This article originally appeared in the October 2014 issue of Smart Business Philadelphia magazine.
In today’s talent marketplace, deferred compensation is one tool to be considered if a company wants to attract — and retain — key people.
“Many closely-held businesses may not or cannot offer equity compensation in the form of stock, but they still have to be able to hire and retain good people, and a deferred compensation package is clearly something to think about,” says Lawrence Silver, Director, Tax Strategies, with Kreischer Miller.
Smart Business spoke with Silver about the types of deferred compensation and how they can be used, as well as any risks that may be involved.
What are some types of deferred compensation?
A deferred compensation plan may involve an employee who earns a comfortable salary but may not currently need all of it. Abiding by the proper format, the employee can elect to have the company hold a percentage of his or her current compensation and defer the payment to some future specified date. In the interim, the deferred compensation is being invested by the employer.
Another use of a deferred compensation plan is when a company takes its own money and puts some away on behalf of a key employee, perhaps for short-term or long-term incentives, to keep and maintain that employee so the employee has certain goals to reach. Again, the employee may only have access to those funds upon meeting some very specific criteria.
How does deferred compensation differ from a 401(k) plan?
A 401(k) plan is a qualified plan and is available for most employees wherein an employee can defer some of his or her current compensation. Deferred compensation is an unqualified plan and is usually in addition to a 401(k) plan to provide benefits to key employees or higher paid employees who want to be able to defer more compensation than is allowed under a 401(k) plan. Deferred compensation is a tool to go beyond the basic 401(k) plan to offer more benefits to key employees.
Are there any risks in a deferred compensation plan?
There are significant risks. The risk for the employee is that deferred compensation is really a promise by the company to pay. It may be a legally binding obligation under the arrangement the employee has with the employer, but at the same time, the employee is nothing more than a general creditor of the employer. So if the employer goes bankrupt or faces hard times, it may be impossible for the employee to ultimately obtain his or her deferred compensation.
The employer must recognize the potential payment of the deferred compensation as an unfunded liability on its financial statements. This liability could affect borrowing capacity and financial covenants because it is a legal obligation.
Additionally, the employer may only claim a tax deduction at the time of payment.
What type of companies or corporations use deferred compensation plans?
While all types of companies use deferred compensation plans, it is not limited to public companies or large private companies.
A private company, where perhaps the company is family owned and doesn’t want to offer equity to nonfamily members, may use a deferred compensation plan known as a “phantom stock” plan. Such a plan mimics the increase in value of the company’s equity over the years. That employee can then participate in the incremental value of the stock while not being an actual stockholder. The downside here is that the ultimate payment under this plan is taxed to the employee at ordinary income tax rates as opposed to lower capital gains tax rates.
What are some mistakes employers make and how can they be avoided?
There are specific rules under the Internal Revenue Code and its regulations that must be strictly followed. There can be significant penalties for the employee if deferred compensation is received prematurely. These plans must be reviewed by legal counsel and financial advisers because it’s possible to inadvertently create a situation that was unintended. ●