Deferring Compensation

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	Deferring Compensation Personal Finance Advisor by Deloitte & Touche OnLine August 16, 1999

Delaying income can help reduce taxes, but not in all cases.

Many businesses permit executives and other key employees to defer a portion of their annual compensation to future years. For the executive/employee, deferral of compensation can provide financial flexibility and significantly increase after-tax income. For the business, a deferred compensation program can be a useful tool for attracting and retaining talented individuals. It is important for all parties to understand the risks and uncertainties, as well as the benefits, associated with deferred compensation programs.

Financial Benefits: Delaying the imposition of income taxes on the amounts deferred is the primary advantage of a non-qualified deferred compensation program. If compensation is deferred to years when the individual’s income level is lower (for example, retirement years), the applicable income tax rate on the deferred amount may be lower. Two other important advantages are the ability to (1) accrue and compound earnings on the entire deferred amount (rather than on the after-tax amount), and (2) accrue and compound such earnings on a pre-tax basis (that is, defer income taxes on the earnings as well as the deferred compensation). The following example illustrates these benefits: $100,000 of compensation is deferred for a period of 15 years, earnings are compounded at 10 percent per year, and the current and future tax rate is 40 percent.

Financial Benefits of Deferring Compensation
Year	After-tax Value of Deferred Compensation	After-Tax Value Without Deferral	Break-Even Tax Rate in the Year the Deferral is Paid*
Five	$96,600	$80,200	50.14%
Ten	$155,600	$107,400	58.57%
Fifteen	$250,600	$143,700	65.58%
*If the future tax rate were higher than the current rate (that is, greater than 40 percent), deferral would continue to result in a net benefit.

Other Advantages: A non-qualified deferred compensation program can include provisions allowing each participant to elect/change on an annual basis (1) the amount to be deferred; (2) source of compensation deferral (for example, base salary, bonus, incentive pay); (3) investment alternatives for the deferred amounts; and (4) future payment schedules. Plans may be flexible -- providing different deferral opportunities and investment options for different levels of eligible employees. As a general rule, non-qualified deferred compensation programs discriminate as to eligibility (that is, are limited to a relatively small number of key executives/employees).

Payment Date and Method: When compensation is deferred, the funds are not available to the executive/employee until the payment date(s), and this date must be selected at the time of the deferral election. A non-qualified plan can include provisions that allow modification of payment date(s) and/or method (for example, installments, lump-sum payout). In most cases, such changes cannot be made when payments are imminent (that is, changes in payment dates or methods are not effective for 12 months). Some plans, however, include a hardship withdrawal provision with strict limitations.

Constructive Receipt or Economic Benefit: Under a non-qualified plan, the executive or employee cannot defer compensation and have the right (that is, able to elect) to receive the deferred funds at anytime. In this situation, the IRS concludes that the executive/employee "constructively received" the compensation. Similarly, an executive/employee cannot benefit from the use of the deferred amounts (for example, use the funds as collateral for a loan) -- in this case, the IRS concludes the individual has the "economic benefit" of the deferred compensation. Deferred amounts that are constructively received by, or that confer an economic benefit on, the individual are subject to income tax when earned (or upon constructive receipt or economic benefit, if later).

Financial Stability of Employer: An important consideration for anyone contemplating the deferral of compensation is the financial stability of his/her employer. Executives/employees who have made deferral elections generally are unsecured creditors of the business with respect to the deferred amounts (that is, the deferred compensation may be at risk if the business enters bankruptcy or insolvency). Even if assets have been set aside for amounts deferred under a non-qualified plan (for example, a Rabbi Trust -- an irrevocable trust approved by the IRS), the assets will be subject to the claims of the business’s creditors in the event of bankruptcy or insolvency.

Tax Rate Uncertainties: Individuals also should consider the possibility that income tax rates will increase in the future, thereby reducing or negating expected benefits of deferring compensation.

These are some thoughts to consider about deferred compensation. Your Deloitte & Touche financial advisor also can provide information and should be consulted before any action is taken.