Deferred Compensation

Deferred compensation provides tailored retirement benefits for highly compensated individuals.

Many business owners enhance their employee fringe benefits to place golden handcuffs on their key employees.  Deferred compensation is a non-qualified plan which provides retirement benefits for select executives.

The appeal of nonqualified deferred compensation plans is the ability to tie quality executives to your business by making the retirement benefits conditional and too worthwhile to leave behind.  As such, the promised benefits "handcuff" your quality key people to your business for the long term.

Deferred Compensation Benefits

For Your Corporation:

The plan places golden handcuffs on key people.

q       No IRS approval is needed to install the plan, and only minimal ERISA requirements apply.

q       The business is free to select the eligible participants.

q       The plan offers flexible benefits.

q       The business can recover all costs, including the time value of money tied up in the plan.

Executive(s):

q       There is no reverse discrimination for highly compensated employees.

q       The plan serves as a tax-deferred retirement benefit.

An Enhancement to Qualified Plans

Deferred compensation reverses the inequities of qualified plans for highly paid employees. Qualified plans have lost a great deal of their appeal for highly paid executives because of government regulations that restrict the amount of money a highly paid person can accumulate in a plan. Additionally, Social Security, benefits favor lower-paid employees.

Therefore, to provide valuable benefits in addition to Social Security, and qualified plans, nonqualified deferred compensation is a perfect supplemental benefit plan.

Highly compensated executives often find themselves in the unfortunate position of having performed well in accumulating funds in a qualified plan. If enough is accumulated over the years, there can be excessive exposure to income taxes and pension excise tax.

Once a certain level has been reached inside a qualified plan, highly compensated employees need to determine whether or not it makes good financial sense to continue contributing to a qualified plan. In many circumstances, it could be better to redirect a qualified plan contribution to a nonqualified plan to keep the pension excise tax under control.

Increase the Retirement Benefits of Your Key People

Deferred Compensation vs. Qualified Plans

* assuming the use of life insurance

How Deferred Compensation Works

q       The company agrees to pay the executive an annual retirement income. The agreement may specify that if the executive dies before retirement, an annual benefit will be paid to the executive's beneficiary.

q       The company informally funds its obligation by purchasing insurance on the life of the executive. The company pays the entire premium to the insurance carrier and is the contract owner and beneficiary. The company controls the cash value of the policy during the executive's lifetime and receives the entire proceeds upon the executive's death.

q       At retirement, the company pays benefits from current cash flow or from policy cash values.

q       Upon the executive's death, the executive's beneficiary, receives benefits according to the terms of the agreement.

Life Insurance: The Ideal Funding Medium

q       Life insurance is the ideal funding medium for deferred compensation plans. Through a concept known as cost recovery, a company can fund the plan to recover all of its costs in setting up a deferred compensation plan.

q       When a company pays insurance premiums, there is also a cost for the use of its money during the course of the plan.

q       At the employee's retirement, the business pays an income to the retiree.

q       At death, the carrier pays the income tax-free life insurance proceeds which can be used to reimburse expenses and perhaps provide a gain.

Cost of Money

Three factors make a gain possible:

q       Cash values inside a life insurance policy grow tax-deferred each year of the plan. 

q       Taxes on the earnings inside the policy are avoided if the policy is retained until death.

q       The business is entitled to deduct benefit payments it makes to the retiree or his/her family

Tax Issues

For the Company:

Although the company does not receive a deduction for its premium payments, benefits paid to the executive can be deducted when paid. The life insurance cash value grows tax-free. The proceeds arc retained income tax-free by the company at thc executive's death.

For the Executive:

In a properly designed deferred compensation plan, no portion of the company's contribution currently is taxable to the executive. The executive doesn't pay any income tax until he or she receives benefits.  When received, the payments are taxed as ordinary income.

This tax treatment applies provided the executive does not have constructive receipt of the life insurance cash values. The key elements of constructive receipt are timing and control.  If an individual gains control over the policy, then the executive currently will be subject to income tax on the value.

A properly designed deferred compensation plan avoids the constructive receipt issue. The business retains control of the policy and only gives the executive a promise to pay income at retirement and/or death.

While the executive should not be given control over the life insurance policy it is possible to build in some protection for the executive through the use or a rabbi trust.  

Rabbi Trusts:  

A rabbi trust (so named for the first taxpayer to raise the issue) strengthens the employer's promise to pay benefits by protecting the executive from future management changes, but not from the company's insolvency or bankruptcy.

The use of a rabbi trust provides psychological assurance to an executive that, short of bankruptcy; the employer will have the necessary funds set aside to fulfill its obligation, while also avoiding current income taxation for funds placed in the trust.

Note: All specific tax and legal questions should be referred to your legal counsel and accountant.

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Contact Us

If you would like more information about deferred compensation, please contact us at 888-669-4883, or email us at info@benico.com.