VI. Non Qualified Deferred Compensation

A.                 Traditional Deferred Compensation

Involves deferring or reserving income at the (normally C) corporate level and paying it later to employees (new strict Internal Revenue Code Section 409A means a formal nonqualified deferred compensation plan for owners is not feasible).

Income Tax Issues

Corporation does not deduct the deferral.  NQDC use almost always limited to 15% corporate tax bracket (for non personal service corporations).  Tax deduction at corporate level is when deferral is paid.  IRC § 404(b).

Comment:      Normally used by owners to shelter income at 15% federal corporate rate.  Game plan is to keep funds at corporate level and pay funds later when owner is in lower bracket.  Owners of small businesses normally do not use a formal deferred compensation plan or formal deferral of “declared” salary.  Often they have informal severance pay (generally limited to 2 years’ pay) contracts continuing salary for a time after retirement, or a formula defining deferred compensation to be paid upon termination.

FICA Issues

IRS Regulations 31.3121(v) describes impact of Social Security Amendments Act of 1983.  FICA implications are complex and a genuine consideration in NQDC. FICA normally applies when a “non-account” or “account” plan defines a legally binding ascertainable benefit to be paid at a future date.  A full discussion of FICA implications is beyond the scope of this outline.

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B.                 NonTraditional Informal NonQualified Deferred Compensation

Small C corporations often accumulate corporate retained earnings as an “informal” deferred compensation plan.  This will be the only method that can be used for owners under the IRC § 409A rules.

Pros – 15% tax rate on first $50,000 of income for eligible C corporations.  No current FICA implications.  Possible deduction for compensation payout or other expense in later year.  Possible eventual liquidation or corporation at capital gains rates.  Possible gift of stock to children to shift gain to next generation.  Death of owner (or spouse in community property context) step up basis up could allow tax free liquidation.

Cons – No assurance tax rate upon liquidation is favorable.  If paid as compensation, resulting deduction may generate unusable net operating loss.  Accumulated earnings tax (IRC § 532) implications for retained earnings over $250,000 ($150,000 for certain service corporations).  Possible increased FICA in later year(s).

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C.                Rabbi Trust

(Not common in small businesses) – Assume the business establishes a deferred compensation plan for a non-owner – or a minority owner.  He/she desires assurance the “funds will be there.”  A Rabbi Trust is an irrevocable trust in which assts are set aside for the exclusive use of satisfying an employer’s contractual obligation to pay deferred compensation.  It can be funded in any manner including cash or insurance products.  Rabbi Trusts are subject to the claims of general creditors but are inaccessible to the business for discretionary use until benefit obligations are met.  The earliest IRS blessing of this was a private letter ruling involving deferred compensation provided by a congregation to its rabbi.  Therefore, the term “Rabbi Trust.”

Comment:      Rabbi Trusts are not typical with formal deferred compensation plans for owners.  They are often funded with life insurance or “tax managed investments” to limit current taxable income to the corporation.

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D.                ERISA Implications

ERISA Sections 3 and 201 and their regulations describe exemptions from ERISA coverage.

CAUTION– Formal deferred compensation plans must be limited to select management employees or highly compensated employees (normally called “top hat” coverage) to avert ERISA coverage.  Top hat plans are exempt from the participation, vesting, funding and fiduciary requirements of ERISA, but are subject to limited reporting and disclosure requirements.  The business must file a brief one-time disclosure statement with the U.S. Department of Labor.

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E.                 Split Dollar Insurance

Variations of Split Dollar abound.  A traditional one used by the author (and the only one discussed here) is the collateral assignment approach as follows

Premium paid part by company and part by employee or owner – hence “split” dollar. Employee typically pays the “economic cost” of policy under P.S. 58 (or the lowest published and available term rate) and the company pays the rest.  The company’s payment is an advance, subject to return in accordance with the Split Dollar Agreement.  A formal written collateral assignment is filed with the insurance company to secure the debt.  The company can bonus the economic cost to the employee as taxable compensation.

Pros – Most of the premium is paid with 15% tax dollars (Split Dollar is not often used with S corporations or with C corporations not in the 15% federal bracket).  Build up in value on funds is tax deferred within life insurance policy.  Amount owed to the company now must bear interest under recent IRS regulations.

Cons – “Economic cost” continues until Split Dollar Agreement terminates.

S Corporation Issue:  IRS PLR9651017 ruling indicates a collateral assignment split dollar life arrangement did not create a second class of stock to cause the corporation to lose its S corporation status (the IRS also ruled the particular arrangement did not cause the proceeds to be in the insureds’ estates).  Lack of the 15% corporation tax rate (and flow through owners) makes split dollar highly unusual in the S corporation context.

Reverse Split Dollar:  A nontraditional split dollar arrangement known as “reverse split dollar” (noncharitable) rents death benefits to the corporation.  Discussion of reverse split dollar is beyond the scope of this outline.

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F.                 Corporate Owned Life Insurance

Life insurance schemes to deduct interest (at high interest rates) on corporate owned life insurance on employees lives (used at times in context of deferred compensation and some split dollar plans were attacked in the Health Reform Act of 1996.  Interest is allowed only for policies on certain key employees and then only at specific rates (certain transitional rules apply).  See IRC § 264(d).

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