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The Practice and Tax Consequences of Nonqualified Deferred Compensation

The Practice and Tax Consequences of Nonqualified Deferred Compensation. David I. Walker diwalker@bu.edu. NQDC joint tax advantage…. Arises when employer can earn a higher after tax return on deferred funds than an employee could earn on her own Is significant when, e.g.:

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The Practice and Tax Consequences of Nonqualified Deferred Compensation

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  1. The Practice and Tax Consequences of Nonqualified Deferred Compensation David I. Walker diwalker@bu.edu

  2. Nonqualified Deferred Compensation NQDC joint tax advantage… • Arises when employer can earn a higher after tax return on deferred funds than an employee could earn on her own • Is significant when, e.g.: • Employer invests freed up funds in own-company stock (utilizing IRC 1032) • Employer invests in dividend paying stock (utilizing DRD) • Employer faces a low effective marginal rate

  3. Nonqualified Deferred Compensation My approach • Joint tax consequences depend on notional investments by employees and actual use of freed up funds by employers • Rely on employer surveys, interviews with compensation consultants, and proxy statement disclosures

  4. Nonqualified Deferred Compensation Participant notional investment • Notional investment options • Often same/similar to 401(k) investment menu • Minority of firms allow notional investment in own company stock • Actual (notional) investments • Generally consistent with life cycle investment theory; but with somewhat shorter term focus • Little in own company stock

  5. Nonqualified Deferred Compensation Employer informal funding/use of freed up funds • Vehicles • Rabbi trusts • COLI • Taxable segregated accounts • Investments • Generally hedging notional investment portfolios of participants • Little set aside in the form of own company stock

  6. Nonqualified Deferred Compensation Barriers to joint tax minimization (and, in particular, utilization of IRC 1032) • Accounting

  7. Nonqualified Deferred Compensation Barriers to joint tax minimization (and, in particular, utilization of IRC 1032) • Accounting • Participant diversification and efficient asset allocation

  8. Nonqualified Deferred Compensation How I learned to stop worrying and love NQDC (?) • IRC 1032 • COLI • Low MTR employers

  9. Nonqualified Deferred Compensation Distributional consequences • NQDC plan terms often mirror qualified plan terms. • In first instance, participants receive qualified plan-like returns. • Any reason to think that the benefit of these advantageous terms are shifted back to shareholders?

  10. Nonqualified Deferred Compensation Why do firms offer NQDC? • Not a managerial power paper, but this looks like stealth compensation for senior execs to me. • Paternalism. • Competition. • Other tax considerations.

  11. Nonqualified Deferred Compensation Executive Pay (R)evolution ERt=0; Pt=25% Ert=35%; Pt=45% Ert=0; Pt=25-45% Ert=35%; Pt=25% Ert=35%; Pt=45% Ert=10-35%; Pt=25%

  12. Nonqualified Deferred Compensation

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