The motivation to enter into a deferred compensation agreement comes from one of two directions:
The agreement may be employer-motivated
. The employer can offer deferred compensation to an employee as an inducement to stay with the company; or
The agreement may be employee-motivated
. For example, an employee earning in excess of $100,000 annually may desire some tax relief. The individual may feel that he or she is not saving enough money for retirement. The employee would like to defer a portion of present income and thereby drop to a lower tax bracket. By using the salary reduction approach, highly-paid executives can gain substantial tax savings.
A wide range of employers can, and do, install deferred compensation plans: corporations, partnerships, sole proprietorships and non-profit organizations. Although the reasons for establishing these plans may be the same regardless of the type of organization, certain types of organizations have very special reasons.
A publicly-traded corporation (one whose stock is traded on an exchange or over-the-counter) are subject to some restraints on the large compensation packages they award their senior executives. In 1993, Congress amended the Internal Revenue Code to limit the tax-deductibility of certain executive compensation over $1 million. This new section, Section 162(m) states, in part: ".... In the case of any publicly held corporation, no deduction shall be allowed under this chapter for applicable employee remuneration with respect to any covered employee to the extent that the amount of such remuneration for the taxable year with respect to such employee exceeds $1,000,000. "
This denial of deductibility makes compensation for highly-paid executives more expensive for the employer. As a result, some of these organizations have looked to deferred compensation plans as an alternative way to reward their senior executives. And of course, publicly-traded corporations also employ deferred compensation plans as a way to attract and retain key executives — motivations that are very common in other organizations.
Closely Held Corporations
Closely-held corporations are not subject to Section 162, however, they have their own reasons for using deferred compensation in their executive pay packages. For example, family-owned businesses can use deferred compensation programs as an alternative to ownership interests as a way to attract or retain key executives. A closely-held corporation may not have the resources of a giant public corporation. It is more likely that such closely-held companies are unable and/or unwilling to provide the general level of compensation and employee benefits available from large public corporations. They might be able to provide competitive benefits packages, however, as long as those benefits are selective. In other words, they may be willing and able to offer one individual a generous salary and benefits arrangement but not be able or willing to provide it to all employees. It is in this kind of setting that nonqualified plans — particularly deferred compensation plans — have an important niche.
It isn't only corporations, whether public or closely held, that may install and benefit from a deferred compensation plan. Sole proprietorships, partnerships and limited liability companies may also receive benefits from such a plan, as can non-profit organizations such as charities, hospitals, private schools, country clubs, etc. Although owners of these organizations won't enjoy the tax benefits of deferred compensation, the organizations can use these plans to attract and retain non-owner executives.
Senior executives — the people most likely to benefit from a deferred compensation plan — have an important voice in the matter. As a result, it is not unusual for a senior executive to try to design his or her compensation arrangement to offer both current income tax relief, and supplemental retirement income
An executive in the top tax bracket could easily be taxed at a combined state and federal marginal income tax rate of 40 percent on the next dollar earned. By delaying receipt of income to a time when his or her marginal tax rate is lower, the executive may be able to avoid a considerable amount of income tax. Deferred compensation plans allow the executive to accomplish that. In addition, that deferred income may substantially increase the executive's income during retirement.
Moreover, the workers covered by deferred compensation may be:
employees: such as general managers, engineers or sales managers; or
independent contractors: such as hospital- or clinic-associated physicians, manufacturers' representatives or attorneys.
Sample Preapproach Letter
The following is a sample preapproach letter that may be used in approaching prospects. It is recommended that the letter be used in conjunction with a suitable brochure.
There is no doubt about the key ingredient in most business success; it is people. The continuing success of any business enterprise is largely dependent on attracting and keeping key employees. And, one of the most effective means of attracting and retaining those key employees is through corporate fringe benefits-specifically, a special retirement program designed solely for key people.
There is a plan available to businesses like yours that can provide future benefits in return for present services. Commonly known as deferred compensation, it is a systematic retirement program for key executives and top managers. This plan offers many advantages to both employees and employers-including the employer's ability to recover all costs.
Take a few moments to review the brochure I've enclosed; I think you'll find this plan an attractive approach to attracting and retaining key employees. I would like to arrange a meeting with you to explain in more detail how a deferred compensation plan can benefit your organization. I will call you next week to arrange a brief meeting.