Integrating deferred comp with estate planning

The recently-passed American Taxpayer Relief Act of 2012 established a clearer baseline for gift and estate transfer planning.  With exemptions clarified, a concept that remains viable is using deferred compensation as part of the planning. This article focuses on non-qualified deferred compensation plans regarding business owners/employees and assumes a lifetime gifting to the next family generation.

Note that traditional qualified plans are considered deferred compensation plans, but they have restrictions that limit their usefulness in this context.

What specific types of plans are included in this analysis?

Some examples of non-qualified deferred compensation plans include:

  • Elective, non-qualified compensation deferrals
  • Stock appreciation rights
  • Phantom stock option and certain life insurance plans, including split dollar life insurance and corporate-owned life insurance whose purpose is to accumulate cash for retirement but insure the key employee in the short term

What financial goals are achieved for the owner by participating in a deferred compensation plan?

The employee or owner accumulates an enhanced income stream for retirement and possibly additional assets to a spouse in the event of premature death.

What is the objective for most estate plans?

The goal of many business owners is to transfer as much property as possible to the next generation, preserve assets for the surviving spouse, and pay on a combined basis the smallest amount of gift and estate taxes.

How can this objective best be accomplished?

A company, on behalf of an owner, adopts a deferred compensation plan and records a liability on its balance sheet.  The net worth of the company is reduced by the liability, thus any gifting or sale to family is diminished in value, resulting in less taxes.  At the time the deferred compensation is distributed, proper planning may allow the distribution to the owner or the owner's beneficiary to be taxed at a lower income tax rate.

Are there any other considerations?

  • Adoption of any deferred compensation plan must make economic sense and fundamentally may require the owner to forego some current compensation to accomplish its end objective. However, the plan should not be an excessive burden to the company’s next generation owner.
  • The beneficiary must recognize that the plan is frequently not funded and thus the asset or income stream may be at risk as to ultimate payment.
  • The company must review its debt agreements, if any, to ensure that restrictive debt covenants are not violated or they are modified so that the deferred compensation liability does not result in a violation of covenants.
  • Gift and estate rules are complex.  Existing estate plans should be reviewed in total to see if deferred compensation fits.

Timothy C. Hilbert can be reached at Email or 215.441.4600.