What is a Deferred Compensation Plan?
A deferred compensation plan is an arrangement whereby an executive or owner defers some portion of their current income until a specified future date. Wages earned in one period are actually paid at a later date. The employer can also make contributions into the plan and apply a vesting schedule to increase the retention aspect of the plan.
Earning on the deferred amounts can be tied to the performance of specific mutual funds, credited at a fix rate of return or tied to an index.
The amounts deferred will not be taxable to the executive until time of payout. At time of payout the company will receive the compensation deduction for payments made.
There are both qualified and nonqualified deferred compensation plans.
A qualified plan receives certain tax preferences under the Internal Revenue Code:
- the employer is entitled to a tax deduction for the amounts contributed to the plan;
- the benefits grow on a tax deferred basis until they are actually paid under the plan; and,
- distributions are generally eligible for rollover to an IRA or other qualified plan, thereby permitting further tax deferral.
Note: Employers should have an IRS ruling regarding the tax status of a qualified plan.
The disadvantages of a qualified plan include:
- nondiscrimination requirements prohibits an employer from providing benefits for highly compensated employees to the exclusion of other employees
- the amount of the employer’s contributions are limited
- regular reporting requirements
A nonqualified plan does not receive favorable tax treatment:
- the employer is not entitled to tax deductions until such time as the benefits are actually paid to the employee
- under the doctrine of constructive receipt the benefits are taxable to the employee at such time as the employee has the right to receive the benefits without regard to when the benefits are actually paid. The taxpayer does not actually have to take possession of the funds.
The advantages of a nonqualified plan are:
- the employer can pick and choose among the recipient employees without regard to years of service, salary level or any other criteria
- allows a business to provide benefits to officers, executives and other highly paid employees
- the amount of the employer’s contributions are not limited
- a nonqualified plan is less expensive to set-up than a qualified plan
- there are no significant filing or reporting requirements
Note: There are special timing rules related to FICA taxes and income taxes.