Lesson 61: Deferred Compensation Plans for Executives

Deferred compensation plans, also known as non-qualified deferred compensation (NQDC) plans, are arrangements in which a portion of an executive's income is paid out at a later date. These plans are often used as a tool for tax deferral and aligning executive incentives with long-term corporate goals.

Overview of Deferred Compensation Plans

For ultra-high net worth clients, deferred compensation plans can be an effective method of deferring tax liabilities and aligning the interests of key executives with the company's long-term performance. Deferred compensation plans can include:

  • Salary deferral arrangements
  • Incentive bonuses
  • Stock options

Advantages and Disadvantages

Before selecting a deferred compensation plan, it's important to understand both the advantages and disadvantages:

Tax Implications

Deferred compensation plans offer tax benefits, but they also come with specific tax implications:

  • Income taxes are deferred until the compensation is paid out
  • Deferred amounts are subject to payroll taxes (FICA and FUTA) when vested

Designing a Deferred Compensation Plan

When designing a deferred compensation plan for an executive, consider the following steps:

  1. Identify the executive's financial goals and retirement timeline
  2. Determine the amount and form of compensation to be deferred
  3. Choose the vesting schedule and distribution events
  4. Consider the investment options for deferred amounts
graph TD A["Designing Deferred Compensation Plan"] --> B["Identify Financial Goals"] B --> C["Determine Amount to Defer"] C --> D["Choose Vesting Schedule"] D --> E["Select Investment Options"]

Example: Structuring a Deferred Compensation Plan for a CEO

Let's consider an example of structuring a deferred compensation plan for a CEO:

  1. The CEO defers 20% of their annual salary and 50% of their annual bonus.
  2. The deferred amounts vest over a 5-year period.
  3. The deferred amounts are invested in a combination of company stock and a diversified portfolio.
graph TD X["Structuring Deferred Compensation Plan for CEO"] --> Y["Defers 20% Salary"] X --> Z["Defers 50% Bonus"] Y --> AA["5-Year Vesting Period"] Z --> AA AA --> BB["Invested in Company Stock"] AA --> CC["Invested in Diversified Portfolio"]

Compliance and Legal Considerations

It's crucial to ensure that deferred compensation plans comply with all relevant laws and regulations, including:

  • Internal Revenue Code Section 409A
  • Employee Retirement Income Security Act (ERISA), where applicable

When to Consider a Deferred Compensation Plan

Deferred compensation plans are suitable in the following scenarios:

  • When an executive is in a high current tax bracket and expects to be in a lower tax bracket at retirement
  • When a company wants to retain key executives and align their interests with long-term company performance

Comparing Deferred Compensation Plans with Other Strategies

It's essential to compare deferred compensation plans with other strategies, such as:

  • Bonus plans
  • Stock option plans
  • Restricted stock units (RSUs)
  • Retirement plans

Example: Deferred Compensation vs. Stock Option Plans

Consider the following comparison:

graph TD DCP["Deferred Compensation Plan"] --> |"Tax Deferral"| T["Tax Advantage"] SOP["Stock Option Plan"] --> |"Potential for High Returns"| T DCP --> |"Risk of Company Insolvency"| R["Risk Consideration"] SOP --> |"Potential Dilution of Shares"| R

Example: Deferred Compensation vs. Restricted Stock Units (RSUs)

Here's a comparison between deferred compensation plans and RSUs:

graph TD DCP[Deferred Compensation Plan] --> |Tax Deferral| T[Tax Advantage] RSU[Restricted Stock Units] --> |Immediate Ownership| T DCP --> |Risk of Company Insolvency| R[Risk Consideration] RSU --> |Subject to Market Volatility| R

Tradeoffs and Considerations

When choosing between deferred compensation plans and other executive compensation strategies, consider the following tradeoffs:

  • Tax Deferral: Deferred compensation plans allow for tax deferral until payout, whereas bonuses and RSUs may be taxed upon receipt.
  • Risk of Insolvency: Deferred amounts may be at risk if the company becomes insolvent, unlike RSUs or options which are tied to stock performance.
  • Administrative Complexity: Deferred compensation plans can be administratively complex, potentially increasing costs.
  • Alignment with Long-Term Goals: Deferred compensation aligns executive incentives with long-term performance, similar to stock options but not immediate bonuses.

Advanced Tax Strategies

For ultra-high net worth clients, integrating deferred compensation plans with other advanced tax strategies can yield significant benefits:

Practical Example: Integrating Deferred Compensation with a Captive Insurance Company

Here's an example of how to integrate a deferred compensation plan with a captive insurance company:

  1. Establish a captive insurance company to insure company-specific risks.
  2. Use the captive insurance company to fund the deferred compensation plan, thereby securing the deferred amounts.
  3. The captive insurance company invests the funds, providing returns that can be used to pay out deferred compensations.
graph TD A[Deferred Compensation Plan] --> B[Captive Insurance Company] B --> C[Funds Deferred Amounts] C --> D[Invests in Secure Assets] D --> E[Provides Returns] E --> F[Pays Out Deferred Compensation]

Conclusion

Deferred compensation plans are a powerful tool for tax deferral and aligning executive incentives with long-term company performance. By understanding the advantages, disadvantages, and tax implications, and effectively integrating these plans with other advanced tax strategies, estate planners can help ultra-high net worth clients maximize their financial goals.

Explore more on estate planning topics in the following lessons:

« Previous
Take the Quiz »