Session 14 Fundamentals of Deferred Compensation

1. CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Session 14Fundamentals of Deferred Compensation

2. Session Details

3. Definition of Nonqualified Deferred Compensation “A nonqualified deferred compensation plan means any plan that provides for the deferral of compensation.”  American Jobs Creation Act of 2004 – IRC Section 409A

4. Nonqualified Deferred Compensation Overview 409A—Increased restrictions on deferred compensation • Nonqualified plans are ideal for business owners and key employees who want to provide benefits for themselves in excess of qualified plan limitations • The historically low personal income tax brackets make nonqualified deferred compensation less attractive than previously • The prospect of rising taxes in the future also makes nonqualified deferred compensation less attractive

5. Nonqualified vs. Qualified Plans

6. Types of Nonqualified Deferred Compensation • Pure deferred compensation (employee funded) • Supplemental plans (employer funded) • Excess benefit plan • Supplemental Executive Retirement Plan (SERP) • Death Benefit Only plan (DBO)—provides a survivor benefit

7. Excess Benefit Plans • An excess benefit plan is linked indirectly to the qualified plan or plans in place and provides for benefits in excess of the amount to which the employee would otherwise be entitled under the qualified plan • The payment is typically made when the employee retires and is usually paid out the same way that benefits are paid under a qualified retirement plan • The plan may be funded, informally funded, or unfunded

8. Supplemental Executive Retirement Plans (SERPs) • A SERP (or top hat plan) is an unfunded plan providing benefits for select employees (generally only high-level executives) in excess of those provided by the employer’s qualified retirement plan • Benefits are usually based on elements of compensation not otherwise provided under the qualified plan (such as a benefit formula with a higher multiple of earnings or ignoring altogether Social Security integration levels) • SERPs can be used for a broader range of purposes than excess benefit plans • Unfunded SERPs are exempt from all but the reporting and disclosure requirements of ERISA

9. Nonqualified Deferred Compensation Tax Implications To employer • Deduction when taxed to employee • Earnings taxed to employer To employee • Taxed when benefit constructively received • Subject to FICA taxes when constructively received

10. ERISA Requirements for Nonqualified Deferred Compensation Plans

11. Nonqualified Deferred Comp Funding Unfunded • Promise to pay • Agreement executed prior to service performance • Available to company creditors Funded • Not available to employer’s creditors • Currently taxable to employee unless substantial risk of forfeiture Informally Funded • Employer “informally” dedicates assets to employee through accounting device or segregating assets to a trust • Rabbi Trust an example

12. Rabbi Trust • A rabbi trust is an employer-sponsored irrevocable grantor trust • Trust has two beneficiaries: • the employee and • creditors of the company • Trust earnings are currently taxable to the employer

13. Secular Trust • Irrevocable fully funded trust established for an employee • Employee is vested in contributions, so current taxation to employee results • Assets are not subject to the claims of an employer’s creditors

14. Requirements for Deferral of Taxation IRS Regulations stipulate three principles that must be followed for deferred compensation: • The agreement to defer compensation must be made before the dollars are earned • The agreement must represent only an unsecured promise • The agreement cannot be funded (i.e., any funds used to provide the benefit must be held by the employer as a general asset available to creditors)

15. Substantial Risk of Forfeiture • Employee’s right to payments must be contingent upon future performance of substantial services (death or disability are not considered substantial services) • Plan must provide for loss of rights to payments if substantial services are not performed OR if employment terminates for reasons other than death or disability • Generally only relevant in funded plans

16. Constructive Receipt • The constructive receipt issue isn’t whether the taxpayer has actually received the income, but whether he or she has access to it • To avoid constructive receipt, agreements usually contain specific provisions establishing substantial risk of forfeiture (funded plans), or availability of funds to company’s general creditors (unfunded plans)

17. Economic Benefit • Economic benefit relates to the receipt of non-cash property that can be valued in cash • When the employee’s benefit is treated as the equivalent to the receipt of cash, current income taxation will result • In unfunded and unsecured plan, mere promise to pay does not confer economic benefit

18. Multiple Choice Question 1 Manning Manufacturing wants to implement a nonqualified deferred compensation plan that will enable the company to set aside the same 10% they are contributing into the profit sharing plan for amounts executives earn above the IRC qualified plan compensation limit. You would recommend a(n) • SERP. • death benefit only plan. • rabbi trust. • excess benefit plan.

19. CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits Session 14End of Slides