A deferred compensation plan delays the payment by employees of any related income taxes until such time as the compensation is actually paid to them. The ideal plan also allows the employer to claim an expense deduction prior to the compensation payment date.
The following types of deferred compensation plans can be used to accomplish one or both of these goals:
- Qualified plan. This type of plan allows the employer to recognize an expense now and the employee to pay taxes only when compensation occurs. This means that the employer can use the early expense recognition to reduce the amount of its taxable income. The employee will also not recognize any appreciation in the amount of transferred funds or other assets until actually paid, and may be able to roll the compensation into an IRA, thereby further deferring recognition of the income. To qualify as a deferred compensation plan, a plan must qualify under several IRS rules, including applicability to a large percentage of employees, and not being used just for highly compensated employees.
- Rabbi trust. Under this plan, the company sets up an irrevocable trust and usually funds it with company stock. This asset can be claimed by company creditors in the event of a company default, so there is an element of risk for any employees being compensated under the plan. Payments are made to employees from this trust in future periods, for which the payment conditions must be specified in the plan. If gradual employee vesting is incorporated into this trust, the company can recognize an expense in proportion to the amount of vesting. If not, and cliff vesting is used instead, then the company recognizes compensation expense at the same time the employees are paid. The expense recognized by the company is the initial value of the company stock contributed to the trust, not its value when paid out to employees.
- Secular trust. This type of trust protects from creditors the assets placed in a trust for the future benefit of employees. However, the employees will now be taxed in the current period, rather than when they receive the funds. This can present a problem for the targeted employees, who may not have enough cash on hand to make the tax payments.
If a plan does not qualify under the IRS rules, it is considered a nonqualified plan. This usually happens when a business wants to issue deferred compensation only to a small number of highly compensated employees. In this case, the employer only recognizes the compensation expense when payment is made to its employees.