The ABC's of Deferred Compensation
Category: Articles
A deferred compensation agreement is any plan or agreement in which an employer promises to pay an amount to an employee at some point in the future for past, present, or future services. As a result, the compensation is generally paid after the services are performed. This arrangement can provide an additional incentive to attract or retain key employees.
The most widely known type of deferred compensation plans are "qualified" pension and profit sharing plans that meet strict rules for participation of employees and numerous other non-discrimination rules. The advantages include a current deduction for employers for amounts paid into the plan, deferral of taxation of income earned in the plan and favorable rules for distribution from the plan. The drawbacks include the need to include a substantial portion of the company's employees and a great deal of complexity.
In contrast, "non-qualified" deferred compensation plans can be more selective on which employee is rewarded and when. These are plans that do not comply with the complex rules for retirement plans. However, the income tax deduction to the company is generally deferred until amounts are paid to the employee and the amounts set aside for payment to the employee(s) continue to be subject to income taxation by the company.
Unfunded plans are plans where the employer has the obligation to pay an employee at some point in the future. While the money can be set aside in a separate account of the employer, the funds remain subject to the company's creditors. A slight variation on this arrangement is the "rabbi trust" where a third party rather than the employer holds the funds, but the funds continue to remain available to the company's creditors.
A funded arrangement is one where the funds are set aside for the benefit of one or more employees where the funds are beyond the reach of the company's creditors. These funded plans are also subject to the ERISA rules. Funding in this manner can cause income recognition to the employees benefiting under the plan.
These deferred compensation arrangements are frequently used to compensate executives and other highly compensated employees. The plan can be structured to defer income recognition to an employee until retirement or another designated point in time. The company can use these vehicles to attract and retain the best possible talent.
In 2004, in response to various abuses, Congress passed a statute (Section 409A) that sets forth certain tax requirements applicable to non-qualified deferred compensation plans. If a plan does not meet certain requirements as to the timing of elections, funding and distribution, amounts payable under the plan are included in income when they vest (become nonforfeitable) rather than when paid out. In addition there is an additional 20% tax applicable to amounts deferred under a non-qualified deferred compensation plan that does not conform to Section 409A.
This is a complex area and we have only begun to explain these rules. Please call us to discuss this in further detail.
David Albert is a Shareholder of Rubino & McGeehin and can be reached at 301-564-3636 or at dalbert@rubino.com. For more information about Rubino & McGeehin, please visit www.rubino.com.