How to Insure Your Income: Establishing Deferred Comp
Deferred compensation can be established in one of two ways -- as a salary continuation plan or as a salary reduction agreement.
The salary continuation approach means that the deferred compensation is actually an additional benefit over and above your present compensation. This is sometimes referred to as a Selective Executive Retirement Plan (SERP). Since a SERP is discriminatory, it is non-qualified. In accordance with the SERP, the employer promises or elects to pay a deferred benefit, in addition to your salary, in the event of retirement, premature death or disability.
Not every business is a prospect for deferred compensation. The best prospects usually will be found in corporations, partnerships, sole proprietorships and certain nonprofit organizations -- such as colleges, universities and hospitals.
If you're considering this kind of arrangement, you need to review your other pension benefits to determine whether deferred comp will adversely affect any retirement benefit.
Example: Izzy's pension contribution amount is based on his current salary. Deferral of some of this current compensation will result in a smaller pension plan contribution. This reduction may create a bigger loss than the gain created by the tax advantage. Izzy probably shouldn't defer his income.
As a rule, a participating employee must not have any beneficial interest in a plan's funding to avoid current taxes. The assets used to fund the plan must be owned by the employer and must be subject to the claims of the employer's creditors. Due to these problems, unfunded plans are used more often.
Example: Curlyco hires Ben as CEO. As part of his compensation package, Ben has a percentage of his salary deferred into a trust account, which will be paid in monthly installments upon his retirement at age 65. Ben's contract includes standard non-compete and forfeiture clauses. After five years, Ben grows disenchanted with Curlyco and, despite being 10 years away from retirement, decides to leave the company to pursue his dream of playing on the professional golf seniors tour. According to the forfeiture clause of his contract with Curlyco, Ben will not receive any of the money deferred into the trust as he putts his way into his golden years.
Despite some of its disadvantages, the funded plan does provide some security for the key executive, in that there is some assurance that the promised benefit will be delivered at a later date. Conversely, the unfunded plan offers no such assurance.
Even though the plan is unfunded, there still must be a substantial risk of forfeiture specified in the agreement, so that there will be no current tax liability based on the concept of economic benefit.
If the employer does not deliver the deferred benefits, the retired or disabled participating employee becomes a creditor of the company. The employer could elect to pay other creditors ahead of the employee. As you might guess, this lack of security is a major disadvantage of an unfunded plan.
To overcome this disadvantage, the IRS permits a deferred compensation plan to be informally funded. This permits the use of life insurance, annuities and trusts, without jeopardizing the favorable tax status of the unfunded plan.
The IRS has ruled that an employer may purchase insurance on the life of a key employee (or an annnuity), in order to assure that necessary funds will be available for the plan. There will be no present economic value or benefit to the employee, and thus no current taxation, provided the employer is the owner, pays the premiums and is beneficiary of the life insurance policy.
