Deferred Compensation Programs
The United States Internal Revenue Code, section 409A regulates the treatment of “non-qualified deferred compensation” for federal income tax purposes and for the timing of deferral elections and of distributions.
“Deferred compensation” is any arrangement where an employee receives wages after they have earned them. The common use of the phrase refers to “non-qualified” deferred compensation and a specific part of the tax code that provides a special benefit to corporate executives and other highly compensated corporate employees.
Deferred compensation is often referred to as deferred comp or non-qualified deferred comp.
Non-qualifying Deferred Compensation Programs
Deferred compensation is a written agreement between an employer and an employee where the employee voluntarily agrees to have part of their compensation withheld by the company, invested on their behalf, and given to them at some pre-specified point in the future. Non-qualifying plans differ from qualified plans as:
- With Non-qualifying plans, the employer contributions are not tax deductible.
- Employers may also pick and choose which employees are offered deferred compensation benefits. In qualified plans, the same plan is offered to all employees.
- Non-qualifying plans are flexible. The benefit promised need not follow any of the rules associated with qualified plans and vesting schedules can be whatever the employer would like it to be.
- Non-qualifying plans allow deferred compensation benefits to independent contractors, not just employees.
- Employees must pay taxes on deferred compensation at the time such compensation is eligible to be received (not just when it is actually dispersed).
Non-qualifying Deferred Compensation Programs is often only available to senior management and other highly compensated employees of companies. Although not restricted to public companies, there purpose of the plan is usually to reduce the risk that a key employee would leave the company and join a competitor. The Non-qualifying Deferred Compensation Programs is offered as an incentive and “lock-in” the employee to their current company.
A note on risk for Non-qualifying Deferred Compensation Programs
Assets in a Non-qualifying Deferred Compensation plan doesn’t fall under ERISA and is a general asset of the issuing corporation. While the corporation may choose to not use or borrow those assets, legally they’re allowed to. Further, should the company fall into financial difficulties, the company can be forced to give deferred compensation assets to creditors in the case of a bankruptcy.
Qualifying Deferred Compensation Programs
A “qualifying” deferred compensation plan is one that is compliant with the ERISA, (the Employee Retirement Income Security Act of 1974). Qualifying plans include:
- 401(k) (for non-government organizations),
- 403(b) (for public education employers), 501(c)(3) (for non-profit organizations and ministers), and
- 457(b) (for state and local government organizations).
ERISA, has many regulations, one of which is how much employee income can qualify. As of 2008 the maximum qualifying annual income was $230,000. So, for example, if a company declared a 25% profit sharing contribution, any employee making less than $230,000 could deposit the entire amount of their profit sharing check (up to $57,500, 25% of $230,000) in their ERISA-qualifying account.
In an ERISA compliant plan, the company’s contribution to the plan is tax deductible to the plan as soon as it’s made, but not taxable to the individual participants until it’s withdrawn. So if a company puts $1,000,000 into a 401(k) plan for employees, it writes off $1,000,000 that year. If the company is in the 25% bracket, the contribution costs it only $750,000 (with $250,000 saved in taxes).
Assets in qualifying Deferred Compensation plans that fall under ERISA (for example, a 401(k) plan) must be put in a trust for a sole benefit of its employees. If a company goes bankrupt, creditors can not get assets inside the company’s ERISA plan.
Further, qualifying Deferred Compensation plans or “ERISA plans” may not discriminate in favor of highly compensated employees on a percentage basis. If the president of the company is making $1,000,000/year and a clerk is making $30,000, and the company declares a 25% profit sharing contribution, the president of the company gets to count the first $230,000 only (2008 limit) and put $57,500 into his account and $7,500 into the clerk’s account.
Federal income tax rates change on a regular basis. If an executive is assuming tax rates will be higher at the time they retire, they should calculate whether or not deferred comp is appropriate. The top federal tax rate in 1975 was 70%. In 2008, it was 35%. If an executive defers compensation at 35% and ends up paying 70%, that was a bad idea. If the reverse is true, it was a great decision. Only time will tell what tax rates will be, but the decision to pay the taxes once the rates have changed is irreversible so careful consideration must be given.