DEFERRED COMPENSATION PLANS

As direct compensation is increased for employees, or non-employees receiving earned income such as fees, the deferral of income from current taxation becomes increasingly attractive.

Deferred Compensation Plans are normally individually tailored and may be installed in a discriminatory fashion. The primary purpose is to defer income until the employee/taxpayer is in a lower bracket.

Wages or fees now being received by the employee, or those that were about to be awarded, can be deferred on a non-qualified basis. A “non-qualified basis” means they do not come under the rigid regulations for qualified retirement plans.

A Deferred Compensation Agreement sets out the essential features of the plan: the benefits are payable upon death, disability and retirement, as well as the rights held by the employee upon termination.

The employer normally funds this liability through the use of life insurance or annuity contracts and must remain the owner of the contract. Insurance contracts are ideal funding mechanisms for Deferred Compensation Plans because they have tax sheltered accumulation, income tax free death benefits and provide complete accounting for each participant.

Normally, the employer receives no current tax deduction, but takes the write-off as the subsequent benefit payments are paid to the employee or beneficiary.

If the plan provides an enforceable retirement benefit, the commuted value of a guaranteed death benefit is included for tax purposes.

Deferred compensation benefits must be forfeitable and represent one of the most effective methods of retaining key employees.

HOW PLANS ARE STRUCTURED

The object of the deferred compensation agreement between the employer and the employee is to establish the right to future compensation in return for present and future services. It is important to avoid current taxation to the employee. Therefore, the plan should be structured to negate any inference of current economic benefit or “constructive receipt.” A contract must be drawn by competent counsel familiar with the applicable laws and the plans of the parties. Listed below is a partial checklist of items that might be considered in the agreement.

PRIMARY ITEMS

1. Preamble: Date of the agreement, parties involved, nature of employment, function of the employee and reasons the employer is establishing the plan.
2. Terms and conditions of employment and types of compensation for that employment.
3. Benefits to the employee’s beneficiaries in the event of the employee’s death prior to retirement.
4. Benefits to the employee after completing the terms of employment (disability or retirement).
5. Conditions under which the employee will forfeit rights under the terms of the agreement, such as discharge for cause or engaging in competition against the employer.
6. Consequences of the failure of the employee to comply with terms of the agreement.
7. Payments under the agreement are not subject to sale, pledge, encumbrance, assignment, transfer or any legal processes.
8. The employee shall have recourse only against the company in enforcing terms and conditions of this contract.

FUNDAMENTALS OF DEFERRED COMPENSATION

Qualified pension and profit sharing plans create a difficulty for management with the “top heavy” rules, as well as the inability to reward key employees because of built in anti-discrimination laws that must be implemented in Qualified Plans.

Because the corporation is often in a lower tax bracket than the key executive, it is generally advisable to accumulate the required funds for retirement and estate liquidity within the corporate shell rather than with after tax proceeds in the employee’s name.

The lowest Federal corporate income tax brackets are currently:

• 15% of the first $50,000
• 25% of the next $25,000
• 34% of the next $25,000
• 39% of the next $235,000
• 34% from $335,000 to $10,000,000
• 35% from $10,000,000 to $15,000,000
• 38% from $15,000,000 to $18,333,333
• 35% of the excess over $18,333,333

Thus, a corporation allocating $75,000 to surplus pays the Federal Treasury 18.33% of that profit or $13,750.

If the corporation decides to pay a dividend to its stockholder executives, it still must pay the tax of $13,750, leaving $61,250 for ultimate distribution to the stockholders.

When the $61,250 or any portion is distributed to the stockholder executives, they pay a tax on an even higher scale. An executive with taxable income (joint return) in excess of $59,400 pays 25.0% of the bonus; if the taxable income is over $119,950, the excess is taxed at 28.0%.

For the sake of this study, let us use the 28.0% bracket to see if deferring compensation makes good common sense. Of the $61,250 available for dividends, $44,100 is still available after payment of personal income tax at 28.0%.

If an individual wanted to assure a $10,000 income from age 65 to age 75, and could accumulate $68,640 at 7.75%, he or she could satisfy that need using both principal and interest.

A 28.0% taxpayer must earn $1,389 before taxes to net a simple $1,000 after tax. In addition, he or she must find an investment that will accumulate tax sheltered, or if not sheltered, earn a yield that offsets this tax liability. To net 9% after tax, an individual would need to earn 12.5%. Not an easy task in these economic times. It is even difficult to get a 9% rate of return, with the safety and guarantees desired.

OPERATION OF THE PROGRAM

The employee and the corporation would enter into a Deferred Compensation Agreement providing that retirement income will be paid to the executive. Should the employee die prematurely, the executive’s family would receive certain payments. The Corporation will be applicant, owner, payer and beneficiary of a life insurance policy on the employee’s life.

DEATH BEFORE RETIREMENT

1. At the employee’s death, the corporation receives the proceeds of the life insurance policy income tax free. (There is a possibility of a corporate Alternate Minimum Tax, but this will probably be offset by the deferred income payment liability.)

2. Payments made to the employee’s family are tax deductible by the corporation and considered income in respect to the decedent for the beneficiary designated by the employee.

AT RETIREMENT

Funding with flexible premium and current interest sensitive plans offers the corporation a number of unique options when paying the deferred benefits. A partial list follows:

1. The corporation may borrow or withdraw the net amount needed from the cash value available in each or all policies.

2. The corporation could cash surrender the policy and place the available cash in a higher yielding instrument, if available.

3. The policy could be retained as “paid up” until such time as death occurs, to preserve the income tax free proceeds for surplus. This could be the case if corporate cash flow was adequate and the tax-deductible benefits were needed.

4. The illustrated suggested method of funding should prove to be the most cost and tax effective method of funding.

5. All or part of these methods may be used.

COST OF DEFERRING COMPENSATION vs. “DO IT YOURSELF”

Assumptions: The present value of capital required to fund $10,000 per year over 10 years when compounding at 7.75% is $68,640.

Tax Brackets: The after tax earnings required to save a given dollar amount must be the reciprocal, i.e.: A 28.0% taxpayer must earn $1.39 to net $1 of NET spendable, for discretionary savings. In addition, the earnings compounded must reflect net after tax on “unearned income.”

ANNUAL SAVINGS REQUIRED (AT 8%) TO ACCUMULATE $68,640 ANNUAL AMOUNT REQUIRED AT TAX BRACKET
Years of Funding Pre-Tax 25% 28% 33%
10 $4,430 $5,907 $6,153 $6,612
15 2,361 3,148 3,279 3,524
20 1,402 1,869 1,947 2,093
25 878 1,171 1,219 1,310
30 567 756 788 846

The above illustration assumes the Executive could net 8% after taxes on the accumulation. However, one must consider the tax on the interest earned on the funds while being accumulated:

• A taxable 8% would net only 5.76% to a 28.0% taxpayer
• A taxable 8% would net only 5.28% to a 33.0% taxpayer

This factor further complicates the selection of the funding vehicle and would add substantially to the cost of funding retirement income outside the corporation. The use of the Corporation for tax leverage may save thousands of dollars in personal taxes and at the same time create family security and additional estate liquidity.

CORPORATE BENEFITS

Whenever an employer uses favorable benefits such as deferred compensation, it creates an environment for employee retention. Since deferred compensation may be non-qualified (can be done differently for each employee), it can be customized. A single employee might desire a plan with greater emphasis on accumulation while one with a large family might prefer greater death benefits.

Furthermore, most corporations will elect to receive income tax free death benefits and pay out deductible survivor benefits, thereby assuring them of substantial gain.

Sources: Tax Facts 2005, National Underwriter Company
Financial Planning Consultants, Inc.