply to a revocable trust that is to be terminated with the trustor’s death. Salary would be deferred until dissolution of the trust. The purpose would be to retain enough assets to cover ongoing medical expenses then liquidate remaining assets and pay outstanding debts such as the deferred salary. This would be setup to allow the trustor to stay in the home with care much longer. The risk would be the length of time involved and whether any assets remained to pay obligations.
Hi Allan, thanks for your readership and comment. I think this is a creative approach to deferred compensation but probably based upon a few misunderstandings. First, a deferred compensation plan wouldn’t apply to a revocable trust because it is a contract between an employer and employee. Your example seems to suggest that a deferred compensation agreement between the employer and the estate of the employee (the trust estate). This approach wouldn’t work under current IRS rules because they intend to collect income taxes from the employee at some point on whatever amount of income is deferred. I’m not sure I understand the second part of your comment referring to allowing the trustor to stay in the home because it seems to conflict with your suggestion that salary would be deferred until dissolution of the trust. If the trust is to be dissolved upon the trustor’s death, then you’re suggesting that the employee’s compensation would be deferred until the employee’s death at which time it would be used by the trust estate. I suggest that all of your suggested goals can be accomplished if the employer uses a permanent life insurance policy to fund the deferred compensation. The deferred comp agreement can allow the employee access to cash value after a defined period of time to provide financial support for the employee…such as allowing them to stay in the home. The deferred comp agreement can also designate the death benefit of the policy, or a portion thereof, to be assigned to the employee’s heirs (the estate). The death benefit can be used by the estate to cover lingering estate expenses, such as the medical expenses referred to in your example. I hope this offers a bit more clarity as to how deferred compensation works. Notwithstanding, these agreements are customized and there may be some other options to consider based upon the specific circumstances. Best to you!