Deferred Comp Plans

Question 1

Why Offer Deferred Compensation?

Answer 1

• To provide benefits to a select group of employees without the limitations of qualified plans.
• To discriminate the provision of benefits to key employees.
• Qualified plans cannot provide sufficient retirement resources for key executives who earn in excess of the covered compensation limit of $305,000 for 2022.

Question 2

Deferred Compensation Arrangements - Characteristics

Answer 2

• They do not have the tax advantages of qualified plans for the employers.
• They usually involve deferral of income by the executive.
• There is no mismatch of tax deduction and taxable income.
• Generally, the employee must have a substantial risk of forfeiture, and must not have constructive receipt of the funds to avoid current taxation.

Question 3

Use of Deferred CComp

Answer 3

To increase the executive’s wage replacement ratio, or

To defer the executive’s compensation, or

In lieu of qualified plans.

Question 4

Wage Replacement Ratio

Answer 4

• Individuals need 70%-80% of their preretirement income during retirement.
• Deferred compensation plans can provide nonqualified benefits to an executive to increase the executive’s wage replacement ratio.

Question 5

Defer Executive Compensation

Answer 5

• Executive Tax Benefits:
  Defer taxable income to the future when the executive’s marginal tax rate is lower.
• Employer Tax Benefits:
  No tax benefit to the employer until paid.

Question 6

Two Things that Determine Comp Is Included in Taxable Income

Answer 6

Constructive Receipt

Substantial Risk of Forfeiture

Payroll Tax

• Deferred compensation is subject to payroll taxes at the time the income is earned, which is:
  
  • When the risk of forfeiture expires or when earnings are paid to the executive.
• Usually the only impact is 1.45% for Medicare portion of payroll taxes.
  
  • Executives with salaries greater than $147,000 for 2022 are usually the only employees who defer compensation into these plans.
• When deferred compensation is paid out to the executive, it is taxed as ordinary income.

Employer Income Tax Deduction

• The matching of income/expense provision applies to deferred compensation.
• The employer has tax deductible expense when the employee recognizes taxable income.
• Payroll taxes on deferred compensation are currently deductible since the compensation is currently payable.

Question 7

Non Qualified Deferred Compensation Plan (NQDC)

Answer 7

• Contractual arrangement between the:
  
  • Employer and Executive.
• The employer promises to pay executive a predetermined amount sometime in the future.
• NQDC Plans are NOT Qualified Plans.

Advantages

To the employer:

• Cash outflows are deferred.
• Potential Payroll Tax savings:
  
  • Current taxable (payroll) value is less than future payout.
• Can be discriminatory with award of plan benefits.
• Deduct in excess of $1,000,000 deductible compensation limit (over years).

To the executive:

• Reduced taxable income.
• Avoids payroll taxes on appreciation.

Question 8

Rabbi Trust

Answer 8

• A rabbi trust is an irrevocable trust which the company cannot remove the funds from the trust.
• The trust holds set-aside funds of a NQDC Plan.
  
  • The funds are for the benefit of the executive.
  • Funds are not available to the employer, BUT may be available to the employer’s general creditors under bankruptcy.
• Substantial risk of forfeiture exists.
• Assets within the rabbi trust are not currently taxable to the executive.

Question 9

Secular Trust

Answer 9

• A secular trust is an irrevocable trust, which the employer cannot remove the funds from the trust.
• The trust holds set-aside funds of a NQDC Plan.
  
  • The funds are for the benefit of the executive.
  • Trust funds are not available to the employer or the employer’s creditors.
• Usually there is no substantial risk of forfeiture for the employee.
  
  • However, the trust may require a vesting period.
    * In such a case, the executive would have substantial risk of forfeiture until meeting the vesting period requirements.
• Without substantial risk of forfeiture, the value of trust is taxable to the executive at the time it is funded.

Question 10

Phantom Stock Plans

Answer 10

• Phantom Stock Plans are nonqualified deferred compensation plans.
• The employer gives fictional shares of stock to key executives.
• At a later time, the stock is valued and the executive will receive the increase in value as compensation.
• No actual stock is issued.
• The executive has taxable income and the employer has a deduction at the time payment is made to the executive.
• A phantom stock plan may be used by a closely held business to attract professional management with a cash amount equal to a portion of a change in the value of the business from the time they start until the time they terminate.

Question 11

Supplemental Executive Retirement Plans (SERP)

Answer 11

• Supplemental executive retirement plans are nonqualified deferred compensation plans.
• SERP Plans are also known as:
  
  • Top-Hat Plans - Benefit a select group of top management.
  • Excess-benefit Plans - Type of SERP that is designed solely to provide benefits in excess of the benefits available in qualified plans.
• They provide additional benefits to an executive during retirement.
• They may be unfunded or funded.

Question 12

Salary-Reduction Plans

Answer 12

• Secular Trust
  * There is a vesting schedule or term of employment requirement.
• Rabbi Trust
  * Just the availability of assets to general creditors creates a substantial risk of forfeiture.

Question 13

Funded NQDC Plans

Answer 13

• Plan assets are set aside into a trust.
• To avoid current taxation since funds are set aside:
  
  • Must have substantial risk of forfeiture, or
  • Lack of constructive receipt.
• Examples:
  
  • Secular Trust
    * There is a vesting schedule or term of employment requirement.

Rabbi Trust
* Just the availability of assets to general creditors creates a substantial risk of forfeiture.

Question 14

Unfunded NQDC Plans

Answer 14

• An unfunded NQDC Plan is an unfunded promise to pay.
  
  • There may be time requirements, or other considerations.
• Funds are not set aside.
• There is no constructive receipt.
• There is substantial risk of forfeiture.
  
  • Substantial risk of forfeiture means the funds are subject to the employer’s general creditors.
• The employer might not pay!
• Executive may not meet requirements to receive funds!
• Meets requirements for tax deferral.

Question 15

Employer Stock Options and Stock Plans

Answer 15

• Stock Options - The right to buy stock at a specified price for a specified period of time.
  
  • The agreement must be in writing, and holder has no obligation to exercise.
• Option price = The fair market value at date of grant
• Vesting is the right to exercise options only after certain period of time, performance, or occurrence.

Question 16

Types of Options

• Incentive Stock Options (ISOs)
• Non Qualified Stock Options (NQSOs)
• Stock Appreciation Rights (SARs)

Answer 16

Incentive Stock Options (ISOs)

• Ties an employee benefit to the stock price of the company and may provide special taxation.
• ISO’s may only be granted to employees.
• The aggregate fair market value of ISO grants must be less than $100,000 per year per executive.
• For ISO special tax treatment, the individual must hold stock two years from date of grant and one year from date of exercise.

Tip: This rule is important to know: For ISO special tax treatment, the individual must hold stock two years from date of grant and one year from date of exercise.

Non Qualified Stock Option (NQSO)

Option that does not meet requirements of an ISO.

Ties an employee benefit to the performance of the company stock.

Exercise does not receive favorable tax treatment.

There is no statutory holding period requirements.

• Employer’s may place holding period requirements on the stock.

Non Qualified Stock Option (NQSO)

• Option that does not meet requirements of an ISO.
• Ties an employee benefit to the performance of the company stock.
• Exercise does not receive favorable tax treatment.
• There is no statutory holding period requirements.
  
  • Employer’s may place holding period requirements on the stock.

Cashless Exercise

• An executive exercises one or more options without cash, very common.
• A third-party lends the executive cash to exercise the option.
• The executive repays the lender almost immediately with the proceeds and has W-2 income for the excess value over the exercise price.
• A cashless exercise is a disqualifying disposition.
• Cashless exercise could be for all or a portion of options that the executive holds.

Tip: A cashless exercise is ALWAYS disqualified!

Question 17

Restricted Stock Plans

*

Answer 17

• Restricted stock plans are plans which pays executives with shares of the employer stock.
• The executive does not pay any amount towards the stock.
• The stock has restrictions preventing the executive from selling or transferring, such as:
  
  • A vesting schedule, which creates a substantial risk of forfeiture.
• Restricted stock plans increase executive retention and ties the executive’s benefit to the employer stock price.

Taxation of Restricted Stock Plans

• At receipt of the restricted stock:
  
  • No taxable income or deduction by the employer unless the executive elects IRC Section 83(b).
• At the time the restriction is lifted:
  
  • The executive’s right to stock vests.
  • There is W-2 income for the fair market value of the stock.
  • The employer has a tax deduction equal to the W-2 amount.
• The executive’s holding period begins at the date the restriction is lifted.

Tip: The benefit is that it allows for immediate taxation and long-term capital gains treatment at sale.

Question 18

IRC Section 83(b) (RSU)

Answer 18

• Section 83(b) is an employee election to include value of stock in taxable income at the date of the grant rather than at the date of vesting or when restrictions are lifted.
• Any gain in value over the grant date is capital gain rather than W-2 income.
• If the employee does not vest, or otherwise loses rights, no tax deductible loss is permitted.
• The employee’s holding period for stock received will be the date the amount was included in the employee’s gross income.
• Must be filed no later than 30 days after the stock is transferred.
• Employee must file a written statement with the IRS.

Question 19

Employee Stock Purchase Plan (ESPP)

Answer 19

• An ESPP allows employees to purchase employer securities at a discounted price and receive favorable tax treatment on the subsequent disposition of the stock (if it is a qualifying disposition).
• An ESPP ties employee benefits to the price of the employer stock.

Tip: A greater than 5% owner may not purchase from the ESPP.

ESPP Discount

The employer can allow employees to purchase stock at a discounted price:

• No less than 85% of a date determined stock price or an average price.
  
  • Example of date determined stock price:
    
    • Lesser of fair market value at the grant date, or exercise date.

Employee Dollar Limit

The statutory purchase limit is $25,000 per year to an ESPP.

The amount is based on the fair market value of the stock at the date of grant.

Most employees could buy at a maximum discount of $21,250 = 85% of $25,000