At the 1999 Oregon Bankers Association Winter Conference in Portland, Oregon, a panel of Miller Nash attorneys discussed compensation packages and employment considerations for executives. This article summarizes David Culpepper’s presentation. Mr. Culpepper is a tax partner of Miller Nash and an authority on executive compensation issues and techniques.
Nonqualified Deferred Compensation
Deferred compensation is cash to be paid later for services rendered now. The purpose is to defer income tax on compensation for an employee who uses the cash receipts and disbursements method of accounting.
Advantages & Disadvantages
In earlier years, an executive paying taxes at a 50 percent marginal rate might expect postretirement rates to be as low as 30 percent. Thus, income deferred until retirement achieved a significant tax-rate reduction. The recent leveling of individual marginal rates has somewhat reduced this benefit, but even if an executive expects to remain in the same tax bracket after retirement, deferral can be advantageous because of the effect of before-tax compounding of earnings.
Most deferred-compensation arrange-ments provide that the amount deferred will be credited with interest or some other measure of earnings. Accordingly, the amounts deferred can accumulate pretax earnings because the interest credited is not actually earned (and is therefore not taxable) but is merely used to determine the amount of the final benefit.
Example
: Two executives each have a 36 percent marginal tax rate. Al receives an annual $10,000 cash bonus and invests the after-tax amount ($6,400) in taxable investments that yield 8 percent per year (compounded continuously). Betty elects to defer her annual $10,000 bonus. The employer credits $10,000 annually to Betty’s deferral account and agrees that when she retires it will pay her that money plus an amount equal to the interest the money would have earned if it had been invested at 8 percent per year, compounded continuously.The chart below shows the net after-tax accumulations for Al and Betty after 5, 10, 15, and 20 years. If Betty’s marginal rate after retirement is less than 36 percent, the difference is even more dramatic.
|
No. Of Years |
Al |
Betty |
|
|
Deferred Payment |
After-Tax Amount |
||
|
5 |
$37,410 |
$63,968 |
$40,940 |
|
10 |
85,734 |
159,393 |
102,012 |
|
15 |
148,156 |
301,745 |
193,117 |
|
20 |
228,787 |
514,099 |
329,023 |
But this example also demonstrates the risk of substantial deferrals. Al will actually have $228,787 after 20 years; Betty will merely have a claim against the employer for $329,023. If the employer does not have the necessary liquidity or (even worse) if the employer is insolvent, Betty may not have anything. Unfunded deferred-compensation plans must give the employee the status of an unsecured general creditor of the employer.
Funded arrangements involve actual transfer or setting aside by the employer of funds to cover its future obligation to pay the executive. Such transfers are usually to a trust, escrow, insurance arrangement, or segregated account in which the covered employees have enforceable rights superior to those of other creditors of the employer. Such funding usually results in immediate (rather than the desired deferred) taxation for the executive. The unfavorable tax treatment of funded, nonqualified, deferred-compensation arrangements severely limits their usefulness.
Because of the substantial risk inherent in unfunded arrangements, their use is generally limited to larger, established corporations. But the alternative of achieving greater security by funding the deferred payments has generally unfavor-able tax consequences. The simplest form of an unfunded arrangement—a mere promise to pay—presents no problem in deferring taxable income, but the employer may want to make some provision to accumulate funds to satisfy its future obligation. Similarly, the executive will derive some security from knowing that the employer is accumulating funds for this purpose. The problem is to allow the employer to "fund" its future obligation without giving the employee sufficient rights in the fund to constitute constructive receipt or an economic benefit. In general, such quasi-funding is possible if the document creating the deferred-compensa-tion arrangement specifically and expressly provides that the employee will have only the rights of an unsecured general creditor.
A middle ground of quasi-funded arrangements uses a "Rabbi Trust," under which the employer transfers funds to a trust but the trust funds are also subject to the claims of creditors of the employer. These arrangements are treated as unfunded for income tax purposes.
Constructive Receipt And Economic Benefit
In structuring any deferred-compensa-tion plan or agreement, care must be taken to avoid the tax doctrines of "constructive receipt" and "economic benefit."
Income that is not actually reduced to an executive’s possession is nonetheless constructively received in a taxable year during which it is (a) credited to the executive’s account or (b) set apart so that he or she may draw it at any time. The executive may not deliberately ignore the income for purposes of selecting the year for reporting it. But income is not construc-tively received if the executive’s control of its receipt is subject to substantial limita-tions or restrictions.
The economic-benefit doctrine applies if the employer has irrevocably paid over money or other property to a third party (such as to a trustee or into escrow) for the benefit of the executive, and the executive either has a vested right to the fund or can realize a present benefit because his or her interest is transferable.
The treatment of deferred arrange-ments by the IRS and the courts has fluctuated over the past decades, especially with respect to compensation agreements under which the employee is the moving party voluntarily seeking to defer receipt of income. Although the operating rules are now apparently settled, the history of the controversy suggests that it would be wise to use caution in structuring such arrangements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
