Deferred compensation is an effective way to attract, retain, and motivate key employees. However, these arrangements are governed by complex tax rules, and even well-designed plans can create significant tax and legal issues if they are not structured and administered properly. With careful planning and periodic review, employers can avoid many common compliance concerns.
What Is Deferred Compensation?
Deferred compensation is any arrangement under which compensation earned in one year may be paid in a later year. These arrangements take many forms, each with its own benefits and compliance requirements. Common types of deferred compensation include deferred cash, phantom stock, stock appreciation rights, profits interests, restricted stock, and stock options.
- Deferred cash: A promise to pay cash at a future date, typically if the employee remains employed for a specific period or achieves defined performance goals. These arrangements generally supplement, rather than replace, base salary.
- Phantom stock: A promise to pay the value of company stock without providing actual ownership rights.
- Stock appreciation rights (SARs): Allow employees to receive the increase in value of company stock without acquiring ownership.
- Profits interests: Available only to certain types of businesses, provide a similar benefit to SARs but also grant limited ownership rights.
- Restricted stock: An award of company stock that makes the employee an owner, subject to forfeiture if specified service or performance conditions are not met. Recipients may elect to be taxed before the forfeiture restrictions lapse, allowing future appreciation to be taxed as capital gain.
- Stock options: The right to purchase company stock in the future at the current or a discounted price, even if the stock has appreciated significantly. Although stock options are common, employees often must make a substantial investment to exercise them.
Why Employers Use Deferred Compensation
When properly structured, deferred compensation plans provide meaningful advantages for both employers and employees. These arrangements allow employers to provide compensation opportunities beyond the contribution limits that apply to qualified retirement plans. For employees, deferred compensation may provide the opportunity to defer both payment and taxation of compensation until a later date.
Risks of Noncompliance
Although deferred compensation plans offer significant advantages, the consequences of noncompliance can be substantial. The Internal Revenue Code imposes strict requirements on deferred compensation arrangements. Failure to comply may result in immediate taxation of deferred amounts. In addition, the service provider may be subject to an additional 20 percent tax, plus interest.
Key Compliance Considerations
Compliance requires careful attention to plan design, documentation, and administration. Employers should understand several important requirements.
- Documentation: Deferred compensation plans must be documented in writing.
- Deferral elections: Initial deferral elections typically must be made before the end of the year preceding the year in which the services are performed. Once a deferred compensation award is made, employers should consult legal counsel before modifying or amending it, as changes can create avoidable compliance issues.
- Permissible payment events: Deferred compensation generally may be paid only upon separation from service, disability, death, a specified time, a change in control, or an unforeseeable emergency. Payments that do not align with one of these permissible events may trigger penalties.
- Operational compliance: Even a plan that is properly drafted can fail to comply if it is not administered correctly. Making payments earlier or later than permitted can create significant issues and should be reviewed by experienced legal counsel.
Looking Ahead
Deferred compensation arrangements can provide meaningful benefits for employers and employees, but success depends on thoughtful planning and ongoing compliance. Employers should periodically review their deferred compensation arrangements to confirm they continue to meet legal requirements and business objectives.
For more information, watch Varnum’s deferred compensation video series or contact a member of Varnum’s Employee Benefits and Executive Compensation Practice Team.
