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By John Wolf and Tom Cullen CPA
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Basic Types of Non-qualified Deferred Compensation
• Type I: Unfunded Bare Contractual Promise Plan Employee bears all risk
• Type II: Funded Company Account Plan Limited Protection:
• The employer may invest deferred amounts
• The employer may obtain life insurance to fund payment on death
• A contract can be guaranteed by third parties
• Type III: Segregated Asset Plan Must meet requirements of §83
• Subject to a substantial risk of forfeiture
Risk
As an employee with deferred benefits, it’s important to be aware of the risk involved. If the company goes bankrupt or its assets are claimed by creditors, you may lose some or all of your benefits. It’s a good idea to consider the possibility of bankruptcy and be prepared for it.
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Funded Company Account Plan – Type II
Deferred cash compensation requires a contract from the employer and can be funded by company assets. Funded plans may lead to employee taxation, but careful planning can avoid it. Learn about retirment plans
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Ownership & Segregation
The tax treatment of the employer and employee will vary based on how the deferred amounts in a funded plan are segregated and to whom they belong. If funds are set aside, they should belong to the employer, not the employee.
Funded Benefits Subject to Forfeiture
Even if the funds are improperly segregated and necessarily “belong” to the employee all is not lost. If the funded benefits are subject to a substantial right of forfeiture, employee taxation can still be deferred with appropriate action (See discussion of Type III plans and §83). The tax consequences of a non-qualified deferred compensation plan, except for incentive stock option plans, are initially determined based upon whether the plan is funded or unfunded. If the plan is funded with assets outside the company, then the next issue is whether the employee’s interest in the plan is forfeit-able or unenforceable.
Bookkeeping Reserve or Separate Account
Employers can’t transfer assets to escrow or give employees collateral. However, they can create a deferred compensation fund as long as it belongs to the employer and can be claimed by creditors. (R.R. 60-31).
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Setting Up Accounts
The assets must remain solely the property of the employer, and designation of those assets as a fund designed for future payment of deferred compensation liabilities may not, in any way, create any rights of the employee. Funds set aside for this purpose should be labeled “special account” or a similar designation on the company books to avoid any indication that those funds “must” be used for payment of deferred compensation. Similarly, the corporation should acknowledge, by Board of Directors resolution, that the funds set aside are available for paying deferred compensation liabilities or any other liabilities of the corporation.
Employee Still Bears Economic Risk
Because it is necessary that the deferred amounts remain subject to the general creditors of the employer to achieve deferral for tax purposes, the economic viability of the employer must be weighed carefully. Payroll and retirement
Limited Protection
There are methods available that have been approved by the IRS to afford the employee some limited protection. Examples are:
Investment of Deferred Amounts
Employers can invest deferred amounts while employees still qualify for tax deferral. However, invested amounts are subject to claims of general creditors. Investing wisely can increase assets to pay deferred amounts and provide some protection. Employers have the right to veto employee investment direction and cannot be obligated to hold any specific asset.
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