Deferred Compensation – Tax, Accounting, and Regulatory Considerations
Nearly all financial institutions offer “qualified” retirement plans to their employees. These plans enjoy the benefit of a deliberate mismatch between the timing of the employer’s deduction (when contributions are made to the plan) and the employee’s recognition of income (when distributions are ultimately received). Additionally, contributions to qualified plans are held in a trust that is exempt from tax and are allowed to grow on a tax-deferred basis for the benefit of the plan’s participants.
In order to provide additional retirement benefits to valuable employees, many institutions also offer “nonqualified” retirement plans. Unlike qualified plans, these nonqualified plans:
- Do not offer full ERISA protection,
- Do not allow a tax deduction for the employer until the compensation is paid, and
- Do not offer protection from creditors.
Federal income tax consequences to employees
Like qualified deferred compensation, nonqualified deferred compensation (NQDC) contributions are pre-tax for the participant, and earnings accumulate tax-free. When paid out, distributions are taxed as ordinary income, no matter what type of income contributed to the earnings accumulation (i.e. there is no benefit from lower rates for dividends or capital gains).
State income tax consequences to employees
Recipients of nonqualified deferred compensation need to be aware of the taxation rules in the state where the deferred compensation was earned. Under federal law, states are prohibited from taxing distributions from qualified plans in any state other than the resident state of the recipient. However some states (referred to as “source states”) may require that some NQDC distributions be taxed in the state where it was earned, rather than in the state where the recipient resides at the time of distribution. Massachusetts, Vermont and Connecticut (as of June 11, 2014) are source states and treat most NQDC earned in those states as taxable there no matter where the recipient is living at the time the compensation is received. Maine also follows this pattern if the deferred compensation is paid out in a lump sum or over a term of less than ten years.
Tax deduction for employer
For NQDCs, unlike qualified plans, the IRS requires a matching of the timing of income recognition by the employee and the employer’s deduction. Therefore, although the employer may be on the accrual basis and all of the conditions for deducting the accrued payroll may have otherwise been met, the employer is not allowed to deduct nonqualified deferred compensation until the time at which it becomes taxable to the employee (i.e. when paid), in effect putting the employer on the cash basis.
Most nonqualified deferred compensation plans qualify as “top-hat” plans and are therefore exempt from most ERISA requirements. Top-hat plans are “unfunded and maintained by an employer primarily for the purpose of providing deferred compensation for a select group of management or highly compensated employees.” A top-hat plan is required to file a one-time registration statement with the Department of Labor within 120 days of the plan’s adoption; thereafter it is not required to file an annual Form 5500.
Employment taxes – employer and employee
Any employer which offers an NQDC plan must be aware of the employment tax implications of these plans. When compensation is deferred, employment taxes (i.e. FICA) must be paid at the time the services are performed which entitle the executive to the deferred compensation, unless the compensation is not vested. Thus, payment of FICA taxes (generally only the Medicare tax as the executive will usually be above the social security limit) by both the employee and the employer, as well as the additional Medicare tax incurred by the employee, are usually payable much earlier than the time when the compensation is actually paid to the employee.
However, once a deferral is subjected to FICA taxation, that amount, plus any income earned on the deferred amount, is never treated as wages for FICA purposes again. (Note that while the avoidance of FICA tax on the deferral’s earnings is usually a benefit, the converse is also true – if the value of the deferred compensation declines, a refund of FICA taxes paid is not available.)
Crossing the t’s and dotting the i’s
NQDC plans are generally subject to the requirements of Internal Revenue Code Section 409A, which was enacted in the wake of the Enron scandal. Section 409A is a complex statute that imposes Draconian penalties for noncompliance. A thorough discussion of Section 409A is beyond the scope of this article, but in general Section 409A requires that elections to defer compensation must be made during the year before the compensation is earned, and that distributions from nonqualified plans can only be made following specific triggering events, including, among others, separation from service and the attaining of a specific date. When drafting an NQDC plan, care must be taken to ensure that the terms comply with Section 409A.
Accounting for deferred compensation
A bank’s obligation under a deferred compensation arrangement should be accrued according to the terms of the individual contract over the required service period in a systematic and rational manner (i.e. there should be an expense each period) from the date the agreement is effective to the date the employee is fully eligible to receive the benefits. Vesting should be considered in this calculation as well. The amounts to be accrued each period should result in a deferred compensation liability at the full eligibility date that equals the then present value of the estimated benefit payments to be made under the contract. The expected future benefit payments can often be reasonably estimated and should be discounted when calculating the liability because the benefits will be paid in periodic installments after the employee retires. In many situations, an institution’s incremental borrowing rate is a reasonable benchmark in determining its discount rate and should be periodically reviewed and revised when appropriate in response to changes in market interest rates. Also keep in mind that multiple deferred compensation contracts may trigger accounting as a pension plan, rather than individual contracts. This results in actuarial calculations although the final results may not be significantly different. Readers can refer to FASB ASC Topic 710 for more information regarding the accounting for deferred compensation arrangements.
Funding deferred compensation with life insurance
Many institutions purchase BOLI (Bank-Owned Life Insurance) in connection with their deferred compensation arrangements to offset some or all of the costs of the arrangements. BOLI generally involves a single large premium payment up-front that creates cash value. The cash value grows tax-free, premiums paid are non-deductible and the proceeds paid to the bank upon death of the insured person are also tax-free. Only the amount that can be realized under the insurance contract as of the balance sheet date should be reported as an asset. Consequently, an institution should report the cash surrender value of the policies, which excludes any surrender charges. Additionally, because there is no right of offset, BOLI should be reported as an asset separately from the deferred compensation liability. Readers can refer to FASB ASC Topic 325 for more information regarding the accounting for BOLI.
The banking regulators issued guidance in 2004 that spells out their expectations regarding the purchase and risk management of BOLI. BOLI is allowed by regulators only if it helps offset the cost of employee or retiree benefits, such as deferred compensation. Investments in BOLI need to be covered by a risk management process that includes:
- Senior management and board oversight.
- Internal policies and procedures, such as limits on BOLI as a percentage of capital.
- Pre-purchase analysis that considers:
- Cost-benefit analysis
- Appropriate amount of insurance
- Vendor qualifications
- Review of available products
- Selection of an insurance carrier
- Review of impact on compensation to covered employees
- Ability to monitor and respond to risks
- Evaluation of alternatives
- Documentation of the decision
- Consideration of liquidity risk, since BOLI is not liquid.
- A thorough understanding of the policies acquired to assess the operational risks.
- Consideration of the exposure to reputation, credit and interest rate risks of the insurance carrier, especially given the very long-term nature of many of these investments.
- Consideration of the legal risks related to compliance.
- Consideration of the price risk for separate account policies.
The capital treatment for a general account insurance contract is to assign a 100% risk weight. In some cases, a separate account policy can qualify for lower risk weighting.
Decoding deferred compensation alphabet soup
- NQDC – Nonqualified Deferred Compensation – a “tax” label for deferred compensation plans that are not “qualified” under Internal Revenue Code section 401. (Qualified plans include 401(k) plans and other typical pension plans such as the RSI Retirement Trust.)
- SERP – Supplemental Employee Retirement Plan (also Search Engine Results Page!)
- ERISA – Employee Retirement Income Security Act of 1974 – the federal law that establishes minimum standards for pension plans, and requires testing and reporting of pension and welfare benefit plans.
- BOLI – Bank-Owned Life Insurance
- FASB ASC – Financial Accounting Standards Board Accounting Standards Codification
Disclaimer of Liability: This publication is intended to provide general information to our clients and friends. It does not constitute accounting, tax, investment, or legal advice; nor is it intended to convey a thorough treatment of the subject matter.