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Deferred Compensation:
Executive Summary

Do you have key employees who are critical to your firm?
Would you like to set aside extra dollars for the future – yours or theirs – without current income tax exposure?
Would you like the ownership of those funds to revert to your firm if the key employee leaves?
Would you like to be able to do all this without having to pass Top Heavy or Highly Compensated Executive compliance testing?

If you answered ‘yes’ to any or all of the above, then a Deferred Comp program might make sense for you.

Key Features:

Contractual agreement between and employer and an employee
Specifies when and how future compensation will be paid
Unfunded and unsecured promise to pay benefits in the future
Employee has no income tax liability until benefits are received
Employer may not take an income tax deduction for informally setting aside assets to fund the plan
Employer may discriminate in determining who shall participate
Employer may include vesting provisions
Non-vested assets revert to the employer for discretionary usage
Participation and vesting may be individually tailored to enhance incentives to achieve goals
Not subject to ERISA compliance and administration requirements

Possible Participants:

Select Group – or – Top Hat ERISA exemption
No purely quantitative definition exists
15% or less of the total employee bases is normally considered not to be excessive
Highly compensated can be either specific (ie – in excess of $105,000 in 2008) or a relative basis (ie – in excess of three times the average of non-covered employees
May include non-employees such as directors or independent contractors
Should not include persons who have “control” of the employer (ie – normally an employee with over 50% ownership in the company

Plan Financing:

Most employers choose to informally pre-fund or finance the plan benefits
Annual financial allocation is typically more manageable a than lump sum payout
Pre- funding creates a fixed asset to ensure that payout will not adversely impact future cash flow
Employer owned permanent life insurance is often a preferred asset for financing
Cash values grow tax deferred
Death proceeds are received income tax free, even if the employee has left the employer
Cash withdrawals are made on a FIFO (first in, first out) basis allowing tax free return of all deposits

Income taxation of the Employer

When an employer is the direct or indirect beneficiary of a life insurance policy, it may not take a deduction
Benefit payments are not deductible until the payments are actually made and included in the employee’s income
So long as the following requirements are met, death benefits are generally not taxable to the employer
Employee is notified that the employer intends to insure his life
Employee is notified of the maximum amount that can be insured
Employee consents to being insured
Employee consents that coverage may continue after he terminates employment
Employee is notified that the employer will be a beneficiary of death proceeds

Income taxation of the Employee:

Employees are not taxed on deferred amounts or plan contributions until they actually or constructively receive the payments
Distributions are includable as ordinary income in the year received
Employees are not taxed on the current values of life insurance so long as the employee has no beneficial interest in the policy,
The policy is accessible to the general creditors of the employer,
The employer is the sole applicant, owner and premium payer of the policy
Substantial risk of forfeiture
IRS Notice 2005-1 at A-10 states that the risk of forfeiture must be substantial and must relate to the purpose of the compensation, i.e. it must relate to the employee’s performance or business activities or organizational goals (such as a prescribed level of earnings, equity value, a liquidity event or substantial future services)
Employer may not place assets outside the reach of corporate creditors